Question

(a) What is the difference between ‘commodity money’ and ‘fiat’ money? Give examples of each. (2 marks)

(b) Explain the ‘classical dichotomy’. (2 marks)

(c) Use a diagram showing the relationship between the ‘value of money’ and the ‘price level’ to explain the effect on the price level and the value of money of an increase in money supply. (2 marks)

(d) “If a government decides to pay for their spending by printing money they are said to levy an inflation tax”. Explain clearly what is meant by an ‘inflation tax’. Is this a good way for Government to raise revenue? Why?/Why not? (4 marks)

Answer 1

a) Commodity Money has an intrinsic value or value on its own.For example: Gold and Silver. It does not need any certification of authority from the government like fiat money. Fiat money has no intrinsic value and holds no meaning unless certified by the government. For Example: Currency and Coins.

b) Classical Dichotomy: According to pre Keynesian and Classical Economists, real variables in the economy like output and real interest rates can be discusses and analysed individually and without taking into consideration nominal variables like money value of output and nominal interest rate. This idea was rejected by Keynesian and new classical economists according to whom, the prices are "STICKY" and not independent from nominal variables.

c) The price level and value of money are inversely proportional. As the price level goes up, the value of money goes down.(As shown in the diagram)

(Money supply) New Money Supply Low Value Price Level of of Money Equilibrin المرام - نا rugh quantity of Money

d) As the government prints more money to increase demand and economic activity, the increase in money supply leads to hike in prices of goods due to increase in demand of those goods.

It is not a good way to raise revenue, especially for the long run since it puts inflationary pressure on the economy and reduces the demand and subsequently production activIties.