Chapter 14: Q5. (page 300)
What “backs” the money supply in the United States? What determines the value (domestic purchasing power) of money? How does the purchasing power of money relate to the price level? In the United States, who is responsible for maintaining money’s purchasing power?
Short Answer
The government backs the money supply in the United States.
The purchasing power of the money can be determined by the total amount of goods and services that can be bought with it. When the price levels are rising, purchasing power falls and vice-versa.
The monetary policy and fiscal policy are responsible for maintaining the purchasing power of money.
Step by step solution
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Step 1. Government backs the money supply.
In the United States, the money supply is backed up by the government, which guarantees to keep the value of the money supply relatively stable. Such a guarantee depends mostly upon the effectiveness and management of silks of the government with regards to the money supply.
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Step 2. Purchasing power of money
The purchasing power of money depends upon the number of goods and services that a given unit of money can buy. For example, if a dollar can buy two candies, then the dollar's purchasing power is the value of two candies.
As the price level in the country increases, the purchasing power of money falls; say previously, a dollar could buy two candies, but due to the rise in the price levels, only one candy can only be bought with one dollar.
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Step 3. The monetary and fiscal policy
The monetary policy is the policy of the Fed through which it controls the money supply in the economy, and fiscal policy is the government’s policy through which stability in the economy is achieved.
Monetary policy controls money supply by regulating interest rates, and fiscal policy achieves stability through spending and taxes. Both these policies play a huge role in maintaining the money’s purchasing power by controlling the price levels in the economy.
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