Lecture 5 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 1. Medium of Exchange 2. Store of value 3. Unit of account

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.

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.

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.

Aggregate Demand and Aggregate Supply – The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. – The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

The Aggregate-Demand Curve... Quantity of Output Price Level 0 Aggregate demand P Y Y2Y2 P2P2 1. A decrease in the price level increases the quantity of goods and services demanded.

The Short-Run Aggregate-Supply Curve is upward sloping Quantity of Output Price Level 0 Short-run aggregate supply 1. A decrease in the price level reduces the quantity of goods and services supplied in the short run. Y P Y2Y2 P2P2

Equilibrium occurs at the intersection of Aggregate Demand and Aggregate Supply curves Quantity of Output Price Level 0 Aggregate supply Aggregate demand Equilibrium output Equilibrium price level

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 rate by 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

Types of Inflation There can be two types of inflation: 1)Demand-Pull Inflation ( Inflation causing due to increase in demand) 2) 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.

2) Cost-Push Inflation: – Cost push inflation results from supply shock or higher production cost. Higher production costs ( Ex: 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.

Interest Rates and Inflation What is interest rate ? Interest rate is the cost of borrowing or profit from lending. There two types of interest rate: 1)Borrowing rate 2) Lending rate The gap or difference between borrowing rate and lending rate of bank is known as net interest spread.

Real and Nominal Interest Rates The nominal interest rate is the interest rate usually reported and not corrected for inflation. – It is the interest rate that a bank pays. The real interest rate is the nominal interest rate that is corrected for the effects of inflation. Example: 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% Question: Consider a borrower and a lender. Who will gain and who loss if nominal interest rate is not adjusted by inflation?

Figure 3 Real and Nominal Interest Rates 1965 Interest Rates (percent per year) 15 Real interest rate – Nominal interest rate