Project #25795 - article review

Make sure to provide at least 3 pages (750 to 1,000 words) using APA style. You must also include a reference page at the end of your summary.

 

 

 

 

“Money and Inflation:

 

A Functional Relationship”

 

 

March 2013

 

 

Classroom Edition

 

 

An informative and accessible economic essay with a classroom application.

 

 

 

Includes the full version of the Page One Economics Newsletter,

 

 

 

 

plus questions for students and an answer key for classroom use.

 

 

 

Common Core Standards (see page 9)

 

 

Prepared by Scott A. Wolla

 

Economic Education Group of the Federal Reserve Bank of St. Louis

 

 

 

© 2013, Federal Reserve Bank of St. Louis. www.stlouisfed.org/education

 

 

Permission is granted to reprint or photocopy this lesson in its entirety for educational purposes, so long as this copyright notice is included on all copies.

 

 

PAGE the back story on fron tO page NeconoEmics EconoNEmWSLEiTcTEsR

 

PAGE ONE Economics

 

In its broadest sense, money is anything generally accepted in exchange for goods and

 

 

 

services. In other words, money is defined by the functions it serves in the economy. In fact,

 

while money has taken many forms over the ages—cowry shells, furs, beads, even large stone

 

wheels—useful forms of money share three basic functions.

 

 

First, money is a store of value, which means that it holds its value over time. You can put

 

 

 

money in a drawer today and spend it next year, when it will buy approximately the same

 

 

amount of goods and services (minus inflation). Second, money is a unit of account, which

 

 

 

means it is a standard measure of value. Listen to a conversation between two people about a

 

recent purchase and you are sure to hear prices quoted in terms of money, not as hours worked

 

or the equivalent value of the purchase in corn (or some other commodity). Third, money is a

 

 

medium of exchange, which means it is generally accepted as a method of payment. I accept

 

 

 

my paycheck in U.S. dollars because I know dollars are readily accepted for payment at the grocery

 

store, gas station, and nearly anywhere I want to buy goods and services.

 

 

Money Versus Barter

 

 

You might not think of it often, but money facilitates transactions in amazing ways. Think

 

 

of conducting an economic transaction without money—a situation called barter. For barter

 

 

 

to work properly, you would need to find someone with the good or service you want; in turn,

 

that person would need to want to trade for what you have to offer. A difficult task to be sure.

 

 

The situation in which two people want to barter with each other is known as the double

 

coincidence of wants. Imagine an accountant who needs her car fixed. Under a barter system

 

 

 

she would need to find someone who needed some tax advice in exchange for car repairs. She

 

might find it difficult, and time consuming, to make such a transaction. Such searches for barter

 

partners are inefficient and wasteful.

 

So, how does money solve the double coincidence of wants problem? In an economy based

 

on money, the accountant provides her accounting services to whoever is willing and able to

 

pay money for them. She then uses the money she earned to pay for car repair services from a

 

mechanic, who is more than willing to accept cash for car repairs. Both parties to the transaction

 

are willing to exchange goods or services for money. In the end, everyone involved is more

 

 

Money and Inflation:

 

A Functional Relationship

 

 

Scott A. Wolla, Senior Economic Education Specialist

 

 

"Economists like to argue that money belongs in the same class as the wheel and inclined plane among

 

ancient inventions of great social utility. Price stability allows that invention to work with minimal friction."

Federal Reserve Chairman Ben S. Bernanke, February 24, 2006

 

the back story on front page economics NEWSLETTER

 

March ô€€€ 2013

 

 

 

 

1

 

 

 

Federal Reserve PAGE ONE Economics Bank of St. Louis 2 NEWSLETTER

 

 

 

NOTE: The year-over-year inflation rate over the past 10 years has fluctuated from a high of 5.5 percent in

 

July 2008 to –2 percent (deflation) in July 2009. The consumer price index is a measure of inflation.

 

 

SOURCE: Federal Reserve Bank of St. Louis FRED (http://research.stlouisfed.org/fred2/graph/?g=eYT).

