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MGT411 Money & Banking GDB 2 Solution Fall 2012

The Case:

Suppose you have been given the responsibility of introducing a new currency for a newly established country. You call a meeting of renowned economist, bankers and financial experts of the country in order to decide whether the currency should be backed by equivalent gold reserves or not? During the meeting, you observe that there is a difference of opinion among the experts. Some of the experts are of the view that the currency should be backed by equivalent gold reserves while others think opposite. 

Required:

What do you think regarding this particular issue? Whether the currency should be backed by equivalent gold reserves or not? In either case (yes or no), support your comments with logical rationale.

Solution:

Absolutely not. One common misconception about money is that it has to be backed by a commodity such as gold or silver. Money is merely a representation of the perception of value. Instead of being backed solely by gold, money should only be backed by trust. Trust on which the note will be honored by a merchant in exchange for his merchandise or as payment for any debt. Another factor that backs the strength of money is confidence for those who use it. This confidence is imposed by governments through careful regulations preventing markets to succumb into irrationality which damages the value that money is supposed to physically represent. Gold is subject to hoarding that could result in serious shortage. If the economy demands more money to represent the value created, it will result in a shortage and thus a liquidity crisis will emerge. The great depression is partly caused by the shortage of gold that supposed to back the enormous size the economy at that time has become after the first world war. Today’s economic growth would never happen if credit is based on the gold available to satisfy it
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Another Solution:

Money has to be anchored to a fixed commodity in order to prevent rampant inflation. Simply printing money without anything backing it is simply dangerous and could detroy the value of people’s savings. It is true that economies expand and their value should increase as new products are created, a gold backed currency prevents asset bubbles as credit is limited based on the available gold or silver to back the printing of new bank notes. During an economic expansion, the limited amount of currency floating around the market prevents inflation by increasing how many more goods can a single note buy because it strengthens due to a limited supply of it. After the United States totally closed the gold window in 1971, the value of the dollar has steadily declined and it now takes more bank notes to buy the same items necessary for daily living.

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