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Money in a Modern Economy and its Impact on Prices

Explain what is used as money in a modern economy and how an increase in the quantity of money can cause prices to rise. (8)

Category:

Macroeconomic Factors and Policies

[CIE AS level November 2016]

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Answer

Tip : It is NOT required for the question set to describe the functions of money and the problems associated with the barter system of trade.


Step ➊ : Define money.

A simple definition of money is that it is anything that is regularly used to buy goods and services. Money can take various forms.


Step ➋ : Explain what is used as money in a modern economy.

Money is generally cash in the form of coins and notes but the definition also includes bank deposits, cheques, debit cards and credit cards. To be acceptable from a day to day practical standpoint, money must also be portable and durable.

Economists also talk about near money. This is a term that is used to denote non-cash assets that can be quickly and easily turned into cash. Such assets include foreign currencies, savings accounts, bonds and certificates of deposits. Like assets, they contribute to the liquidity of banks by providing a supply of cash if this is needed to meet their liabilities to depositors.

Money can also be in the form of a valuable commodity such as gold or platinum. In Russia, for example, oil has been widely exchanged for imports such as buses and trucks from Hungary or agricultural goods from Poland.


Step ➌ : Explain how an increase in the quantity of money can cause prices to rise.

An increase in the quantity of money can cause prices to rise. Monetarists argue that the key cause of higher aggregate demand is increases in the money supply. They suggest that if the money supply grows more rapidly than output, the greater supply of money will drive up the price level.

Over-expansion of the money supply can also create demand-pull inflation. When Increasing the money supply faster than the growth in real output will cause inflation. The reason is that there is more money chasing the same number of goods. Therefore, the increase in monetary demand causes firms to put up prices.

If the money supply expands, it lowers the value of the currency. When the national currency decline relative to the value of foreign currencies, the price of imports rises. That increases prices in the general economy as well.

The monetarist explanation of inflation operates through the Quantity Theory of Money, M V = P T where M is the money supply, V is the velocity of circulation, P is the price level and T is total transactions or output. As monetarists assume that V and T are determined, in the long run, by real variables, such as the productive capacity of the economy, there is a direct relationship between the growth of the money supply and inflation.


Step ➍ : Conclude.

In a modern economy, money is made up of cash and bank deposits. These are generally accepted in payment of the debt. If money supply grows more rapidly than output, the greater supply of money will drive up the price level.


Mark Scheme ♕

For knowledge and understanding of ‘money’ in a modern economy. (Up to 4 marks)
• For an understanding of what is meant by money in terms of its general acceptability in settlement of debt or as a medium of exchange when purchasing goods and services (1 mark)
• For explaining what acts as money in a modern economy: cash and bank deposits (Up to 3 marks)
If there is no reference to bank deposits 2 maximum.
For elaboration reward recognition of modern methods of transferring bank deposits for example cheques and contactless payments and what is meant by ‘near money’.
4 marks maximum
For application showing how an increase in the money supply can cause an increase in aggregate expenditure and demand-pull inflation. (Up to 4 marks)
4 marks maximum


Examiner Report ♕

Relatively few candidates scored well. Many described, often in considerable detail, the functions of money and the problems associated with the barter system of trade. This was not required for the question set. Candidates needed to identify ‘what is used as money in a modern economy’. In a modern economy, money is made up of cash and bank deposits. These are generally accepted in payment of debt. Many candidates repeated a widely held misconception that cheques are a type of money. Cheques and electronic methods of payment are simply modern methods of transferring bank deposits. The second part of this question asked how an increase in the quantity of money can cause prices to rise and this was done much better by most candidates. Many answers, however, still had weaknesses. One was a tendency to provide the formula for the quantity theory, but the link between increases in the money supply and the consequent rise in prices was often asserted rather than explained

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