 

readily satisfied. Using money allows a more efficient outcome because it cuts down on search

 

costs, and it allows workers to specialize in what they do best.

 

 

 

Money and Inflation

 

 

Even when you have money available to purchase goods and services, as in the accountant/

 

 

mechanic example, money’s ability to serve its functions has limits. High rates of inflation, for

 

 

 

example, make money less useful in many ways. First, when inflation rates are very high, the

 

longer you hold money as cash, the more value it loses, so you attempt to spend it immediately

 

rather than hold it. In this situation, money does not function as an effective store of value. In

 

fact, if people expect high rates of inflation and the rate of their transactions increases as a

 

result, inflation will increase even further. Second, if inflation rises to very high rates, money’s

 

usefulness as a unit of account diminishes. If prices are changing rapidly, communication

 

between buyers and sellers becomes complicated. Comparing prices becomes complex if all

 

prices are rising rapidly. Third, inflation reduces the usefulness of money as a medium of

 

exchange. In the case of extreme inflation (hyperinflation), people may abandon the use of one

 

currency for a more stable one. In Zimbabwe, for example, the inflation rate rose from 24,411

 

percent in 2007 to an estimated 89.7 sextillion (89,700,000,000,000,000,000,000) percent in

 

November 2008 (Waller, 2011). Hyperinflation was so problematic that people abandoned the

 

Zimbabwean dollar, preferring to conduct transactions in U.S. dollars or South African rands.

 

The Zimbabwean currency became nearly useless as money and was removed from circulation

 

in 2009 (Central Intelligence Agency, 2013). However, a market in Zimbabwean dollars has

 

since developed for currency collectors and souvenir seekers—you can buy a Zimbabwean

 

$100 trillion dollar bill for approximately 5 U.S. dollars (McGroarty and Mutsaka, 2011).

 

 

2

 

 

 

Federal Reserve Bank of St. Louis 3

 

 

 

So, if high inflation is bad, is an inflation rate of zero best? What is the optimal inflation

 

rate? The Federal Reserve has determined that a 2 percent rate of inflation is most consistent

 

 

with its dual mandate (the goals created for it by Congress) of maximum employment and

 

price stability. Two percent is considered a low rate of inflation, which only slightly distorts

 

 

 

the functions of money discussed previously. And, if the inflation rate is stable, people come to

 

build 2 percent into their expectations of future prices, and wages and interest rates can adjust

 

accordingly.

 

If the low inflation rate of 2 percent is good, why not have an even lower rate of zero? When

 

 

the inflation rate is less than 2 percent, the danger of deflation exists. Falling prices might sound

 

 

 

appealing, but falling prices would likely lead to falling wages as well—and deflation is associated

 

with very weak economic conditions (Board of Governors of the Federal Reserve System, 2013).

 

An inflation rate greater than zero maintains an “inflation buffer,” which reduces the chances

 

of deflation should the economy start to weaken (Bernanke, 2010). On the other side of the

 

Fed’s dual mandate (maximum employment), it is generally agreed that economic growth and

 

employment are enhanced when inflation is low and stable (Bernanke, 2006).

 

 

Conclusion

 

 

Money facilitates transactions in ways that keep the economy functioning well, but not so

 

well when inflation is high and volatile. In contrast, a low and stable rate of inflation helps

 

 

ensure that money performs its functions efficiently. ô€€€

 

 

 

 

 

REFERENCES

 

 

 

 

Bernanke, Ben S. “The Benefits of Price Stability.” Speech presented at The Center for Economic Policy Studies and on the

 

occasion of the Seventy-Fifth Anniversary of the Woodrow Wilson School of Public and International Affairs, Princeton

 

University, Princeton, New Jersey, February, 24; 2006;

 

 

http://www.federalreserve.gov/newsevents/speech/bernanke20060224a.htm.

