Inflation frustration: why more money isn't always a good thing.

Question 1

Define Inflation.

Answer 1

Inflation is the word Economists use to describe a situation in which the general level of prices in the economy is rising.

This situation doesn’t mean that every price of every good is going up - a few prices may even be falling - but the overall trend is upward.

Typically, the trend is for prices to go up only a small percentage each year, but people dislike even mild inflation, because no one likes higher prices.

Question 2

What problems might mild inflation cause?

Answer 2

Mild inflation makes retiring planning very difficult. After all, if you don’t know how expensive things are going to be when you retire, calculating with any certainty how much money you’ll need to be saving right now is difficult.

Question 3

What causes inflation and how can economists stop it?

Answer 3

The culprit is a money supply that grows too quickly, and the solution is simply to slow or halt the growth of the money supply.

Unfortunately, some political pressure is always exerted in favour of inflation so that simply knowing how to prevent inflation doesn’t necessarily mean it isn’t going to develop.

Question 4

Historically, what are some examples of the things different groups have used as money?

Answer 4

Seashells were used as money in ancient China, throughout the Pacific and also by the Native Americans.

Boxes of cigarettes were used as money in POW camps during ww2.

Various agricultural products such as barley or cattle were used as money in many cultures.

Huge donut-shaped stones were used on the island of Yap in the Pacific.

But eventually, most of the western world realised metal made the best money. Metal doesn’t wear out or shatter like seashells, it doesn’t get mouldy like barley and it can easily be carried around in your pocket unlike huge donut-shaped stones.

Question 5

How is the value of money determined?

Answer 5

The value of money is determined by supply and demand.

The SUPPLY of money is under government control, and the government can very easily print more money any it wants to.

The DEMAND for money derives from its usefulness as a means of paying for things and from the fact that having money means not having to engage in barter.

Question 6

What is the r/ship between prices and the value of money?

Answer 6

Prices and the value of money are inversely related, meaning that when the value of money goes up, prices go down (and vice versa).

Ex. Suppose money is in short supply and is therefore very valuable. Because money is very valuable it buys a lot of stuff.

I.e imagine £10 buys 1000g of coffee ( = 10g for 10p). But if money is very common, each unit isn’t very valuable. In this case, say that £10 buys you 100g of coffee (so you only get 1g for 10p). Therefore, the greater the supply of money, the higher the prices.

Question 7

What happens when the government increases the supply of money AT THE SAME RATE as the growing demand for money?

Answer 7

If the gov increases the supply of money at the same rate as the growing demand for money, prices don’t change. In other words, a supply and demand for money grow at equal rates, the relative value of money doesn’t change.

Question 8

What happens if the gov increases the supply of money FASTER than the demand for money grows?

Answer 8

If the gov increases the supply of money FASTER than the demand for money grows, inflation results as money becomes relatively more plentiful and each piece of money becomes relatively less valuable. With each piece of money carrying less value, you need more of it to buy stuff, causing prices to rise.

Question 9

What happens if the gov increases the supply of money SLOWER than the demand for money grows?

Answer 9

If the gov increases the supply of money SLOWER than the demand for money grows, deflation results because each piece of money grows relatively more valuable. Buying any given good or service requires less money.

Question 10

Is there any way of knowing exactly how much inflation you can expect from printing any given amount of money?

Answer 10

Yes. The QUANTITY THEORY OF MONEY states that the overall level of prices in the economy is proportional to the quantity of money circulating in the economy.

In other words: if you double the money supply, you double prices.

Question 11

Who were the Kings of money?

Answer 11

In the 6th century BC King Croesus of Lydia issued the first government-certified coins that guaranteed purity and weight.

Soon all Mediterranean nations were using the coins as they were the most trustworthy medium of exchange available. As a result the Lydian empire became very very rich.

But because coins are heavy and hard to carry around, the Mongolian emperor Kublai Khan created the first paper money in the 13th century.

This paper money was actually a kind of precious-metal certificate; people holding one could go to a government vault and redeem it for gold (i.e. as good as gold).

When Marco Polo came back from China and told the Europeans about this notion they laughed at him, as they were unable to conceive of anything other than gold or silver that could serve as money. So once paper money fell in China, it was centuries before any other government issued any again.

