Unit 4 Money and Inflation (1).docx

Unit 4 Money and Inflation In general sense of the term, 'money' means the currency notes and coins. In economics, however, 'money' is a concept rather than a commodity. Money is used in a much wider sense and is defined differently by different economist. There is no universally agreeable definit...

Unit 4 Money and Inflation In general sense of the term, 'money' means the currency notes and coins. In economics, however, 'money' is a concept rather than a commodity. Money is used in a much wider sense and is defined differently by different economist. There is no universally agreeable definition of money. Conceptually, **money can be defined as any commodity that is generally accepted as a medium of exchange and a measure of value.** Historically many commodities have performed these functions of money, and forms of money have been changing from cattle to credit cards. **[Characteristics of Money]** - [General acceptability]: It should be desired and accepted by all as medium of exchange. - [Durability]: Money changes hands all the time and therefore it should not wear easily. - [Manageability:] Its mass should be small relative to its value, i.e. it must be portable. - [Homogeneity and divisibility]: The various denominations of a currency should be made of the same material and look the same.  - [Recognisability]: It should be easily recognizable and distinguishable from other materials. - [Value:] It should be limited in supply because the relative scarcity of a currency determines its value. - [A relatively fixed value:] Its value should be fairly constant. Money loses its value and purchasing power due to inflation. **[Functions of Money]** Money was devised initially as a medium of exchange and a measure of value. However, it acquired over time some other functions also. [Money as a medium of exchange] Money functions as a medium of exchange between any two goods. This is the most important and unique function of money. The importance of this function lies in that it has solved one of the biggest problems of the batter system. in the barter system, for exchange to take place, there must be 'double coincidence of wants'. the double coincidence of wants exist when , between any two persons, one is willing to accept what the other person is willing to give in exchange. Until this condition is fulfilled, exchange cannot take place. [Money as a Unit of Account] The second basic function of money is that it works as a measure of value of goods and services. All values are measured in terms of money. As a measure of value, money works as a common denominator, as a unit of account. Today unlike batter system, the value of all goods and services is expressed in terms of money. Money being a common denominator, the values of different goods can be added to find one value of all possession of a person, of a firm and a nation. In fact, money makes computation of national income possible. In the absence of money, measuring value would be an extremely difficult proposition in a modern economy. [Money as a Store of Value] The third basic function of money is that it serves the purpose of storing value for future use. The need to store value must have arisen for such reasons as; need for storing surplus produce because production and consumption or exchange of goods and services are not instantaneous in most cases, need for storing value for future use arises due to uncertainties of life and accumulative nature of the people. The advent of money has provided a means to store value for future use. [Money as Standard of Deferred Payments] Borrow today and repay tomorrow or buy today and pay later has been an old practice. This is deferred payment system. One necessary condition of deferred payment is that the value returned after a time gap must be the same. During the barter days, it might be a difficult problem to judge whether the value returned after a lapse of time was the same **[INFLATION]** Inflation is an increase in the overall price level. Keeping inflation low has long been a goal of government policy. Especially problematic are hyperinflations, or periods of very rapid increases in the overall price level. In a broad sense of the term, inflation means a considerable and persistent rise in the general price level over a period of time. **[Types of Inflation]** Inflation is generally classified on the basis of its rate and causes. While rate-based classification of inflation refers to the severity of inflation or how high or low is the rate of inflation, cause --based classification of inflation refers to the factors that causes inflation. In this section we discuss the types of inflation classified on the basis of its rate [Moderate Inflation] When the general level of price rises at a moderate rate over a long period of time, it is called moderate inflation or creeping inflation. The moderate rate of inflation may vary from country to country. However, a single digit rate of annual inflation is called moderate inflation or creeping inflation. [Galloping inflation] The economists have different views on galloping inflation. For example, according to Baumol and Blinder Galloping inflation refers to an inflation that proceeds at an exceptionally high rate. They do not specify what rate of inflation is 'exceptionally