 

 

 

Bernanke, Ben S. “Monetary Policy Objectives and Tools in a Low-Inflation Environment.” Speech presented at the Revisiting

 

Monetary Policy in a Low-Inflation Environment Conference, Federal Reserve Bank of Boston, Boston, Massachusetts, October

 

 

15, 2010; http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm.

 

 

 

Board of Governors of the Federal Reserve System. “Why Does the Federal Reserve Aim for 2 Percent Inflation Over Time?”

 

 

Current FAQs, January 3, 2013; http://www.federalreserve.gov/faqs/economy_14400.htm.

 

Central Intelligence Agency. “Zimbabwe.” The World Factbook, January 22, 2013;

 

https://www.cia.gov/library/publications/the-world-factbook/geos/zi.html.

 

McGroarty, Patrick and Mutsaka, Farai. “How to Turn 100 Trillion Dollars Into Five and Feel Good About It.” Wall Street Journal,

 

May 11, 2011; http://online.wsj.com/article/SB10001424052748703730804576314953091790360.html.

 

 

 

Waller, Christopher J. “Independence + Accountability: Why the Fed Is a Well-Designed Central Bank.” Federal Reserve Bank of

 

 

St. Louis Review, September/October 2011, 93(5), pp. 293-301;

 

http://research.stlouisfed.org/publications/review/11/09/293-302Waller.pdf.

 

PAGE ONE Economics NEWSLETTER

 

 

 

 

3

 

 

GLOSSARY

 

 

 

 

Barter: Trading goods and services for other goods and services without using money.

 

Dual mandate: The Federal Reserve’s responsibility to use monetary policy to promote maximum employment and stable

 

 

 

prices.

 

 

Double coincidence of wants: Each participant in an exchange is willing to trade what he or she has in exchange for what

 

 

 

the other participant is willing to trade.

 

 

Deflation: A general, sustained downward movement of prices for goods and services in an economy.

 

Inflation: A general, sustained upward movement of prices for goods and services in an economy.

 

Medium of exchange: Anything generally accepted in exchange for goods and services.

 

Money: Anything generally accepted in exchange for goods and services. Money serves as a store of value, unit of account,

 

 

 

and medium of exchange.

 

 

Price stability: A low and stable rate of inflation maintained over an extended period of time.

 

Search costs: The financial and opportunity costs consumers pay when searching for a counterparty in a transaction.

 

Store of value: The ability of a currency, commodity, or other type of capital to retain its worth over time.

 

Unit of account: A common measurement used to compare the value of goods and services.

 

PAGE ONE Economics NEWSLETTER

 

Federal Reserve Bank of St. Louis 4

 

Page One Economics Newsletter from the Federal Reserve Bank of St. Louis provides an informative, accessible economic essay written by our economic

 

 

 

education specialists, who also write the accompanying classroom edition and lesson plan. The newsletter and lesson plans are published 9 times per

 

year, January through May and August through November.

 

 

Please visit our website and archives http://research.stlouisfed.org/pageone-economics/ for more information and resources.

 

 

 

 

Views expressed do not necessarily reflect official positions of the Federal Reserve System.

 

 

 

4

 

 

Name___________________________________ Period_______

 

 

 

Federal Reserve Bank of St. Louis Page One Economics Newsletter:

 

 

 

 

“Money and Inflation: A Functional Relationship”

 

 

After reading the article, answer the following questions.

 

1. How does money solve the double coincidence of wants problem that arises in a barter system?

 

2. In the table below, describe each of the functions of money and how inflation reduces the ability of

 

each of these functions.

 

3. Why is an inflation goal of 2 percent better than zero percent?

 

 

Function Description of function How inflation reduces this function

 

Store of value

 

Unit of account

 

Medium of exchange

 

 

 

.

 

 

 

5

 

 

Teacher’s Guide

 

 

 

Federal Reserve Bank of St. Louis Page One Economics Newsletter:

 

 

 

 

“Money and Inflation: A Functional Relationship”

 

 

After reading the article, answer the following questions.

