Chapter 2: Introducing Money and the Financial System

multiple-choice flashcards

What is money? Identify and briefly explain its three functions.
A) Store of value, medium of exchange, unit of account
B) Income, investment, capital
C) Bonds, stocks, deposits
D) Savings, loans, trade

A) Money acts as a medium of exchange (used to buy goods), a unit of account (measures value), and a store of value (keeps purchasing power over time).

What is a barter economy, and why is it inefficient?
A) Because it requires a double coincidence of wants
B) Because it uses paper currency
C) Because it has fixed prices
D) Because it relies on banks

A) In a barter system, goods are traded directly. It’s inefficient since both parties must want what the other offers — making trade slow and limited.

What existed before fiat money, and what made it unique?
A) Commodity money — it had intrinsic value
B) Paper money — it was lightweight
C) Cryptocurrency — it was digital
D) Barter — it used credit

A) Before fiat money, commodity money (like gold or silver) was used. It had value itself, unlike fiat money, which has value by government decree.

How does money relate to specialization in an economy?
A) It discourages trade
B) It makes trade harder
C) It enables specialization by allowing people to sell what they produce and buy what they need
D) It limits production

C) Money facilitates specialization — people focus on one trade and use money to exchange goods, boosting efficiency and productivity.

What are the requirements for an asset to serve as money?
A) Divisible, portable, durable, recognizable, and stable in value
B) Expensive and rare
C) Backed by gold
D) Physically large and hard to store

A) For something to be money, it must be easy to divide, carry, last over time, be easily identified, and keep a stable value.

What’s the difference between fiat money and legal tender?
A) Fiat money has intrinsic value
B) Legal tender is only coins
C) Fiat money has value because the government declares it; legal tender must be accepted for debts
D) Legal tender is not used today

C) Fiat money has no intrinsic value — it’s valuable because of government decree. Legal tender means it must be accepted to settle debts.

What’s a payment system?
A) Any method of settling financial transactions
B) A tax collection system
C) A savings account
D) A type of bond

A) The payment system is how people and businesses transfer money — from barter to coins, paper money, checks, and now digital and electronic payments.

Who controls the payment system in the U.S.?
A) Congress
B) Federal Reserve
C) IRS
D) SEC

B) The Federal Reserve supervises and stabilizes the payment system, ensuring money moves securely between institutions.

What are desirable outcomes in a payment system?
A) High fees and slow transfers
B) Efficiency, security, reliability, and accessibility
C) Government-only use
D) Manual transactions only

B) An ideal payment system should be fast, low-cost, safe, and widely available to support commerce and confidence in money.

What are some breakthroughs that have existed in the payment system?
A) Credit cards, online banking, mobile payments, and digital wallets
B) Gold coins only
C) Barter and trade
D) None of the above

A) Modern technology has evolved payments — credit/debit cards, electronic transfers, and mobile apps like Apple Pay make transactions faster and more efficient.

What’s the primary advantage of private payment systems?
A) They provide competition and innovation
B) They eliminate the need for government
C) They are free of risk
D) They prevent fraud

A) Private systems like PayPal or Venmo foster innovation and efficiency by competing with traditional banking methods.

Why should the money supply be measured?
A) To track inflation, stability, and policy effectiveness
B) To increase taxes
C) To manage trade
D) To predict population growth

A) Measuring the money supply helps central banks control inflation, evaluate economic activity, and guide monetary policy.

What are the two basic monetary aggregates?
A) M1 and M2
B) GDP and GNP
C) Bonds and Stocks
D) Deposits and Loans

A) M1 = most liquid (cash, checking deposits). M2 = M1 + savings deposits, money market funds, and small time deposits.

What’s the difference between M1 and M2?
A) M1 includes savings accounts
B) M2 includes less liquid assets in addition to M1
C) M2 excludes checking deposits
D) They are the same

B) M2 is broader — includes M1 plus assets that can be converted to cash easily, like savings deposits and money market accounts.

Explain the velocity of money.
A) How fast money circulates in the economy
B) How much money people save
C) How money is stored
D) How banks lend

A) Velocity is how often a unit of money is used to buy goods/services in a period. High velocity = active economy.

Describe Fisher’s Equation of Exchange.
A) MV = PQ
B) M/P = QV
C) P = MVQ
D) Q = M + V

A) MV = PQ — Money supply (M) × Velocity (V) = Price level (P) × Quantity of goods (Q). It links money to nominal GDP.

What does the quantity theory of money state?
A) Inflation is unrelated to money
B) Increases in money supply lead to proportional increases in price level (inflation)
C) Inflation lowers GDP
D) Money has no effect on output

B) The theory says that if money supply grows faster than output, prices rise — showing the link between money and inflation.

According to the quantity theory, what does inflation depend on?
A) Changes in real GDP
B) The rate of money supply growth compared to real GDP growth
C) Changes in government spending
D) Interest rates

B) Inflation occurs when money supply grows faster than real GDP, meaning more money chases the same amount of goods.

How accurate are inflation forecasts using the quantity theory?
A) Always exact
B) Roughly accurate in the long run but not short term
C) Completely wrong
D) Not used by economists

B) Over long periods, changes in money supply predict inflation well, but short-term inflation also depends on velocity and expectations.

What is hyperinflation?
A) A moderate rise in prices
B) Extremely rapid inflation (often >50% per month)
C) Price stability
D) Deflation

B) Hyperinflation is when prices skyrocket due to money supply expansion, eroding money’s value as a medium of exchange.

What happens to money during hyperinflation?
A) It gains purchasing power
B) It loses its function as a medium of exchange and store of value
C) It becomes more trusted
D) It stops circulating

B) During hyperinflation, money rapidly loses value, forcing people to barter or use foreign currencies instead.

What causes hyperinflation?
A) Too little money supply
B) Rapid money printing by the government
C) Technological growth
D) Population decline

B) Governments that print excessive money to finance deficits cause inflation to spiral, eroding confidence in currency.

How can governments contribute to hyperinflation?
A) By reducing taxes
B) By financing spending through excessive money creation
C) By cutting spending
D) By increasing interest rates

B) When governments cover deficits by printing more money instead of raising revenue, prices surge uncontrollably.

What is the general conclusion about central bank independence?
A) It reduces inflation and political pressure on monetary policy
B) It increases inflation
C) It decreases credibility
D) It causes hyperinflation

A) Independent central banks can focus on long-term stability, reducing inflation and avoiding short-term political influence.