Quiz 31: Fiscal Policy, Deficits, and Debt


(a) M1 is the narrowest definition of the money supply, and only includes currency and checkable deposits. Here, Federal Reserve Notes are part of the currency, along with coins. The currency in this economy is thus equal to img . Note that we do not count currency held by commercial bank as part of currency, because it will result in double counting of M1. Next, we see that there is $1500 of checkable deposits in the economy. Hence, M1 in this economy is equal to currency plus checkable deposits, or $740 plus $1500, which is equal to $2240. (b) M2 includes everything in M1 along with near-monies , such as saving deposits (which includes money market deposit accounts), small-denominated (less than $100,000) time deposits, and money market mutual funds held by individuals. In this economy, we see that saving deposits is $140, small denominated time deposits are $100, and Money Market Mutual Funds are $400. Therefore, we have: img Note that iron ore is not a type of near-monies, and thus is not counted in M2.

Three basic function of money are:- 1. Medium of exchange- The most important function of is that it serves as a medium of exchange. Money commands general purchasing power to purchase goods and services which people want. Money is generally and widely accepted as medium through which most of the purchase or sales are made. 2. Unit of Account- The second important function of money is that it acts as a common unit of account or measure of value. Money serves as a unit of measurement in terms of which the values of all goods and services are measured and expressed. When we express the value of a commodity in terms of money, it is known as price. 3. Store of Value- Money also serves as a store of value, i.e., people can keep their wealth in the form of money. Money is a perfectly liquid asset, i.e., it is ready and generally acceptable means of payment. Money allows us to store purchasing power which can be used at any time in future to purchase goods and services, including other assets. The rapid inflation will undermine the basic function of medium of exchange because people will again shift barter system. Drastic inflation will reduce money's use as a measure value; inflation will depreciate the value of money. The country will only employ money as a unit of account when purchasing power is relatively stable. Due to drastic decrease in the value of money, the price fixers will not be able to fixe price of their goods. Money's usefulness as a store of value is destroyed in a drastic inflation. People will only use money as a store of value when there is no depreciation in the value of money. People will loose their confidence in the value of money.

Remember that the definition of M1 is: img . We see that the person withdrawing $200 from his checking account will cause checkable deposits in the economy to go down by $200, but will cause currency in the economy to go up by $200. Therefore, the net effect on M1 is zero. In other words, this transaction will not cause the M1 to change in the economy.

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