Functions of Money, Inflation, and Monetary Policy

• These notes summarise key concepts in economics, including the functions of money, inflation, deflation, and monetary policy.

Functions of Money

• Medium of Exchange: Money simplifies trade by eliminating the need for direct barter, requiring mutually desired goods between parties.
• Unit of Account: It serves as a standard measure of the value of goods and services, facilitating price setting and comparison.
• Store of Value: Money allows value to be saved and used later, enabling the deferral of purchasing power.
• Alternative stores of value include gold, real estate and stocks, which may maintain value better. Alternative investments are sought when money loses its store of value function, especially during high inflation.
• The Euro serves all three functions as a medium of exchange, unit of account and store of value.
• It is accepted in many countries, facilitates price comparisons, and retains value due to the European Central Bank's (ECB) monetary policy.
• Bitcoin does not fully meet all the functions of money:
  • It has limited acceptance as a medium of exchange.
  • Its volatility makes it unsuitable as a unit of account.
  • Its volatile value makes it a risky long-term store of value.

Inflation Rate

• It corresponds to the percentage change in the consumer price index (CPI) compared to the previous period.
• Influenced by supply and demand, money supply, production costs, wages, and raw material prices.
• Effects include:
• Moderate inflation (around 2%) is considered normal and supports economic growth.
• High inflation reduces purchasing power and increases the cost of living.
• Deflation (negative inflation) can lead to economic crises.

Consumer Price Index (CPI)

• It is a measure of the price development of goods and services purchased by an average consumer.
• Calculated as the ratio of the cost of a basket of goods in the current year to the cost in the base year, multiplied by 100.
• The basket of goods is selected to reflect the consumption patterns of an average consumer.

Consequences of Inflation

• Store of Value: Inflation reduces the value of money over time as less can be purchased with the same amount.
• Unit of Account: It complicates price discovery and comparison across periods due to constantly rising prices.
• Medium of Exchange: Higher inflation can reduce the acceptance of money as people shift to more stable stores of value.

Winners and Losers of Inflation

• Losers:
• Savers: The purchasing power of savings decreases.
• Employees: Wages often increase slower than inflation, reducing real purchasing power.
• Creditors: Lenders receive repayments with reduced value.
• Retirees: Fixed pension benefits lose value unless adjusted for inflation.
• Winners:
• Debtors: They repay debts with inflated currency, reducing the real burden.
• Governments: They benefit when they have debts.
• Real Estate Owners: Property values may increase.
• Companies: They can increase profits by implementing price increases.

Reasons for a 2% Inflation Target

• Encourages consumption and investment due to the expectation of rising prices.
• Avoids deflation, which can stifle consumption and investment.
• Lowers real interest rates, promoting investment through cheaper credit.
• Reduces debt burdens, providing relief to debtors.
• Increases wages, boosting purchasing power and consumption.

Deflation Summary

• It is a decline in the general price level of goods and services.
• Causes include real estate bubbles, government saving, and reduced demand.
• Consequences:
• Companies experience lower revenues, reduce investment, cut wages, or lay off employees.
• Consumers save due to fear of job loss, reducing spending.
• Banks provide fewer loans, reducing the money supply.

Possible Developments and Reactions to Deflation

• Positive: Consumers buy more due to lower prices, increasing revenues for companies.
• Negative: Deflationary spiral where falling prices and incomes lead to less consumption, business failures and reduced lending.
• Central banks may lower interest rates, purchase bonds, or increase government spending.
• Risks of deflation include speculative bubbles and rising government debt.

Influence of Inflation on GDP

• Moderate inflation can stimulate economic growth by encouraging consumer spending.
• Rapidly rising living costs can decrease consumer spending, reducing production levels and employment.

Monetary Policy Goal

• The European Central Bank (ECB) aims for price stability and influences the banking system to achieve this.
• Commercial banks need central bank money to meet cash demands, maintain minimum reserves, and process cashless payments.
• Banks can borrow money from each other in the money market.
• The overnight rate is the interest rate for short-term interbank loans and is guided by the ECB's key interest rates.

Effects of Interest Rate Changes by the Central Bank

• Lowering Interest Rates:
• Makes refinancing for banks cheaper, allowing them to offer lower interest rates to customers.
• Increases credit demand by non-banks due to lower interest rates.
• Boosts domestic investment and consumer goods demand, leading to higher prices and inflation.
• Raising Interest Rates:
• Makes refinancing for banks more expensive, leading to higher interest rates for customers.
• Decreases credit demand by non-banks due to higher interest rates.
• Reduces domestic investment and consumer goods demand, leading to lower prices to combat inflation.
• A rate cut stimulates the economy but could lead to inflation, while a rate hike slows it down but helps lower inflation.

Effects of Lowering the Key Interest Rate on Investment Goods Demand

• Cheaper credit makes investments more attractive.
• Increased willingness of companies to borrow more money to invest.
• Improve investment profitability due to cheaper financing.
• Increase confidence in the economy.
• Higher consumer demand can lead to further investments by companies.

Money Creation Multiplier

• It shows how much new money is created in the economy through bank lending when a central bank introduces new money into circulation.
• It determined by the reserve ratio, the percentage of deposits that banks must hold as reserves.