Question

3) Explain the three ways money is used. What are the components of M1? M2? Explain the two types of money and give examples. When did we leave the gold standard and why?

5) Define an equity security and a debt security. What makes them different? Give an example of each. How does trading occur in each of these markets? How can diversification reduce portfolio risk, explain what that would look like in holdings?

Answer 1

3) Money is anything which is generally acceptable as a medium of exchange. Functions of money includes:

a) Medium of Exchange: It means that money acts as a medium for the sale and purchase of goods and services. In the absence of money, goods were exchanged for goods. This required double coincidence of wants. Accordingly, an exchange was difficult, and therefore limited. The introduction of money has separated the acts of sale and purchase: a double coincidence of wants is no longer required. The exchange is now much simpler and is, therefore, unlimited. This has raised the overall level of economic activity in an economy.

b) Measure of Value or Unit of Value: Money serves as a measure of value in terms of unit of account. Unit of account means that the value of each good or service is measured in the monetary unit. Measurement of value was very difficult in the barter system: one good was valued in terms of the other. There was no common unit of value. An introduction of money has removed this difficulty. Now, each good is valued in terms of money.

c) Store of Value: Store of value implies store of wealth. Storing wealth has become considerably easy with the introduction of money. Stored wealth is a source for future investment. It was not convenient to store value in the barter system of exchange because goods tend to wear out or perish. On the other hand, it is convenient to store value in terms of money because money has the merit of general acceptability, value of money remains relatively stable compared to other commodities.

M1 Measurement:

M1 = C + DD + OD

Here, C refers to currency and includes coins and paper notes held by the public.

DD refers to demand deposits of the people with the commercial banks. These are cheqable deposits which can be withdrawn or transferred on demand

OD are other deposits which includes:

(i) Demand deposits with RBI of public financial institutions like IDBI.

(ii) Demand deposits with RBI of foreign central banks and of the foreign governments.

(iii) Demand deposits of international financial institutions like IMF and World bank.

M2 Measurement:

It is a broader concept of the supply of money compared to M1. Besides all the components of M1, it also includes savings of the people with the post offices. Thus,

M2 = M1 + Deposits with post office saving bank account

Types of money:

1. Fiat money refers to money by order of the government. It includes notes and coins.

2. Fiduciary money refers to money backed up by trust between the payer and the payee. Example: Cheques

At present, no country backs its currency with gold, but many have in the past, including the U.S. The U.S effectively abandoned the gold standard in 1933, and completely severed the link between the dollar and gold in 1971.

Gold standard do not allow the Fed to redeem dollars with gold. Inflation usually resulted, but for the most part abandoning the gold standard created more economic growth.