Question

Suppose the value of the dollar declines relative to other currencies. How does the decline affect the three functions of money?

Short answer

If the value of the Dollar declines relative to other currencies, it affects all three functions of money. As a medium of exchange, more Dollars will be needed to purchase the same foreign goods or services. As a unit of account, the Dollar's decrease in value could lead to inflation or price instability. As a store of value, the decrease in the Dollar's value may erode its ability to store and retrieve wealth effectively, thereby decreasing the wealth of those who hold their wealth in Dollars.

Step-by-step solution

Identify the Functions of Money

The first step is to identify the three major roles of money: a medium of exchange, a unit of account, and a store of value. These three roles are the baseline against which the effects of a declining Dollar will be evaluated.

Analyze the Impact on Function 1 - Medium of Exchange

As a medium of exchange, money is used in transactions to purchase goods and services. If the value of the Dollar decreases relative to other currencies, it is likely that foreign goods will become more expensive for Americans to buy, as their money is now less valuable in comparison. This means, the function of money as a medium of exchange is affected because it requires more Dollars to purchase the same goods or services from abroad.

Analyze the Impact on Function 2 - Unit of Account

As a unit of account, money provides a standardised measure of the value of goods and services. If the Dollar's value decreases, it could lead to price instability or inflation, because buying foreign goods or getting foreign services becomes more expensive. Thus, the function of money as a unit of account could be impacted because the worth of products and services (especially imported) in terms of Dollar can change.

Analyze the Impact on Function 3 - Store of Value

As a store of value, money allows us to store and retrieve wealth. A decline in the Dollar's value may erode purchasing power, and thus affect the ability of money to store value effectively. People who hold their wealth in Dollars find that their wealth decreases if the value of the Dollar falls. Therefore, the function of money as a store of value could be adversely affected.