high'. Samuelson and Nordhaus define galloping inflation more precisely. According to them "inflation in the double -- or triple- digit range of 20, 100, or 200 per cent a year is labelled galloping inflation" [Hyper Inflation] In general, price rise at more than three digit rate per annum is called 'hyperinflation'. According to some economists, however, "hyperinflation is often defined as inflation that exceeds 50% per month. An inflation rate of 50% implies a more than 100- fold increase in the price level over a year". During the period of hyperinflation, paper currency becomes worthless and demand for money decreases drastically. [Causes of Inflation] The modern approach to inflation follows the theory of price discrimination. The price theory tells that, in a competitive market, price of a commodity is determined by the market demand for and the market supply of the commodity and that variation in the price of the commodity, if any, is caused by the variation in the demand and supply factors. likewise, according to the modern theories of inflation, the general price level is determined by the aggregate demand and aggregate supply, and variation in the aggregate price level is caused by variations in the aggregate demand and aggregate supply. The modern analysis of inflation shows that inflation is caused by both demand-side and supply-side factors. The demand side factors are called demand-pull factors and supply --side factors are called cost push factors. Accordingly, there are two kinds of inflation - Demand pull inflation - Cost push inflation **[Demand-pull inflation]** Demand pull inflation occurs when aggregate demand is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap. When there is excess demand, producers can raise their prices and achieve bigger profit margins. Demand-pull inflation becomes a threat when an economy has experienced a boom with GDP rising faster than the long-run trend growth of potential GDP. Demand-pull inflation is likely when there is full employment of resources and SRAS (short run Aggregate Supply) is inelastic What are the main causes of Demand-Pull Inflation? - A depreciation of the exchange rate increases the price of imports and reduces the foreign price of a country\'s exports. If consumers buy fewer imports, while exports grow, AD will rise -- and there may be a multiplier effect on the level of demand and output - Higher demand from a fiscal stimulus e.g. lower direct or indirect taxes or higher government spending. If direct taxes are reduced, consumers have more disposable income causing demand to rise. Higher government spending and increased borrowing creates extra demand in the circular flow - Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand -- for example in raising demand for loans or in leading to house price inflation. Monetarist economists believe that inflation is caused by "too much money chasing too few goods\" and that governments can lose control of inflation if they allow the financial system to expand the money supply too quickly. **[Cost push Inflation]** Cost-push inflation occurs when firms respond to rising costs by increasing prices in order to protect their profit margins. [There are many reasons why costs might rise:] - Component costs: e.g. an increase in the prices of raw materials and other components. This might be because of a rise in commodity prices such as oil, copper and agricultural products used in food processing. A recent example has been a surge in the world price of wheat. - Rising labour costs - caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low because skilled workers become scarce and this can drive pay levels higher. Wages might increase when people expect higher inflation so they ask for more pay in order to protect their real incomes. Trade unions may use their bargaining power to bid for and achieve increasing wages, this could be a cause of cost-push inflation - Expectations of inflation are important in shaping what actually happens to inflation. When people see prices are rising for everyday items they get concerned about the effects of inflation on their real standard of living. One of the dangers of a pick-up in inflation is what the Bank of England calls "second-round effects\" i.e. an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life. This is also known as a "wage-price effect\" - Higher indirect taxes -- for example a rise in the duty on alcohol, fuels and cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers. - A fall in the exchange rate -- this can cause cost push inflation because it leads to an increase in the prices of imported products such as essential raw materials, components and finished products - Monopoly employers/profit-push inflation -- where dominants firms in a market use their market power (at whatever level of demand) to increase prices well above costs  **Reference** Retrieved from :[[https://www.tutor2u.net/economics/reference/inflation-causes-of-inflation]](https://www.tutor2u.net/economics/reference/inflation-causes-of-inflation) Mankiw, N. Gregory. (2011). Essentials of Economics. 6th Ed. Pearson Publishers Mankiw, N. Gregory. (2009). Principles of Macroeconomics. South-Western Cengage Learning, Mason OH Dwivedi DN. (2011). Macroeconomic Theory and Policy. 3rd Ed. Tata McGraw-Hill Publishers