Money, Prices, and Inflation

Money, Prices, and Inflation:


Newspaper as well as television commentators devote a lot of attention to inflation. Inflation disturbs the economy in a number of different ways. Furthermore even when inflation is absent fear that it will emerge has a powerful effect on the economy. The measures of economic policy-making agencies like the Federal Reserve are tightly constrained by fear that certain courses of action will lead to inflation.

The U.S. experienced an episode of comparatively mild inflation--prices rising at between five and ten percent per year--in the 1970s. Even though relatively mild, that inflation was big enough to cause significant economic and political trauma. Evading a repeat of the inflation of the 1970s remains a major goal of economic policy even today, a quarter century later.

Several countries have experienced inflations that aren’t mild. In Russia in 1998 the price height rose at a rate of 60 percent per year. In Germany in 1923 prices rise at a rate of 60 percent per week. So-called hyperinflations have been observed in many other countries in this century from Hungary to China, from Argentina to Ukraine. They are very destructive. They impose severe damage on the ability of money to grease the wheels of the social mechanism of exchange that is the market economy. The system of prices as well as market exchange breaks down, and production can drop to a small fraction of potential output.

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Legend: All actions of price changes show a burst of inflation in the U.S. in 1970s.

Source: 2000 Economic Report of the President (Washington: GPO).

The power to examine real variables without ever referring to the price level is a special feature of the full-employment flexible-price model of the economy. Economists entitle this the classical dichotomy: real variables (like real investment spending, real GDP, or the real exchange rate) can be analyzed and computed without thinking of nominal variables like the price level. You will as well hear economists speak of this as the property that ‘money’ is neutral or that ‘money’ is a veil--a covering that doesn’t affect the shape of the face underneath.

Here we explore what figure out the overall level of prices and the rate of inflation (or deflation) in our full-employment flexible-price model of the macro-economy. This is significance doing for two reasons. First it offers a useful baseline analysis against which to contrast the finish of future chapters. Second, whenever we look over relatively long spans of time--decades, they do have time to move in response to shocks, perhaps--wages as well as prices are effectively flexible and the flexible-price assumption is a fruitful and useful one.

Money: Liquid Wealth That Can Be Spent

When normal people utilize the word ‘money’, they may denote a number of things. ‘Money’ may be used as a synonym for wealth: when we say ‘she has a lot of money’, we signify that she is wealthy. ‘Money’ may be used as a synonym for income: when we say ‘he makes a lot of money’, we signify that he has a high income.

When an economist utilizes the word ‘money’, but he or she means something different. To an economist, ‘money’ is asset that is held in a readily-spendable form. Money is that type of wealth that you can use immediately to buy things for the reason that others will accept it as payment. Today the economy's stock of funds is made up of:

a) Coin as well as currency that are transferred by handing the cash over to the seller (which almost everyone will accept as payment for goods and services.

b) Checking account balances that are move by writing a check (which most people will accept as payment for goods and services).

c) Other assets--like savings account balances--that is able to be turned into cash or demand deposits nearly risklessly, instantaneously and costlessly.

Why do economists accept this special definition of money? I don’t know. Giving usual household words special definitions is probably a bad thing to do. It causes confusion as well as misunderstanding. Yet economists perform so for not only ‘money’ but as well for terms like ‘investment’ and ‘utility’.

Whether assets that are able to be quickly and cheaply turned into cash like money market mutual funds, savings account balances, liquid Treasury securities etc are included in the money stock is a matter of taste and judgment. At what level of cost as well as inconvenience is an asset no longer ‘readily spendable’? There is no hard, clear, bright-line, unambiguous answer. Therefore economists have a number of different measures of the money stock—identified by symbols like H, M1, M2, M3, and L-- each of which draws the line around a diverse set of assets that it counts as wealth readily enough spent to be ‘money’.

The Usefulness of Money:

Try to imagine a barter economy, an economy with no the social convention of money. In our world all you require to carry out a market transaction--whether you want to buy or sell some good or service--is to either have money (if you want to buy) or for the purchaser to have money (if you want to sell). In a barter economy market exchange would need the so-called coincidence of wants. You would have to encompass physically in your possession some good or service that they wanted, moreover they would have to have in their possession some good or service that you wanted. As Figure shows, discovering consumption goods to satisfy the coincidence of wants would get remarkably complicated remarkably quickly. With no money, an extraordinary amount of time as well as energy would be spent simply arranging the goods one needed to trade.

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Figure: Coincidence of Wants

Legend: With no money, how is the carpenter to convince the farmer to give him corn when the farmer wants a haircut but does not need furniture--which the cook wants? How is the mover going to convince the cook to feed him when the cook does not need the moving truck--the writer does? With money, all can sell what they have for cash as well as have confidence that they can then turn around and use the cash to buy what they need.

Units of Account:

There is one other characteristic worth noting. The similar assets that serve as the most common form of readily-spendable purchasing power as well serve us as units of account. Dollars or Euros or yen aren’t only what we use to settle transactions, but as well what we use to quote prices to one another. At some times as well as places the function of money as a medium of exchange as well as of money as a unit of account have been separated, however today they almost invariably go together.

This is a possible cause of trouble. Anything that modify the real value of the domestic money in terms of its purchasing power over goods and services will as well alter the real terms of those existing contracts that use the money as the unit of account. The effect of alterations in the price level on contracts that have used the domestic money as a unit of account is a principal source of the social costs of inflation and deflation. The effect of alternations in the exchange rate on contracts that have used foreign monies as units of account is a principal source of the social costs of currency crises.

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