Deck 13: Money and the Financial System

Question 1

FUNCTIONS OF MONEY What are the three important functions of money? Define each of them.

Answer 1

Following are the three major functions of money:
In barter system, people trade their goods in exchange of others good; but if a seller wants to sell his/her good without buying another trader's good, then the trade may not take place. Thus, to avoid such a situation, money has been introduced.
Medium of exchange:
Medium of exchange refers to anything which is accepted in terms of payment for the exchange of goods between traders in the market.
Unit of account:
Another major function of money is that, it can measure the value of a product in the form of quantity. In barter system, a major difficulty was to identify the standard of measure, i.e., how much quantity has to be given in terms of exchange of other goods. Hence, money has served as a unit of measure.
Store of value:
Money is considered as a store of value as it stores surplus purchasing power and helps in accumulating capital formation in future. Money can be stored for a long period in the form of security and also the possibility to destroy is less.

Question 2

Identify three functions of money and six qualities of the ideal money
(Ideal Money) What are six qualities of the ideal money?

Answer 2

The six qualities of ideal money are as follows -
1. Durability - Ideal money should be one that can able to maintain its quality over a long-period of time. Easily perishable commodity cannot act as money as its quality will deteriorate over time and thus would have no value or decreased value for transaction purpose.
Thus, ideal money is one that is durable enough to stood test of time.
2. Portability - Ideal money should be one that can be carried easily. If the commodity chosen as money is bulky then it would be difficult to carry it over long distances for transaction purpose. Thus, ideal money should be one that is portable enough.
3. Divisibility - Third important quality of ideal money is that it should be possible to divide it in smaller units. This divisibility will enable the transactions that involve values in fraction otherwise it would be difficult to undertake transactions that have values in fraction. Divisibility will give freedom to fix price even in fraction as well.
So, ideal money should be one that can be divided into smaller units.
4. Uniform quality - The quality of commodity or thing to be used as money should be uniform or same. This means there should not be subset of quality. If two qualities of thing used as money exist then in that case people will use inferior quality for trading and good quality for safe-keeping.
This will lead to circulation of inferior quality money which can reduce acceptability.
Thus, ideal money should have uniform quality so that no such thing happens and acceptability remains constant.
5. Opportunity cost should be low - This means that the commodity used as money should not led to tying up of otherwise valuable resources. For example, if wheat is being used as money then in that case that wheat (used as money) would not be available for making bread, flour etc. This means opportunity cost of wheat is high and thus wheat would not be ideal money.
Ideal money should be one that leads to tying up of fewer resources thereby making available larger resources for other uses.
Hence, ideal money is one that have low opportunity cost.
6. Stable value - Ideal money should be one whose value remains stable overtime because stable value overtime induces people to accept this for exchange and holding purpose as they know that its value will not deteriorate in coming future.
Thus, ideal money should be one whose value remains relatively stable overtime.

Question 3

ORIGINS OF BANKING Discuss the various ways in which London goldsmiths functioned as early banks.

Answer 3

Goldsmith: a banker
The London goldsmiths were offering deposits and lending money to the needy. For safekeeping, an individual can deposit money with the goldsmith. At the same time, the goldsmith can lend the deposited money to another person and earn rate of interest. Moreover, written instruction of goldsmith was used as a check.
For example, if a goldsmith issues the written instruction worth of 200 Euros to a lender, then the lender spends the written instruction without producing any evidence. In this way, in early time, goldsmiths played the role of a banker.

Question 4

TYPES OF MONEY Complete each of the following sentences:
a. A product that serves both as money and as a commodity is _______.
b. Most coins and all paper money circulating in the United States have face values that exceed the value of the materials from which they are made. Therefore, they are forms of _______.
c. If the government declares that creditors must accept a form of money as payment for debts, the money becomes _______.
d. A common unit for measuring the value of every good or service in the economy is known as a(n) _______.

Question 5

FIAT MONEY Most economists believe that the better fiat money serves as a store of value, the more acceptable it is. What does this statement mean? How could people lose faith in money?

Question 6

THE VALUE OF MONEY When the value of money was based on its gold content, new discoveries of gold were frequently followed by periods of inflation. Explain.

Question 7

DEPOSITORY INSTITUTIONS What is a depository institution, and what types of depository institutions are found in the United States? How do they act as intermediaries between savers and borrowers? Why do they play this role?

Question 8

Explain what is meant by a fractional reserve banking system
(Depository Institutions) Explain why a bank typically holds as reserves only a fraction of its deposit liabilities? In light of this arrangement, why is it important that depositors have confidence in their bank's health?

Question 9

Describe the Fed, summarize its two mandated objectives, and outline some of its other goals
(Federal Reserve System) What are the main powers and responsibilities of the Federal Reserve System? What are its two mandates and some of it's other goals?

Question 10

Describe subprime mortgages and the role they played in the financial crisis of 2008
(Subprime Mortgages) What are subprime mortgages, and what role did they play in the financial crisis of 2008?

Question 11

Describe subprime mortgages and the role they played in the financial crisis of 2008
(Bank Deregulation) Some economists argue that deregulating the interest rates that could be paid on deposits combined with deposit insurance led to the insolvency of many depository institutions during the 1980s. On what basis do they make such an argument?