Money & Banking

1. If velocity of money is constant; real growth in the output of the economy is between -1.5% and +2.5%; and inflation is between -1% and 2.0%; what is the growth rate of money?
Velocity of Money: the rate at which money changes hand. As we know, velocity of money is equal to the price multiplied by output divided by money supply. Mathematically, If velocity of money is constant, then, M  (P  Y)

Thus, in terms of growth rate, Inflation Rate = Money Growth Rate + Growth Rate of Velocity  Growth Rate of Real GDP (2% - (-1%)) = Money growth rate + 0 - (2.5% -1.5%) Money growth rate = 3% + 1% Therefore, Money growth rate = 4%

2. The CPI is a commonly used and closely watched measure of inflation. However, it has limitations. What are they?

True. The CPI is the most commonly used and closely watched measure of inflation. However, the CPI has several limitations which may cause a higher rate of inflation getting reported.

Some of the limitations of using CPI are as follows:
The CPI fails to adjust for improvements in quality.
The weights used to add together the prices of different goods and services that go into the index are often out-of-date. Thus, the CPI are increasingly outdated and hence fail to accurately reflect changing consumer patterns Consumers often substitute away from goods that are increasing in price.
3. Assuming a constant nominal GDP, would the velocity of M1 equal the velocity of M2? Explain."
Yes, if the nominal GDP is constant, the velocity of M1 will be equal to the velocity of M2. M0 and M1, for example, are also called narrow money and include coins and notes that are in circulation and other money equivalents that can be converted easily to cash. M2 included M1 and, in addition, short-term time deposits in banks and certain money market funds.

An increase in the supply of money typically lowers interest rates, which in turns generates more investment and puts more money in the hands of consumers, thereby stimulating spending.
But if the nominal GDP is constant, the velocity will be equal since If velocity of money is constant, then, M  (P  Y)
Then M1 = M2

4. Why inflation is higher than money growth in high-inflation countries and is lower than money growth in low-inflation countries? Explain in detail using correctly labeled graphs.
According to the quantity equation, the inflation rate and the rate of money growth are closely linked. It means that inflation could always be traced to excessive money growth.
Inflation is higher than money growth in high-inflation countries and is lower than money growth in low-inflation countries. There are certain mechanisms to support this:
First, when economic growth is high and wages are rising rapidly, there may be less public opposition to inflation.
Second, whenever there is lots of growth, markets are forward-looking and the supply of credit outraces the growth of the moment
The above figure clearly indicates that countries with high money growth are the countries that experience high inflation. If you were to draw a line through the points that came as close as possible to them, that line would have a positive slope
5. Consider an island where people use sand dollars (shells) as currency. For simplicity, assume that people consume only one good: fish. Currently, there are 400 sand dollars in circulation and there are 200 fish purchased each year. Based on this information, what is the price of fish?

Now, suppose that a change in climate leads to new sand dollars washing ashore, leaving a total of 500 sand dollars. If there are still 200 fish purchased each year, what is the new price of fish? In order to prevent inflation, what would have to happen to the amount of fish purchased each year?

There are 400 sand dollars (shells) as currency and 200 fish purchased each year

Price of fish = 400/200 = 2 sand dollars

Thus, price of fish is 2 sand dollars

Now, there are 500 total sand dollars and still 200 fish purchased each year, then new price of fish = 500/200 = 2.5 sand dollars

New price of fish = 2.5 sand dollars

In order to prevent inflation, there should be more money supply (sand dollars) in the market which means that consumer will demand more good (fish) for consumption. Thus, demand for fish will increase to 250 fish purchased each year when 500 sand dollars are available. This increasing demand will pull the price down to its original level (2 sand dollars)

6. Explain how money solves the problem of the "double coincidence of wants."

Money solves the problem of double coincidence of wants by acting as a medium of exchange. If a shoe manufacturer wants to sell shoes in a market and buy rice under barter exchange, both parties selling shoes and rice have to agree to sell and buy each other’s commodities and this creates a problem called double coincidence of wants. This problem is solved by money. A person holding money can easily exchange it for any commodity. This means that everyone prefers payments in money and get money for what they want to sell .Here the shoe manufacturer will first exchange shoes for money and then exchange the money for rice.

7. Suppose there is an economy that has 100 people each of whom makes a different good, and that they use a barter system for exchange. How many relative prices will there be?

There will be (100)2 = 10,000 relative prices for the goods. Since it’s a barter system, one person has an option of selling his commodity to remaining 99 people and each person will have a different good to exchange for his/her commodity.

8. And what distinguish fiat money from commodity money? Explain.
Commodity money is different from fiat money in two respective ways;
First, under commodity system, the money supply adjusts automatically to monetary needs whereas under fiat monetary system, the money supply is regulated artificially. The Central bank decides how much money to create and issue.
Second, the value of commodity money is directly proportional to the material of which it is made whereas the value of money is independent of its material and depends solely on the demand and supply of money.
Third, an example of commodity money is gold or metal coins whereas fiat money is simply a purchase voucher.
9. Explain why credit cards are not considered money even though people seem to use them like money.

Credit cards are not considered as money even though people seem to use them like money because credit card purchase is a loan, a promise to pay back in the future and hence it does not fall under the definitions of money supply. Also, Money is considered as a very liquid asset which can be quickly converted to cash or used as cash. On the contrary, credit cards work as a loan. If you buy the game using a credit card, the credit card company will pay the shopkeeper today and you will have an obligation to pay the credit card company when your credit card bill comes in. This obligation to the credit card company does not represent money.