Question 12

Why would a government ever print too much money?

Answer 12

When gov’s can’t raise enough tax revenue to pay their obligations.

When gov’s feel pressure from debtors who want inflation so that they can repay their debts using less valuable money.

When gov’s want to try to stimulate the economy during a recession or depression.

Question 13

What happened in Germany during the 1920’s?

Answer 13

Hyperinflation hit Germany in the 1920’s. It was so bad it led Germans to vote for Hitler.

After WW1,Germany had incurred massive debts in terms of war reparations. Most of its debts were in its own currency, the German Mark.

Because the German government had the exclusive right to produce German marks, the debt proved an irresistible temptation to begin printing money to pay off debt. Soon the rate of inflation was rising well over 100% per month and by the end of the year was 6000%.

Waiters had to regularly pencil in new prices on a daily basis and if you ate slowly you were sometimes charged twice what was printed on the menu because the price had gone up while you ate.

Others couldn’t be bothered counting the money and so they stacked it and weighed the bricks of cash i.e. 2kg of cash for a chicken.

Question 14

Why was it difficult for a government to devalue the currency by printing too much money?

Answer 14

Due to the so called GOLD STANDARD, you were able to go to the Bank of England with a sum of money and exchange it for a precise amount of gold.

This made it difficult for a government to devalue the currency by printing too much money because it first had to get more gold with which to back the new money. Because purchasing gold is expensive, gov’s were effectively restrained from increasing their money supplies.

Question 15

What did President Nixon do in 1971?

Answer 15

A major break occurred in 1971, when, in order to pay for the escalating costs of the Vietnam war, Nixon took the U.S. off the gold standard and put them on the FIAT SYSTEM in which paper currency isn’t backed by anything.

People just have to accept the currency as though it has value. In fact, in Latin FIAT means ‘let it be done’.

Question 16

What is a problem with the FIAT money system?

Answer 16

Fiat money, basically refers to how a gov creates money simply by ordering it into existence. The problem with the fiat money system is that nothing limits the number of little pieces of paper that the gov can print up to pay its debts.

Question 17

What is the problem with printing money to pay your debts?

Answer 17

The problem with printing money to pay your debts is that as soon as the money is out there, people spend it, drive up prices and cause inflation.

If you keep printing money you end up with people offering shopkeepers and producers more and more money for the same amount of goods.

i.e. like a giant auction where everybody bidding on items keeps getting more and more money to bid with. The more money you print, the less each individual £ is worth.

Question 18

What does hyperinflation do to savings and investments?

Answer 18

Hyperinflation destroys the incentive to save because the only sensible thing to do during hyperinflation is to spend it as quickly as possible before it loses even more value.

People’s life savings become worthless during hyperinflation, and those with no savings for the future are discouraged because they know that any money they save will also lose its value.

The discouragement of saving causes major business problems because if people aren’t saving, no money is available for businesses to borrow for new investments. And without new investments, the economy can’t grow.

Question 19

What is meant by ‘money is a store of value’?

Answer 19

If you sell a cow today for one gold coin you should be able to trade back that coin in one weeks/months time for a cow. When money retains its value, you can hold it instead of holding cows, or property or any other asset.

Inflation weakens the use of money as a store of value because each unit of currency is worth less and less as time passes.

Question 20

What is meant by ‘money is a unit of account’?

Answer 20

When money becomes widely accepted in an economy, it often becomes a unit of account in which people write contracts i.e. ‘£50 worth of timber’ rather than ‘50 sq meters of timber’.

This practice makes sense if money holds its value over time, but in the presence of inflation, using money as a unit of account creates problems as the value of money declines i.e. if the value of money is falling, how much timber, exactly, is ‘£50 worth of timber’?

Question 21

What is meant by ‘money is a standard of deferred payment’?

Answer 21

If you want a cow, you probably wouldn’t borrow a cow with the promise to repay two cows next. Instead, you’d be much more likely to borrow and repay in terms of money. That is, you’d borrow one gold coin and use it to buy a cow, after promising to pay back two gold coins next year.