 

1. How does money solve the double coincidence of wants problem that arises in a barter system?

 

 

 

In a barter system, you would need to find someone with the good or service you want; in turn, that

 

person would need to want what you have to offer. In a money-based economy, people sell their labor

 

for wages (money) and buy the goods and services they want with money. Finding people willing to trade

 

goods and services in exchange for money is easier than barter—it reduces search costs.

 

 

 

2. In the table below, describe each of the functions of money and how inflation reduces the ability of

 

each of these functions.

 

3. Why is an inflation goal of 2 percent better than zero percent?

 

 

 

Two percent is considered a low rate of inflation, which only slightly distorts the functions of money.

 

When the inflation rate is less than 2 percent, the danger of deflation exists—and deflation is associated

 

with very weak economic conditions. An inflation rate greater than zero maintains an “inflation buffer,”

 

which reduces the chances of deflation should the economy start to weaken.

 

 

 

Function Description of function How inflation reduces this function

 

 

Store of value Money holds its value Inflation is a general, sustained upward

 

 

 

 

over time. movement in prices for goods and services

 

in the economy—that is, inflation reduces

 

the purchasing power of money. So, during

 

periods of inflation, money is a less effective

 

store of value.

 

 

 

Unit of account Money is a standard If all prices are rising rapidly, comparing

 

 

 

 

measure of value. prices becomes complex and money is

 

less useful to measure value.

 

 

 

Medium of exchange Money is widely accepted If a country’s inflation becomes extreme

 

 

 

 

as a method of payment. (hyperinflation), its currency will be less

 

appealing to buyers and sellers; another

 

country’s currency may become preferable

 

as a more effective and stable medium of

 

exchange.

 

 

 

6

 

 

For Further Discussion

 

 

Review these main points from the essay and lead a discussion using the questions provided below.

 

 

 

• Money has existed in nearly all societies for thousands of years and has taken many forms.

 

• Without money, people would have to barter for goods and services.

 

• Barter is trading goods and services for other goods and services without using money.

 

 

• Barter requires a double coincidence of wants, a situation in which each participant in a transaction is

 

 

 

willing to trade what he or she has in exchange for what the other participant is willing to trade.

 

Lead your students in a discussion using the following questions and responses.

 

 

Lesson One: Barter imposes search costs that make trade very difficult.

 

 

1. Tell your students that you want to hire someone to mow your lawn, but you have only paper clips—lots

 

and lots of paper clips—to offer as payment. You are willing to pay 5,000 paper clips each time your lawn

 

is mowed. You predict you will need your lawn mowed every week during the spring and summer and less

 

often in the fall.

 

2. Ask the students who will accept your offer of 5,000 paper clips in exchange for each lawn mowing. (It is

 

likely no students will volunteer.)

 

3. Ask the students if paper clips have value. (Yes; in fact, tell the students that 5,000 paper clips have an

 

approximate monetary value of $30.)

 

4. Ask the students why they are not willing to mow your lawn in exchange for paper clips. (They likely do

 

not want 5,000 paper clips; they can’t use that many paper clips; it would be difficult to exchange the

 

paper clips for other things they want.)

 

5. Ask the students if they think it would be difficult for you to find someone who will trade paper clips for

 

lawn mowing. (Yes; people who mow lawns might not want 5,000 paper clips.)

 

 

6. Tell the students that search costs are the time and effort a person spends looking for someone to trade

 

 

 

with. Define search costs as the opportunity costs of searching for a counterparty in a transaction. For

 

example, finding someone to mow my lawn for paper clips might require me to advertise, which entails

 

a financial cost. Or it might require me to spend time interviewing several people before I find someone

 

willing to mow for paper clips. That time could have been spent with friends or earning income. In other

 

words, there are opportunity costs.

 

7. Tell the students that a double coincidence of wants makes barter difficult. Tell the students that a

 

medium of exchange—a single item that both people want that could be used to facilitate the trade—

 

might make the process easier.

