Money and Interest Rates 1. List and define the 3 main functions of money 2. Exp

Question

Money and Interest Rates 1. List and define the 3 main functions of money 2. Explain the difference between Commodity Money and Fiat Money 3. Which kind of Money does the U.S. use? 4. Pages 202-203 of your text book describe the relationship between the price of bonds and interest rates in the economy. Study that section and answer the following question. Assume that this bond lasts a lifetime and the income you get for keeping the bond stays the same each year Let P the price for buying the bond Let C= coupon which is the amount the owner of the bond gets each year in income Let 1 = interest rate the owner of the bond could get if she put her money in a savings account (instead of using it to buy a bond) Then the following formula is true a. Now, let's say that the interest rate F. 10, and the coupon c= 10, what is the price of the bond'? (show your work) b. Now let's say the interest rate falls to i.05. What happens to the price of the bond? (remember, C stays the same) (show your work) Can you explain your answer to b?

Explanation / Answer

1-Money is widely accepted medium for exchange of goods and services. Almost all activities in an economy is directly and indirectly related with money. It has three main functions i.e.,

Exchange of Goods and Service:

Money is used for exchange of goods and services in the market. We purchase goods and services either from retail market or online store. Each good or service has specific price at which customers buys from the market. For example if you need to purchase milk or milk products then first you must visit local dairy shop and ascertain the price of dairy product that you need to buy. If the price of 500 ml. milk packet is Rs. 24 and you need to purchase 2 kg of milk then you need to spend 4*Rs.24= Rs.96 for purchase.

Store of Value:

Money has also a stored value for specific period. For example if you earn Rs. 500 daily from your work then you have stored value of purchasing 10 kg flour & 10 kg, rice considering current price of flour= Rs. 20/kg, rice= Rs. 30/kg. The stored value of money erodes over period of time due to inflationary trends in the market. Considering if price of certain commodities fall then stored value of your earned money increases.

Unit of Account:

Money also functions as unit of account i.e., it is measured in terms of quantity of goods or volume of services that sellers decide to sell to customers. Similarly it also helps the customers in ascertaining exact quantity of goods and services that they can purchase from the shops.

2- Commodity money is the value of the commodity that is used for its making i.e., gold, silver, copper etc. It is just like an exchange medium that customers can use for buying items from the market. For example, if you use one gold coin for buying items, then seller will measures its actual value in term of gold and then sell items of that specific value.

Flat money also called paper currency is the legal tender approved by a state. It is just like purchase voucher of specific amount that people can use for exchange of goods and services. Similarly it can also be used for paying off debts by individuals, government or institutions.

The major difference between commodity money and flat money is that commodity money always complete the monetary transaction whereas flat money never completes the transaction, it just discharge transaction with promise or obligation for final transaction. Furthermore, flow of flat money is controlled by the political government and it can be controlled or scrapped as and when government decides.

3- United States use flat currency dollars made of cotton fibre paper unlike paper used by many countries.

4- there is inverse relationship betweeen bond price with interest rate. Thus if interest rate falls to i= .05 then price of the bond will rise.

Given P = C//i, i= 10, C=10, then P=10/10=1

Again if i=.05 and C=10 then P= 10/.05= 10*100/5=200

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