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Frederic S. The traveler also saves the costs of exchanging currencies. Why might each of the following commodities not serve well as money? LO2 a. Tomatoes b. Bricks c. Cattle Answer: a. Tomatoes are perishable and thus would not serve as a store of value.
Bricks are heavy and bulky and will break easily. In addition, even though bricks break easily, they are not easily divisible into usable units. Cattle are not standardized in terms of weight and other potentially important characteristics. What will be the impact of this discovery on the economy? Theoretically, inflation could result if the supply of money was increased by a large enough amount. You receive a check drawn on another bank and deposit it into your checking account.
Would your answer change if the check is drawn on the account of another customer of your own bank? LO2 Answer: Funds drawn on another bank are not immediately available i.
So, when you deposit a check drawn on another bank, you must wait until your bank obtains the funds from the other bank. Over a nine-year period in the 16th century, King Henry VIII reduced the silver content of the British pound to one-sixth its initial value.
Why do you think he did so? What do you think happened to the use of pounds as a means of payment? If you held both the old and new pounds, which would you use first, and why? LO1 Answer: King Henry needed to silver to pay for wars. The use of pounds as a means of payment declined because people could not be sure how much silver each coin contained.
People spent the new coins first since the old coins had a higher intrinsic value. Under what circumstances might you expect barter to reemerge in an economy that has fiat money as a means of payment? LO2 Answer: You might expect an economy to revert to barter when the public loses confidence in the fiat money issued by the government, perhaps because of over-use of the printing presses. You visit a tropical island that has only four goods in its economy — oranges, pineapples, coconuts and bananas.
There is no money in this economy. LO1 a. Draw a grid showing all the prices for this economy. An islander suggests designating oranges as the means of payment and unit of account for the economy. How many prices would there be if her suggestion were followed? Do you think the change suggested in part b is worth implementing?
Why or why not? Answer: a. There would be six prices in total. Oranges Pineapples. In the case of this four-good economy, there is only a small gain by using oranges as a unit of account. The gains would be significantly bigger in an economy with more goods. If the islanders think the range of goods in their economy is likely to expand, then it is probably worth implementing the change. One of the drawbacks to consider would be the danger that more people would grow oranges, due to their special status, thus pushing up the prices of the other fruits in terms of oranges.
Consider again the tropical island described in Problem Under what circumstances would you recommend the issue of a paper currency by the government of the island? What advantages might this strategy have over the use of oranges as money?
LO1 Answer: The islanders must have enough confidence in their government to accept notes backed only by a government decree that have no intrinsic value themselves. The have to believe that these notes will be widely accepted by other islanders as final payment for goods and services and in settlement of debts.
They must trust that the government will not print too much of the money and undermine its value. Some advantages of the paper money over commodity money in the form of oranges include: being easier to carry, longer lasting and more divisible. Most importantly, it would be the government that would control the supply of money on the island as only the government could print new notes, while any of the islanders might decide to grow more oranges.
What factors should you take into account when considering using the following assets as stores of value? Gold b. Real estate c. Stocks d. Government bonds Answer: a. The potential for the price of gold to rise, the ability to buy and sell gold easily and any costs associated with storage and security. The rate at which real estate is appreciating and is likely to appreciate in the future; how easy or difficult it is to sell real estate; the housing services you could receive from holding the real estate.
The potential appreciation in nominal value of the stock; the historical volatility of the stock price; the volume of the stock being traded on the secondary market to gauge its liquidity. When assessing an asset as a store of value, the primary things to consider are the risk and return of the asset and its liquidity. LO1 Answer: If there were deflation in the economy, then paper currency would increase in value.
When deflation occurs, overall prices in the economy are falling and so the currency you hold has more purchasing power. During periods of falling prices of goods and services, prices of assets often fall too and so currency might be an attractive option as a store of value.
Suppose a significant fall the price of certain stocks caused the market makers in those stocks to experience difficulties with their funding liquidity. Under what circumstances might that development lead to liquidity problems in markets for other assets? This, in turn, reduces loans available for other market participants potentially causing them to alter their behavior and could lead to funding liquidity problems throughout the financial system.
Moreover, to fund itself, the market maker might try to sell other assets, depressing their prices and spreading the disruption. Suppose the inflation rate based on the consumer price index is higher during the year than that based on the GDP deflator. Assuming underlying tastes and preferences in the economy stay the same, what can you say about food and apparel price movements during the year?
LO3 Answer: Since the two price indices yield different inflation rates with preferences remaining constant, the relative price of the two goods must have changed. In other. This would induce consumers to substitute away from apparel to food. As a fixed weight index, the CPI would not take this substitution into account while the GDP deflator would, as it is calculated on the basis of what is actually purchased.
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