Low and Stable Inflation Exam Questions

The correct answer is C - store of value.

Explanation:
A medium of exchange refers to money being widely accepted in exchange for goods and services. A significant increase in the rate of inflation from 2% to 20% does not necessarily impact the function of money as a medium of exchange directly. People can still use the money for transactions, albeit with adjustments for the higher prices due to inflation.

A standard for deferred payment refers to the function of money being accepted for payments in the future. Even with the increased inflation rate, money can still be used as a standard for deferred payment. However, individuals making long-term contracts or loans may be impacted by the higher inflation rate.

A unit of account describes money's role in measuring the value of goods and services, making it easier to compare prices. With a significant increase in inflation, the value of money decreases, which may affect the reliability of money as a stable unit of account. However, this function may not be as severely impacted compared to the store of value function.

A store of value indicates that money can be saved and maintain its value over time. In the case of a sharp increase in inflation from 2% to 20%, money would lose its purchasing power rapidly. Consequently, storing money in the form of cash or low-interest savings accounts would be less effective as the value erodes quickly under high inflation. Therefore, the store of value function is likely to be most affected by a significant rise in inflation.

Keynesians and monetarists disagree about how quickly markets clear and about which policy instrument works, but they are both economists of the market economy, and both accept that resources should be allocated by individual choice expressed through the price mechanism rather than by central direction. That shared foundation is what makes their argument a technical one rather than a difference about the kind of system a country should have. The velocity of circulation being stable is a monetarist position, and it is the assumption that turns the quantity equation into a theory of inflation; Keynesians deny it precisely because velocity falls when money is held idle. Expectations adapting rapidly is monetarist too, and it is why monetarists expect any boost from expansionary policy to be short-lived. Fiscal policy being the most effective instrument is the Keynesian claim, and monetarists reject it on the grounds that government borrowing crowds out private spending. Each wrong option belongs firmly to one school, so none can be shared.

Read the NOT. Monetarists hold that velocity is STABLE and predictable, that assumption is what lets money supply growth translate into inflation, so calling it highly unstable misstates their view. The other three are genuine monetarist positions: a vertical long-run AS curve, flexible wages, and inflation as a monetary phenomenon.

Answer: D - an increase in investment

Explanation: In the circular flow of income, leakages refer to any income that is taken out of the main economic flow, like savings, taxes, and imports. To offset a leakage, an injection needs to be introduced into the system to maintain economic equilibrium.

Among the given options, an increase in investment (choice D) would be the most appropriate action to offset a leakage. When there is an increase in investment, businesses are expanding and injecting more money into the economy, which helps to fill the gap created by the leakage and keeps the circular flow of income stable.

Reducing domestic consumption (choice A), reducing government expenditure (choice B), or increasing the rate of interest (choice C) could potentially worsen the situation by reducing overall economic activity instead of offsetting the leakage. For instance, reducing consumption would decrease demand in the economy, while cutting government expenditure might slow down economic growth. An increase in the rate of interest could discourage borrowing and investment, leading to a tightening of economic activity.

Therefore, the correct answer is D - an increase in investment, as it would help offset the leakage and support economic stability in the circular flow of income.