Monday, October 22, 2007

Inflation and the Function of Money

Money is said to have four functions

1. Medium of Exchange - used for buying and selling goods.

2. Store of Value: We value goods and wealth through money. Money makes it easy to compare goods

3. Standard of Deferred Payment: Money is used to pay back debt.

4. Unit of Account: prices and accounting records use money

Inflation means an increase in the general price level. An inflation rate of 10% means that the average price level rises by 10%. Inflation means that the value of money decreases. If goods are more expensive a £10 note will buy less over time.

Inflation reduces the effectiveness of money as a medium of exchange. High inflation means that it becomes difficult to place a value on goods because the value of money is always falling. In extreme cases of hyper inflation prices can rise so much that money becomes worthless and people resort to a barter economy. e.g Hungary 1946, Germany 1922

As inflation increases, the volatility of the inflation rate tends to increase. This means that it is harder to place a value on money, thus it becomes more difficult to use it as a store of value.

With a high rate of inflation, the real value of debt erodes. This means that it is effectively easier to pay back the debt. Therefore, in periods of high inflation, banks will be less willing to lend money because they will lose out if people pay back the debt in the future when money is worth less. They will not lend money unless they can charge an interest rate higher than the rate of inflation. If the rate of inflation is stable it is easier to make these calculations.

With high inflation there will be greater Menu costs. This is the cost of changing price lists to reflect the changing value of money.

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