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Lecture 4 Money and Inflation

Lecture 4 Money and Inflation. Money. What is money? Money is any object that is generally accepted as payment for goods and services and repayment of debts. The main functions of money are Medium of Exchange Store of value Unit of account.

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Lecture 4 Money and Inflation

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  1. Lecture 4Money and Inflation

  2. Money • What is money? Money is any object that is generally accepted as payment for goods and services and repayment of debts. The main functions of money are • Medium of Exchange • Store of value • Unit of account

  3. Medium of exchange: Money's most important function is as a medium of exchange to facilitate transactions. Without money, all transactions would have to be conducted by barter, which involves direct exchange of one good or service for another. The difficulty with a barter system is that in order to obtain a particular good or service from a supplier, one has to possess a good or service of equal value, which the supplier also desires. In other words, in a barter system, exchange can take place only if there is a double coincidence of wants between two transacting parties. The likelihood of a double coincidence of wants, however, is small and makes the exchange of goods and services rather difficult. Money effectively eliminates the double coincidence of wants problem by serving as a medium of exchange that is accepted in all transactions, by all parties, regardless of whether they desire each others' goods and services.

  4. Store of value. In order to be a medium of exchange, money must hold its value over time; that is, it must be a store of value. If money could not be stored for some period of time and still remain valuable in exchange, it would not solve the double coincidence of wants problem and therefore would not be adopted as a medium of exchange. As a store of value, money is not unique; many other stores of value exist, such as land, works of art, and even baseball cards and stamps. Money may not even be the best store of value because it depreciates with inflation. However, money is more liquid than most other stores of value because as a medium of exchange, it is readily accepted everywhere. Furthermore, money is an easily transported store of value.

  5. Unit of account: Money also functions as a unit of account, providing a common measure of the value of goods and services being exchanged. Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about how much of the good to supply and how much of the good to purchase.

  6. Types of money in money markets M1 : Money in circulation ( notes and coins) + Demand deposit + Traveler checks M2 : M1 + Savings and Time deposit in banks M3 : M1 + M2 + Time deposit in other financial institutions

  7. Quantity theory of money • The primary cause of inflation is the growth in the quantity of money. • Quantity Theory of Money states that money supply has a direct, proportional relationship with the price level. For example, if the currency in circulation increased, there would be a proportional increase in the price of goods ( price level). The equation of quantity theory of money is MV = PQ M = the total amount of money in circulation on average in an economy during a year. V = velocity, average number of times each unit of money changes hands during the year P= weighted average price level of goods and services in the economy Q= total amount of goods and services • Here • PQ is the total value of goods and services

  8. Assume that 1) Velocity (V) is constant for an economy 2) Q which is total goods and services produced in an economy is also constant for a given period. In that case Price level ( P ) changes if amount of money ( M) changes. That means if amount of money in the economy increases price level increases (inflation increases). If amount of money in the economy decreases then price level decreases ( Inflation decreases). So the quantity theory of money shows that there is positive relation between amount of money in the economy and price level. So an increase in money supply can lead to an increase in inflation.

  9. INFLATION • Inflation refers to a situation in which the economy’s overall price level is rising. • Definition: Inflation is the persistent/continuous increase in price level in one year. • We find inflation rateby calculating the percentage change in the price level of current year from the previous year. So we can think inflation as the growth rate of price level . • Some of the Facts about inflation: • Not all prices rise at the same rate during inflation. • Not everyone suffers equally from inflation. • Although inflation makes some people worse off, it makes some people better off • Hyperinflation is an extraordinarily high rate of inflation such as Germany experienced in the 1920s. • Hyperinflation is inflation that exceeds 50% per month

  10. Types of Inflation There can be two types of inflation: • Demand-Pull Inflation ( Inflation causing due to increase in demand) • Cost-Push Inflation ( Inflation causing due to decrease in supply ) 1) Demand-Pull Inflation : Demand-pull inflation results from excessive pressure on the demand side of the economy. When there is an increase in demand ( For example: Due to increase in income or increase in money supply) the aggregate demand will shift to the right. In this case there will be an increase in price level and increase in aggregate output. This continuous increase in price level due to increase in aggregate demand is known as demand pull inflation.

  11. 2) Cost-Push Inflation: • Cost push inflation results from supply shock or higher production cost. Higher production costs ( due to increase in price of input) or supply shock ( ex: flood) can put upward pressure on product prices. When there is a supply shock ( example: disaster like flood) or increase in production cost ( Think about rice supply. If price of fertilizer increases cost of production increases, so rice supply decreases) the aggregate supply curve will shift to the left. This will lead to an increase in price level and decrease in aggregate output. This increase in price level due to the decrease in aggregate supply is known as cost push inflation.

  12. Real and Nominal Interest Rates • Interest rate is known as the cost of borrowing. • Nominal interestrate is the interest rate usually reported and not corrected for inflation. • It is the interest rate that a bank pays. • Real interest rateis the nominal interest rate that is corrected for the effects of inflation. • You borrowed $1,000 for one year. • Nominal interest rate was 15%. • During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation =15% - 10% = 5% Inquiry: When we have inflation in the economy and we have not adjusted the interest rate for inflation , then who will be the gainer and who will be the loser? Hints: Think from borrowers and lenders perspective.

  13. Nominal interest rate Real interest rate Real and Nominal Interest Rates Interest Rates (percent per year) 15 10 5 0 –5 1965 1970 1975 1980 1985 1990 1995 2000

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