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Unformatted text preview: Macroeconomic Policy Class Notes Money, inflation and interest rates Revised: December 5, 2011 Latest version available at www.fperri.net/teaching/macropolicyf11.htm What is money? A standard way to begin a discussion about money is to try to define what it is. This is somewhat difficult to do because historically many things have been used as money - shells, beads, cigarettes, pieces of paper. What characteristics make any of these suitable as a form of money? One way to think about this is to define money in terms of the services it provides. Money is an asset . An asset is something that serves as a store of value , that is something that can transfer purchasing power from today to the future. Notice that money might not be the best way to store value (cash for example is money and does not pay interest and loses value because of inflation). But, lots of things, stocks, bonds, real estate, can and do fulfill that function. Money is really quite different from other assets because it provides another important service - it serves as a medium of exchange . The medium of exchange role implies that it is freely exchanged for goods and services and it has wide acceptance and (generally) well understood value; in other words money can be used to make transactions. Another service that money provides is that it serves as a unit of account . The role of unit of account means that when we talk about the value of other assets or consumption goods we use monetary units as a standard way of denominating them. The unit of account means also means that money is the good we use to measure prices, that is we define the concept of price of an object as the number of units of money that are required to purchase that object. This is important to recognize as when we think about inflation, that is how price level change, we have to think about how the stock of money changes. The fundamental prerequisite for functions 1,2 and 3 is that money has to have current and future value. After outlining its functions we can then state that money is the stock of assets that can be used to make transactions (stock of liquid assets). Money, inflation and interest rates 2 How does money come into being and why are people willing to accept some forms of money? Or in other words where does the value we attach to money come from? We know that different forms of money have evolved naturally in many societies. One example that is often cited is that cigarettes became used as a form of money in POW camps during World War II. They are also often used as a form of money in U.S. prisons. What problems does the existence of an accepted form of money solve? The easiest way to understand this is to imagine a simple economy in which individuals all specialize in the production of a single good. Some grow wheat, some harvest wood, some raise chickens and some educate the young. Specialization, as we learned studying international trade, is efficient but how do educators and wood harvesters get...
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