Inflation makes people reluctant to lend money. They fear that when the loans are repaid, the repayment cash isn’t going to have the same purchasing power as the cash that was lent.

This uncertainty can have a devastating effect on the development of new businesses, which rely heavily on loans to fund their operations.

Question 22

What is meant by ‘money is a medium of exchange’?

Answer 22

Money is a medium of trade between buyers and sellers.

In a barter economy, an orange farmer who wants to buy beer may have to first trade oranges for apples and then apples for beer because the guy selling beer only wants apples. Money can eliminate this kind of hassle.

But if inflation is bad enough, money is no longer an effective medium of exchange i.e. during hyperinflations economies often revert to barter so that buyers and sellers don’t have to worry about the falling value of money. Or, economies have to resort to cumbersome bartering i.e. adopting a trusted foreign currency such as the US dollar.

Question 23

How might inflation be seen as a giant tax increase?

Answer 23

This seems strange because you usually think of gov’s taxing by taking away chunks of people’s money, not by printing more.

But a tax is basically anything that transfers private property to the gov. Debasing the currency or printing more money can have this effect.

Question 24

What is an inflation tax?

Answer 24

Suppose the gov wants to buy a £20,000 van for a village. The honest way to do so is to use £20,000 of tax revenues to buy a van. But a sneakier way is to print £20,000 in new cash to buy the van.

By printing and spending the new cash, the gov has converted £20,000 of private property- the van - into public property. Because printing new money ends up causing inflation, this type of taxation is often referred to as inflation tax.

Question 25

In the UK, what measure is used to capture the effect of inflation?

Answer 25

The Consumer Price Index (CPI) captures the price of a basket of goods, and is often tweaked to take into account the change in consumer purchases over time.

Question 26

How do you calculate the inflation rate?

Answer 26

First total up how much the market basket costs each year.

(note: capital letter P denotes £’s and pi denotes the rate of inflation.)

pi= (Psecond year - Pfirst year) / Pfirst year

Ex. if pi= 8.8% this means you need 8.8% more money in the second year to buy the market basket.

Question 27

What are nominal and real prices?

Answer 27

Nominal prices are simply money prices, which can change over time due to inflation.

Because nominal prices can change, economists like to focus on real prices, which keep track of how much of one kind of thing you have to give up to get another kind of thing, no matter what happens to nominal prices.

Question 28

What are three big issues with using the price index to track the cost of living?

Answer 28

1) The market basket can never perfectly reflect family spending i.e. families differ greatly, not only in terms of what they buy but also in terms of how many of each thing they buy.
2) The market basket becomes outdated i.e. when to replace one item with another in the list is a fine judgment call ex. DVD players and VCRs.
3) The market basket can’t account for quality. Price isn’t the only thing consumers look for. Ex. what if a beer stays the same price but improves in quality from one year to the next (the same goes for computers, mobile phones and video games).

Question 29

What’s the difference between nominal and real interest rates?

Answer 29

Nominal interest rates are simply the normal money interest rates that you’re used to dealing with; they measure the returns to a loan in terms of money borrowed and money returned.

Real interest rates however, compensate for inflation by measuring the returns to a loan in terms of units of stuff lent and units of stuff returned.

This distinction is very important because what makes people want to save and invest is the REAL interest rate. After all, what lenders really care about isn’t how much money they get back but how much stuff they can buy with it.

Question 30

Who was Irving Fisher and what did he come up with?

Answer 30

Economist Irving Fisher came up with the Fisher equation, which links nominal and real interest rates.

Where i = the nominal interest rate, r = real interest rate and pi(e) = the expected rate of inflation, the formula is:

i = r + pi(e)

This equation simply says that the nominal interest rate is the real interest rate plus the expected rate of inflation.

Question 31

Give an example, using the Fisher equation.

Answer 31

Suppose a borrower and a lender agree that 6% is a fair real rate of interest, and they also agree that inflation is likely to be 3.3% over the course of one year.

Using the Fisher equation, they write the loan contract with a 9.3% nominal interest rate. A year later, when the borrower repays the lender 9.3% more money than was borrowed, that money is expected to have only 6% more purchasing power than the borrowed money, given the expected increase in prices.