Question

Consider how the following situations would affect the economy’s monetary system.

a. Suppose that the people on Yap discovered an easy way to make limestone wheels. How would this development affect the usefulness of stone wheels as money? Explain

b. Suppose that someone in your country discovered an easy way to counterfeit the legal currency notes which circulate in your economy. How would this development affect the monetary system? Explain

Answer 1

Part a) Given the fact that people on Yap can now easily make limestone wheels that can be used as money, will result in an increase in the money supply in the economy.

For a given level of income, an increase in the money supply causes interest rate to decline as additional money will now be used for speculative purpose pushing the price of bonds up and their yield down. Decline in the interest rate will result in increased investment as firms will now find it cheaper to borrow for investment in plants and machinery. So, there will be inflationary pressure in the economy due to artificial increase in the aggregate demand created by people creating money on their own.

Part b) Increase in counterfeit currency would undermine the legitimacy and credibility of the economy’s monetary system. As a result of this people are more likely to put their confidence in some other more stable and strong currency, as US dollar sometimes become unofficial currency in countries where monetary authorities loses credibility and confidence of the people. This is because, money supply is altered by the monetary authority to ensure moderate inflation so that real money supply is optimum or purchasing power of money is not adversely reduced.

Now, with the addition of counterfeit currency there will be an increase in the money supply in the economy. For a given level of income, an increase in the money supply causes interest rate to decline as additional money will now be used for speculative purpose pushing the price of bonds up and their yield down. Decline in the interest rate will result in increased investment as firms will now find it cheaper to borrow for investment in plants and machinery. So, there will be inflationary pressure in the economy due to artificial increase in the aggregate demand created by people creating money on their own.