 

8. Ask the students if they can think of items that might fit this description. (Money)

 

9. Ask the students whether they would mow a lawn for $30. (Several volunteers will likely emerge.) Remind

 

them that those 5,000 paper clips have a retail value of approximately $30 and ask why they would accept

 

$30 but not $30 worth of paper clips. (Again, people who mow lawns might not want 5,000 paper clips.)

 

 

7

 

 

 

10. Ask the students to summarize how a money-based economy reduces search costs. (It is easier to find

 

someone to mow a lawn for $30 than for 5,000 paper clips. People will readily accept money because it

 

is a good medium of exchange—they know that other people will also readily accept it for goods and

 

services they need.)

 

 

Lesson Two: Money allows for degrees of specialization that would not occur in a barter economy.

 

 

Suppose Mr. Smithton has developed highly specialized skills. He is an engineer who designs a microscopic

 

part used in disk drives of large industrial computers. His employer is one of the few companies in the world

 

that produces this vital part and it is very profitable as a result. Because his skills are highly specialized and

 

valuable, his company pays him a large salary to perform his duties.

 

Now, imagine Mr. Smithton has these same skills in a barter economy. In a barter economy, he must trade his

 

highly specialized skill for food and housing.

 

1. Ask the students if they can think of any food producers (farmers) who might have food to offer

 

Mr. Smithton in return for talents designing highly engineered microscopic parts. (Probably not)

 

2. Ask the students if they can think of any landlords who will rent an apartment to Mr. Smithton in exchange

 

for his talents. Why not? (Probably not. Unless a landlord also owns a large industrial computer manufacturing

 

firm, he or she would probably not want his skills.)

 

3. Remind the students that search costs are the time and effort a person spends looking for someone to

 

trade with. In this case, Mr. Smithton might spend hours or days trying to find someone who will trade

 

goods and services he wants in exchange for his specialized engineering skills.

 

4. Ask the students if search costs are likely to be higher or lower than average for a person with highly

 

specialized skills. (Search costs are likely to be very high for workers with highly specialized skills.)

 

5. Ask the students how a person with more generally appealing skills such as a baker, carpenter, or plumber

 

might fare in a barter economy. (They would probably find it easier to barter with their skills. In other

 

words, their search costs would be lower than for those with more specialized skills.)

 

6. Ask the students what might happen to the incentives for people to develop specialized skills in a barter

 

economy. (Because people with highly specialized skills might have the most difficulty finding trading

 

partners, there would be an incentive for people to develop more general skills. In fact, as an engineer

 

Mr. Smithton might have such difficulty trying to find food that he would reduce the time he spends

 

engineering to spend more time gardening.)

 

7. Think about highly specialized surgeons or the people who fix sophisticated computers. Do we generally

 

regard specialized skills as good for the economy? (Workers with highly specialized skills are important to

 

the development of new technologies that increase productivity, produce jobs, and potential economic

 

growth. They are very important to the economy. Imagine all of the specialized labor involved in the design

 

and production of an automobile. It is doubtful that something as complex as an automobile could exist

 

in a barter-based economy.)

 

 

Conclusion

 

 

While we may take money for granted, it is truly amazing. Money acts as a medium of exchange. This allows

 

people to make transactions for goods and services in ways that minimize search costs and encourage workers

 

to develop highly specialized skills that create benefits for a growing economy.

 

 

8

 

 

Common Core State Standards

 

 

Grades 6-12 Literacy in History/Social Studies and Technical Subjects

 

 

 

Key Ideas and Details

 

 

 

RH.11-12.1: Cite specific textual evidence to support analysis of primary and secondary sources,

 

connecting insights gained from specific details to an understanding of the text as a whole.

 

RH.11-12.2: Determine the central ideas or information of a primary or secondary source; provide

 

an accurate summary that makes clear the relationships among the key details and ideas.

 

 

Craft and Structure

 

 

 

RH.11-12.4: Determine the meaning of words and phrases as they are used in a text, including

 

analyzing how an author uses and refines the meaning of a key term over the course of a text

 

 

(e.g., how Madison defines faction in Federalist No. 10).

 

 

 

 

9

 

 

 

 

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