Question

1. What are the three basic functions of money? Describe how rapid inflation can undermine money’s ability to perform each of the three functions.

2. Which two of the following financial institutions offer checkable deposits included within the M1 money supply: mutual fund companies; insurance companies; commercial banks; securities firms; thrift institutions? Which of the following items is not included in either M1 or M2: currency held by the public; checkable deposits; money market mutual fund balances; small-denominated (less than $100,000) time deposits; currency held by banks; savings deposits?

3. What “backs” the money supply in the United States? What determines the value (domestic purchasing power) of money? How does the purchasing power of money relate to the price level? Who in the United States is responsible for maintaining money’s purchasing power?

4. How is the chairperson of the Federal Reserve System selected? Describe the relationship between the Board of Governors of the Federal Reserve System and the 12 Federal Reserve Banks. What is the purpose of the Federal Open Market Committee (FOMC)? What is its makeup?

Answer 1

1.What are the three basic functions of money? Describe how rapid inflation can undermine money's ability to perform each of the three functions?

In any economy money has three basic functions.Money serves as a medium of exchange,a store of value and an unit of account.Let us know more about these three basic functions.

a>Medium of exchange- One of the most important functions of money is that it serves as a medium of exchange.It helps to facilitate transcations so that we do not have to face the difficulty of barter trade where double coincidence of wants is a prerequisite in order to obtain goods.We can buy any good by simple exchange of money for it.

b>Store of value- Money does not deteriorate.It can be stored and saved and put to use in the future for the purpose of making transctions.It can be saved for some period of time and still remain valuable for the purpose of exchange and thus it is used as a medium of exchange.

c>Unit of account-The value of various goods and services are expressed in the form of money.It serves as a common measure of value,which facilitates transactions for buyers and sellers.All transactions are undertaken using money.

Now let us understand what effect inflation has on the above mentioned functions of money.

We know that inflataion is a situation where the prices of various goods ans services increases.During inflation there is a large amount of money which chases a relatively small amount of goods and services.It therefore undermines money in performing its basic functions.

During inflation money as a medium of exchanage looses its value as people realise that the quantity or quality of the goods or services is decreasing or declining.People accept money as a medium of exchange when there is certainty that it will retain its value form the time that they recieve it till the time they want to spend it.

During inflation the prices of goods and services do not represent the goods value as they increase drastically.It becomes impossible to adjust the prices of goods and services in line with their relative value.The situation is a boon for speculators who make a profit at the expense of the non speculators who no longer trust money as a measure of value.

During inflation money as a store of value decreases as more quantity of money is required in order to buy a good or service.It simply means that a dollars worth decreases in time of inflation.When we apply the rule of 70 we can determine how long it will take a dollar to loose half of its value or puchasing power.By dividing the rate of inflation into 70 we can figure out how long it would take money to loose its purchasing power by half.

Thus explained the three basic functions of money and how inflation affects eacah one of them.