I have a test tonight in my Economics class and while I'm reviewing I thought I would share one of the topics covered in the examination: Money and Inflation. I want to thank Curt Wyse for looking up the information for me and N. Gregory Mankiw for writing it down in his book.
What are the three functions of money?
1. Store of value - money is a way to transfer purchasing value from the present to the future.
2. Unit of account - a yardstick with which we measure economic transactions.
3. Medium of exchange - money is what we use to buy goods and services.
Explain Milton Friedman's famous claim: "Inflation is always and everywhere a monetary phenomenon."
The quantity theory states that the central bank (the Federal Reserve for all you Americans out there), which controls the supply of money, has ultimate control over the rate of inflation. If the central bank keeps the money supply stable, the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly. Thus, as Friedman says, inflation is a monetary policy. It is dependent upon how much money the central bank keeps in circulation, not the strength or weakness of the economy.
Use the concept of "seigniorage" to explain the "inflation tax."
Seigniorage is the ability of the government to print money. When the government prints money (and puts it into circulation), it increases the money supply. An increase in the money supply, in turn, causes inflation. Thus, when the government prints money to raise revenue, everyone's existing money becomes worth less through the inflationary increase in prices. While not a physical tax, the effect of this inflation tax is the same in that the government increases its revenue at the expense of the citizens.
What are the three notable costs of expected inflation? What is the major cost of unexpected inflation?
Notable costs of expected inflation:
"Shoe Leather Costs" - Since an increase in inflation causes people to hold less money, they will make more trips to the bank to withdraw smaller amounts. (Leaving money in the bank allows them to partially offset the inflation through the higher levels of interest rates they earn on their bank deposits). The "Shoe Leather cost" is so named since people will wear out their shoes more rapidly due to the increased trips to the bank.
Menu Costs - This is the cost of reprinting and distributing catalogues and menus due to the higher frequency of price changes during high inflationary times.
Price Variability Costs - These costs are related to menu costs and account for the decrease in margin between printing of menus/catalogues. During times of high inflation, the purchasing power of a currency declines, but it is impossible to keep all catalogs/menus current. Thus, a firm's relative prices will fall as inflation changes purchasing power between printing of prices.
The Cost of Unanticipated Inflation:
The major cost of unanticipated inflation is the redistribution of wealth among individuals. This happens because people take anticipated inflation into account in their decision making, but cannot do the same for the unanticipated. For instance, when taking out a long term loan, both parties agree on an interest rate based on the anticipated inflation. If inflation ends up being much higher, the borrower pays back the amount with less valuable dollars. This causes the borrower to end up with some value/money the lender was supposed to have had, but was unable to collect due to inflation. Similarly, individuals on fixed pensions are often planning on a certain level of inflation. If inflation is higher or lower than the estimate, they either end up with more or less purchasing power.
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