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Chapter 25: Problem 4

Why do businesses accept paper currency when they know that, unlike a gold coin, the paper the currency is printed on is worth very little?

Short Answer

Expert verified
Businesses accept paper currency despite its nominal value because it is a form of 'fiat money'. This means its value comes from its function as a medium of exchange, unit of account and store of value recognized by government. Its wider acceptance and functionality within the economic system also play key roles. The intrinsic value of paper money is less important than its accepted value in the market.

Step by step solution

01

Understanding Fiat Money

Fiat money refers to a currency that is issued by a government and is not backed by a physical commodity, like gold or silver. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. This is why, although the paper that the currency is printed on has minimal intrinsic value, it holds a value in the market.
02

Establishing Trust in the System

One of the most important features that fiat money provides is trust within the economy. Businesses accept paper currency as it is issued by the government, making it a legal tender. This designation means that the currency is recognized by the government as valid for payment of debts, which ensures acceptance of the currency by businesses.
03

Functionality in the Economic System

Paper currency serves as a medium of exchange that facilitates transactions. In order for a system of barter to work (i.e., trade goods or services directly for other goods or services), each party must have what the other wants. Money eliminates this problem by serving as a medium that is universally accepted in exchange for goods and services, allowing a greater range of trade and commerce.

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Most popular questions from this chapter

Suppose that Congress passes a new law that requires all firms to accept paper currency in exchange for whatever they are selling. Briefly discuss who would gain and who would lose from this legislation.

Suppose that the Federal Reserve makes a \$10 million discount loan to First National Bank (FNB) by increasing FNB's account at the Fed. a. Use a T-account to show the effect of this transaction on FNB's balance sheet. Remember that the funds a bank has on deposit at the Fed count as part of its reserves. b. Assume that before receiving the discount loan, FNB has no excess reserves. What is the maximum amount of this \(\$ 10\) million that FNB can lend out? c. What is the maximum total increase in the money supply that can result from the Fed's discount loan? Assume that the required reserve ratio is 10 percent.

In November 2016 , the Indian government decided to withdraw paper currency that made up more than 86 percent of the value of all rupee bills in circulation. An article in the Wall Street Journal published shortly after that decision described a small merchant in India as having "traded one customer a kilogram of potatoes, cauliflower and tomatoes for half a liter of honey. That was a good deal, he says. In normal times, the honey would be 120 rupees in the market (around \(\$ 1.80\) ) and the vegetables 70 rupees." Is this merchant's ability to arrange a barter deal with a customer an indication that the Indian economy doesn't actually require money to function efficiently? Briefly explain.

Distinguish among money, income, and wealth. Which one of the three does the central bank of a country control?

An article in the New York Times stated that "income is only one way of measuring wealth." Do you agree that income is a way of measuring wealth?
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