Question

Define: a. barter economy b. transaction costs c. money d. medium of exchange e. unit of account f. store of value g. fractional reserve banking

Short answer

a. Barter Economy: Direct exchange of goods/services without use of money. b. Transaction Costs: Costs involved in an economic exchange. c. Money: Item/record accepted as payment. d. Medium of Exchange: Intermediary used in trade. e. Unit of Account: Standard numerical unit of market value measurement. f. Store of Value: Asset that maintains value. g. Fractional Reserve Banking: A banking system where only a fraction of bank deposits are backed by actual cash on hand.

Step-by-step solution

Define Barter Economy

A barter economy is one where goods and services are exchanged directly for other goods and services without using a medium of exchange, such as money.

Define Transaction Costs

Transaction costs are the costs involved in making an economic transaction. They might include fees, time, and the mental effort of making the exchange.

Define Money

Money is any item or record that is generally accepted as payment for goods and services or repayment of debts in a particular country or socioeconomic context.

Define Medium of Exchange

A medium of exchange is an intermediary used in trade to avoid the inconveniences of a pure barter system, such as money.

Define Unit of Account

A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. E.g., in the United States the unit of account is the Dollar.

Define Store of Value

A store of value is an asset that maintains its value without depreciating, like gold or other precious metals. Money can also be a store of value, but only if inflation is not an issue.

Define Fractional Reserve Banking

Fractional reserve banking is a system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is considered to be most efficient since it allows banks to use the rest of the money in various investment projects or loan it out.

Key concepts

Barter Economy

A barter economy is a system where people trade goods and services directly without a common intermediary, such as money. Instead of buying products with currency, you exchange something you have for something else you need. This might sound simple, but it comes with its own challenges.

• Lack of a common measure of value: It can be hard to agree on how much one good or service is worth compared to another.
• Double coincidence of wants: You need to find someone who not only has what you need but also wants what you have.
• Complexity in storing wealth: Physical goods can be perishable or hard to store for future use.

While barter systems have been used in ancient times, they present inconveniences that paved the way for money as a more efficient medium of exchange.

Transaction Costs

Transaction costs refer to the expenses incurred when buying or selling goods and services. These are not just monetary costs but include time and effort as well. Imagine you're trying to find someone to trade your eggs for their milk. This process entails:

• Research time: Looking for someone who has what you need.
• Negotiation time: Discussing the terms and delivery of the exchange.
• Actual transportation or logistics effort: Getting the goods from them and delivering yours.

Transaction costs can add up quickly, making barter and some market transactions inefficient. By using money, people reduce transaction costs, making exchanges smoother and more predictable.

Medium of Exchange

A medium of exchange is something that facilitates trade between parties. In modern economies, money serves this purpose. It simplifies the trading process by eliminating the double coincidence of wants required in a barter system.
Money makes trading easy because:

• It is widely accepted by everyone in the economy.
• It standardizes value, making transactions simpler to agree on.
• It can easily be carried and transferred from one person to another.

Because of these properties, money acts efficiently as a medium of exchange, enabling smooth economic activity and growth.

Unit of Account

A unit of account is essentially the yardstick we use to measure the economic value of goods and services. It standardizes the way we express prices, salaries, and other monetary values. In practice, this means:

• You can easily compare the cost of different products and services.
• It allows for the organization and understanding of economic data and market trends.
• It provides a clear computational framework that simplifies financial planning and record-keeping.

Using something like the dollar, a unified unit of account, helps people and businesses decide how to allocate resources effectively and efficiently.

Store of Value

A store of value is an asset that can save the purchasing power for the future. Money fulfills this role if it does not lose its value quickly due to inflation. Besides money, other examples like gold or real estate can be considered stores of value. Benefits of an effective store of value include:

• Preserving wealth over time: You are assured that your savings maintain their purchasing power.
• Assistance in planning for future expenses or investments.
• Protection against economic instability or currency depreciation.

For money to remain a good store of value, it must be stable. If inflation is high, it might be less reliable, pushing people to seek alternative assets.

Fractional Reserve Banking

Fractional reserve banking is a system where banks keep only a part of deposits as cash and lend out the remaining balance. This system boosts economic activity by providing more funds for investment and loans while still maintaining enough reserves to meet everyday withdrawal needs. Some key aspects of fractional reserve banking are:

• It allows banks to expand the money supply within the economy.
• Banks earn interest on loans, contributing to their income and stimulating growth.
• It requires banks to manage a careful balance between keeping enough reserves to maintain confidence and optimizing loan amounts for efficient service utilization.

While efficient, it needs regulations to ensure financial stability, preventing issues such as bank runs where many clients try to withdraw their money simultaneously.