Questions for Review

1. Money has three functions: it is a store of value, a unit of account, and a medium of exchange. As a store of value, money provides a way to transfer purchasing power from the present to the future. As a unit of account, money provides the terms in which prices are quoted and debts are recorded. As a medium of exchange, money is what we use to buy goods and services. 2. Fiat money is established as money by the government but has no intrinsic value. For example, a U.S. dollar bill is fiat money. Commodity money is money that is based on a commodity with some intrinsic value. Gold, when used as money, is an example of commodity money. 3. In many countries, a central bank controls the money supply. In the United States, the central bank is the Federal Reserve—often called the Fed. The control of the money supply is called monetary policy. The primary way that the Fed controls the money supply is through open-market operations, which involve the purchase or sale of government bonds. To increase the money supply, the Fed uses dollars to buy government bonds from the public, putting more dollars into the hands of the public. To decrease the money supply, the Fed sells some of its government bonds, taking dollars out of the hands of the public. 4. The quantity equation is an identity that expresses the link between the number of transactions that people make and how much money they hold. We write it as Money × Velocity = Price × Transactions M × V = P × T. The right-hand side of the quantity equation tells us about the total number of transactions that occur during a given period of time, say, a year. T represents the total number of transactions. P represents the price of a typical transaction. Hence, the product P × T represents the number of dollars exchanged in a year. The left-hand side of the quantity equation tells us about the money used to make these transactions. M represents the quantity of money in the economy. V represents the transactions velocity of money—the rate at which money circulates in the economy. Because the number of transactions is difficult to measure, economists usually use a slightly different version of the quantity equation, in which the total output of the economy Y replaces the number of transactions T: Money × Velocity = Price × Output M × V = P × Y. P now represents the price of one unit of output, so that P × Y is the dollar value of output—nominal GDP. V represents the income velocity of money—the number of times a dollar bill becomes a part of someone’s income. 5. If we assume that velocity in the quantity equation is constant, then we can view the quantity equation as a theory of nominal GDP. The quantity equation with fixed velocity states that MV = PY. If velocity V is constant, then a change in the quantity of money (M) causes a proportionate change in nominal GDP (PY). If we assume further that output is fixed by the factors of production and the production technology, then we can conclude that the quantity of money determines the price level. This is called the quantity theory of money. C H A P T E R 4 Money and Inflation