Lesson 9: Money and Inflation

Introduction

In this lesson students learn that anything that performs the functions of money can be money (even macaroni!).  As they use their macaroni to bid on items during an auction, they learn that the value of money depends on the quantity of money relative to the quantity of goods and services they can buy with that money.   Historical and contemporary examples as well as video clips help students understand the role that banks and the Federal Reserve  play in expanding and contracting the money supply.

Objectives

At the end of this lesson students will be able to:

• Identify the three functions of money.
• Explain how banks create money through fractional reserve banking.
• Give examples of how the Federal Reserve uses their tools to increase or decrease the money supply.
• Explain the cause of inflation.
• Provide examples of the costs of inflation

Economic Concepts

Money	Inflation	Government Spending
Discount Rate	Federal Funds Rate	Federal Reserve System
Open Market Operations	Monetary Policy	Interest Rate

Key Ideas

1. Review:

• Voluntary trade creates wealth.
• Institutions that facilitate trade help to increase wealth and raise standards of living.

2. Money enhances voluntary trade by reducing transaction costs.

• Money is anything generally accepted in exchange for goods and services.
• Money performs three functions in market economies:
  • Money is a store of value
  • Money is a standard of value.
  • Money is a medium of exchange.

3. The interest rate is the opportunity cost of holding money, because instead of holding money, people could hold interest-earning assets (such as Certificates of Deposit or bonds) instead.

4. Interest rates are determined by the interaction of lenders who supply funds, and borrowers, who demand funds.

• Savers supply funds to be loaned and are paid interest for waiting to consume at a later date.
• Demanders of these funds are the borrowers, who pay interest in order to have the right to spend now instead of waiting for future income. This spending might be on consumption or on investment goods (such as plant and equipment).
• Interest rates vary with the type of market. Rates change within a market in response to changes in supply and demand for loanable funds.

5. The money supply is a measure of the total amount of money in an economy.

• The money supply changes through activities of the commercial banking system.
• The Federal Reserve System is charged with, among other things, managing the money supply of the United States. It does this by managing the stock of currency in circulation and the amount of reserves in the banking system.
  • The Federal Reserve uses open market operations to alter the amount of currency and bank reserves, generally signaling its intentions to do so through changes in its target value for the Federal Funds rate and changes in the Discount rate.
  • The Federal Fund rate is the rate of interest at which U.S. banks lend to one another their excess reserves held on deposit by Federal Reserve banks.
  • The Discount rate is the rate at which member banks may borrow short term funds directly from a Federal Reserve Bank.
• Other policy vehicles available to the Fed include: reserve requirements, margin requirements on stock loans, credit controls on lending quality, and changes in eligible “collateral” for direct loans to member banks and other commercial institutions (e.g., investment banks).

6. Inflation is a general increase in the level of prices throughout the economy.

• The most commonly used measure of inflation is the Consumer Price Index, (or CPI). The GDP Deflator is another important measure of inflation. Changes in these price indices indicate changes in the purchasing power of the U.S. dollar.
• Unanticipated inflation alters the normal signals buyers and sellers receive from prices, changing their behavior in markets.
  • Inflation encourages more debt and faster spending as buyers and sellers try to avoid rising prices.
  • Inflation creates uncertainty and makes future planning more difficult.
• Unanticipated inflation erodes the purchasing power of nominal assets, including money, bonds, and savings accounts. Individuals with fixed incomes also lose.
• Very rapid inflation (a/k/a hyperinflation) causes markets of all types to break down, for two reasons.
  • The extremely high cost of using money during hyperinflations forces people to resort to barter, which is an inefficient means of transacting.
  • A high average rate of inflation is always accompanied by much uncertainty about the future inflation rate, which makes many contracts more risky. Greater levels of risk increase the value of the “option to wait,” which delays many consumption and investment decisions, and thereby slows economic growth.

7. Inflation is a monetary phenomenon, and almost always occurs because increases in the stock of money exceed growth in output of goods and services.

• Rapid increases in the money supply can be the result of poor management by the central bank or by a decision to print money to support government spending.
  • A frequent problem in developing nations is that governments without stable or consistent tax collections often resort to printing money to finance government spending.
• Inflation increases pressure on government to impose price controls which tends to make conditions worse instead of better.
  • Intended to halt rising prices, price controls instead disguise inflation and disrupt the allocation of goods and services.

   

Ideas To Take Away From This Lesson

• Money is an innovation that significantly improved the operation of markets.
• Banks facilitate the operation of markets by expanding the quantity of money in circulation.
• Inflation is a consequence of the money supply growing faster than production.
• The Fed manages price and interest rate levels by changing the money supply.
• Inflation creates disruptions and losses in the overall economy as buyers and sellers act to avoid its effects.