Question

Q14.1 What are the functions of money? Q14.2 How does the existence of money simplify the process of buying and selling? Q14. 3 What is the double coincidence of wants? Q14.4 What components of money are counted in M1? Q14.5 What components of money are counted in M2? Q14.6 How can a bank end up with a negative net worth? Q14.7 What is the asset-liability time mismatch that all banks face? Q14.8 How do banks create money? Q15.1 Why is it important for the members of the Board of Governors of the Federal Reserve to have longer terms in office than elected officials, like the President? Q15.2 Why does contractionary monetary policy cause interest rates to rise? Q15.3 Describe the three traditional tools that a central bank has for controlling the money supply. Q15.4 Explain how expansionary, tight, contractionary, and loose monetary policy affect aggregate demand? Q15.5 Explain what the basic quantity equation of money is. Q16.1 How will a stronger euro affect the following economic agents? a. A British exporter to Germany b. A Dutch tourist visiting Chile c. A Greek bank investing in a Canadian government bond d. A French exporter to Germany Q16.2 Suppose Argentina gets inflation under control and the Argentine inflation rate decreases substantially. What would likely happen to the demand for the Argentine pesos, the supply of Argentine pesos, and the peso/U.S. dollar exchange rate? Q16.3 How would a contractionary monetary policy affect the exchange rate, net exports, aggregate demand, and the aggregate supply? Q16.4 What is the difference between a floating exchange rate, a soft peg, a hard peg, and dollarization? Q16.5 Why would a nation "dollarize"- that is, adopt another country's currency instead of having its own?

Answer 1

Q14.1 Money has three main functions. They are medium of exchange, store of value and unit of count. It acts as a medium through which goods are exchanged. It stores wealth avoiding the disadvantage of barter where the value of the wealth held in terms of a particular good can reduce. It also acts as a unit of count where all the goods can be measured in common terms.

Q14.2 Before the invention of money, barter system was existing. Good had to be exchanged against goods. Which meant one would exchange apple for oranges. For exchange, you should have various criterion like double coincidence of wants and willingness to exchange. These are removed by the invention of money where money is used to buy goods and sell goods.

Q14.3 Double coincidence of wants is a necessary condition in barter system. It means, you can exchange only if you find a party willing to accept what you offer and you shouold also want what the other party has. Without this, an exchange cannot happen.

Q14.4 M1 is called narrow money and its components include all coins and notes in circulation in the economy and includes all liquid assets that can be easily converted to money.

Q14.5 M2 is broader compared to M1 and is called near money. It includes short term deposits in the banks and also money market funds for short term.

Q14.6 Negative networth is a situation in the balance sheet of a firm when their liabilities are more than the assets. Banks also can end with negative net worth. Liabilties that banks have are deposits by people and assets are the loans disbursed. This will happen when the bank has many NPAs which is non performing assets and also when the asset value plummets down whereby the liabilities overweighs the asset value of the bank.

Q14.7 Asset liability mismatch is a scenario that all banks face due to the time line difference for assets and liabilities. The liabilities for banks are the public deposits which has short term as well as long term. The assets of the bank however are loans like home loans which are long ter. Hence there is a time gap between assets and liabilities.

Q 14.8 Most of the money in the economy is created by the banks in form of loans. They convert the deposits they get into loans for different people thereby pumping the money into the economy. The deposit will still reflect under a person's name by the banks create loans to others on the back of this deposit thereby creating money in the economy.

Q15.1 It is important for the board of governors in the federal reserve to have a longer term because of the lag in the economy itself. Any macroeconomic reform will take sometime to show its impact on the economy. The reason and plans behind the policy will be known to the board. Any change immediately will put new people on the board who might not know the actual magnitude of the policy and they might bring in policies that do more harm than good.

Q15.2 In a contractionary monetary policy, the central bank wants to curb the money supply in the economy. They increase the interest rates to curb the money borrowed in the economy. They increase the repo rates with commercial banks. These banks inturn, increase the rates for the public. The other way of looking at this is, since the cenral bank is trying to soak the excess money in the economy, there is lesser cash available for investments. Hence there are too many people trying to chase this money causing the interest rates to shoot.

Q15.3 The three traditional tools are open market operation, bank rate and cash reserve ratio.

Q15.4 In expansionary monetary policy, the central bank pumps in money into the economy. If the economy has not reached full employment level, then the money will help in creation of goods and income and hence aggregate demand will increase with multiplier effect. In contractionary monetary policy, the central bank ejects the money from the economy. Hence the withdrawal of spending will affect the economic activity and will lower the aggregate demand. In loose monetary policy, the central bank does not keep reign on the interest rates. It lets the economy grow and pumps cash but not to the extend of the expansionary policy. The aggregate demand would increase here where as in tight policy, the funds in the economy will be less and hence the aggregate demand cannot grow.