The Economics of Money and Prices: Conceptual Questions

Problem 1. Which of these are basic functions of money? More than one answer may be correct.

(a) Hedge against price inflation.
(b) Unit of account.
(c) Tool used for barter.
(d) Store of value.
(e) Medium of exchange.
(f) Automatically appreciating asset.
(g) Measure of one's intrinsic human worth.
(h) The root of all evil.

Solution 1. The three basic functions of money are its usefulness as a medium of exchange, a store of value, and a unit of account. Holding money tends to be a poor decision when there exists dramatic price inflation, and money is designed to avoid, not facilitate, barter. Money does not always appreciate automatically in value, except in times of deflation. Furthermore, money is neither a measure of one's intrinsic human worth nor the root of evil - Paris Hilton and St. Paul notwithstanding. Thus, (b), (d), and (e) are correct answers.

Problem 2. Which of these are motives for holding money? More than one answer may be correct.

(a) Speculative demand
(b) Legal tender laws
(c) Effective demand
(d) Precautionary demand
(e) Aggregate demand
(f) Transactions demand
(g) Exchange demand

Solution 2. The three motives for holding money are transactions demand (f) - as many everyday activities and transactions involve spending cash or writing cash - precautionary demand (d) - as money may be needed for unforeseen future contingencies, and speculative demand (a) - resulting from one's uncertainty about the value of money and other assets. Thus, (a), (d), and (f) are correct answers.

Problem 3. Which of these is a valid formula for L, the demand to hold money?

(a) L = MP - where M is the money supply, P is the price level
(b) L = P/M - where M is the money supply, P is the price level
(c) L = M/P - where M is the money supply, P is the price level
(d) L = MV - where M is the money supply, V is the velocity of circulation
(e) L = V/M - where M is the money supply, V is the velocity of circulation

(f) L = M/V - where M is the money supply, V is the velocity of circulation

Solution 3. The correct formula for the demand for money is L = M/P, i.e., answer (c).

Problem 4. Which of these is true about L(i, Y), the demand to hold money? Here, i is the interest rate, and Y is income. More than one answer may be correct.

(a) ∂L/∂i < 0, i.e., L_i (b) ∂L/∂i = 0, i.e., L_i = 0
(c) ∂L/∂i > 0, i.e., L_i > 0
(d) ∂L/∂Y < 0, i.e., L_Y (e) ∂L/∂Y = 0, i.e., L_Y = 0
(f) ∂L/∂Y > 0, i.e., L_Y > 0

Solution 4. If the interest rate i increases, this will reduce the demand to hold money, so L_iY > 0. Thus, (a) and (f) are correct answers.

Problem 5. Which of these are characteristic of a gold standard as historically practiced? More than one answer may be correct.

(a) Fluctuating foreign exchange rates.
(b) Fixed exchange rates among different currencies.
(c) Inflationary central bank tendencies.
(d) Free convertibility of currencies into one another.
(e) Fixed rates of economic growth.
(f) Requirements for occasional explicit cooperation among governments.
(g) Strong public distrust in the value of the national currency.
(h) The impossibility of running perpetual trade surpluses.

Solution 5. A historical gold standard involved fixed gold parity rates in each country - which led to fixed and stable exchange rates among national currencies. So (a) is false and (b) is true. A gold standard kept inflation to a minimum and sometimes was even deflationary; it also gave central banks little discretion, so (c) is false. A gold standard required free convertibility of currencies, so (d) is true. It by no means fixed economic growth (as if anything can!), so (e) is false. The gold standard did require occasional coordination among governments, so (f) is true. Since the gold standard was not inflationary, there was no reason for the public to distrust its value, so (g) is false. David Hume's specie-flow mechanism demonstrated that, under a gold standard, perpetual trade surpluses are impossible, and so mercantilist attempts to run them were self-defeating.

See Mr. Stolyarov's complete index of Intermediate Macroeconomics Problems and Solutions here.