Question

A. Short Essay Questions

Money and Banking

1)How do economists define money? Explain. What are the three functions of money? Explain each. Explain the evolution of money. 2)What are the principal uses of funds (assets) and sources of funds (liabilities) of banks? Explain. What are the two potential problems (flaws) in our banking system? Explain each.

3)What is a bank run? Explain. How can a bank run turn into a financial panic? Explain. How can the Federal Reserve prevent banking panics? Explain. How can a bank become insolvent? Explain. How do regulators respond when a bank becomes insolvent? Explain.

Answer 1

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

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) Standard of deferred payments: Deferred payments refer to those payments which are made sometimes in the future. When we borrow money from somebody, we have to return both the principal as well as interest amount. It is difficult to make such transactions in terms of goods and services. Money performs this function most effectively.

Evolution of Money: Initially there is existence of barter system in which one good is exchanged for other without the use of money but this system has drawback of double coincidence of wants. To make transaction easier, money is evolved.