Trust plays an important role in complex modern economic sys

Trust plays an important role in complex modern economic systems such as the U.S. economy. You will write about two examples. For each, define the term, describe the role it plays in the economy, and identify the role trust plays.

A. Fiat money (3 points)

B. Fractional reserve banking (5 points)

Solution

Fiat Money:

Fiat money is that money which has no intrinsic value but declared as a legal tender by the government.

Since, it is only a declaration by the government so it is not backed by any commodity, such as gold. Fiat money does not have any intrinsic value unlike currencies backed by gold or silver, (e.g., paper money and much coinage).

Fiat money allows the declaring government to employ virtually any material, such as paper, as a medium of exchange. However, since the value of fiat money lies solely in the faith of those using it, its value can be easily diminished and result in rapid inflation.

Fractional reserve banking:

Fractional reserve banking is a process in which bank holds a fraction of the demand deposits and loan out the rest. This is the primary activity of each and every bank. Through this process the bank creates the money.

The government can use this as a tool under different conditions of the economy. If the government wants more money to be circulated in the economy then the central bank reduces its reserve requirement so banks are left with more cash which can be lend out to the public.