Money and Inflation

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MCD 2090 Tutorial 5
Money and Inflation
Tutorial Questions

1. What is money? What distinguishes money from other assets in the economy? Briefly explain the difference between fiat money and commodity money giving examples of each. Why current deposits are included in the supply of money?

Money is the commonly accepted set of assets in an economy that people regularly use to buy goods and services from other people. • Commodity money takes the form of a commodity with intrinsic (real) value. – Examples: gold, silver, cigarettes.

• Fiat money is used as money because of government decree. – It does not have its own value.
– Examples: coins, currency, cheque deposits.
• Current deposits are balances in bank accounts that depositors can access on demand by using a debit card or writing a cheque. These accounts serve as cash money with us.

2. What are the main functions of money? How does inflation affect the ability of money to serve each of these functions? The functions of money:
▪ Medium of exchange: “an item that buyers give to sellers when they want to purchase goods and services” ( Gans, et al., 2012. p. 680/276). It is commonly accepted by all as a medium to buy goods and services. ▪ Unit of account: “the yardstick people use to post prices and record debts” ( Gans, et al., 2012. p. 680/276). Money is used as a unit to keep accounts (for example, company accounts, prices, profits etc) ▪ Store of value: “an item that people can use to transfer purchasing power from the present to the future” ( Gans, et al., 2012. p. 680/276). ▪ Liquidity: “the ease with which an asset can be converted into the economy’s medium of exchange” ( Gans, et al., 2012. p. 680/276). Money makes an asset liquid after the asset is sold.

Inflation will cause loss of confidence in the money as such because with inflation the value of money will fall. How fast the value of money will be falling will depend upon the rate of inflation.

The fall in confidence due to loss of value of money will hamper the functioning of money. The medium of exchange, store of value and unit of account functions will not be performed very efficiently. (Students may give examples here, like storing one million dollars for buying a house in the future; how inflation will reduce the real value of this amount of money when used in the future). You may state that if due to inflation money is loosing its value, money will fail in performing its store of value function.

3. The quantity theory of money links the quantity of money in the economy with the value of money. The quantity equation expresses the relationship between economic variables.

a) Clearly explain the quantity equation and its underlying assumptions. b) Using a diagram showing the relationship between price and value of money, clearly explain how an increase in the money supply changes the price level the real value of money. c) Using a separate diagram, clearly explain how the decrease in the money supply affect the real value of money and the price

a. According to Quantity theory, there is a direct and proportional relationship between Money Supply and price level of goods and services. If the amount of money in an economy doubles, price levels also double, doubling the inflation rate.

The quantity equation:

In this equation
– the quantity of money (M)
– the velocity of circulation of money (V)
– And the dollar value (P) of the economy’s output of goods and services (Y) are related. – An increase in the quantity of money must be reflected in changes in one of the other three variables

This is a long run theory, The theory assumes that:

I. The velocity of money (V) is very stable over time II. Output...
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