Inflation and the Functions of Money

There are several different functions of money in an economy including medium of exchange, store value, unit of account and standard for deferred payments

Medium of Exchange

• The main purpose of money is for it to be a medium of exchange so that it can be exchanged for goods and services between buyers and sellers when they trade.
• Although, when hyperinflation occurs, inflation will increase at a incredibly rapid rate (possibly rising at some hundred or thousand percent annually) and it may result in money becoming useless/worthless. Due to money becoming worthless, it may no longer be an ideal medium of exchange and people may prefer to use gold, food or other commodities s a medium of exchange.

Store of value

• Money can be saved and retrieved or used at a later time. This encourages people to save as money saved now can be used in the future.
• However, money is not an ideal store of value when inflation is high. If interest rates are higher than the rate of inflation, this can run down the value and worth of a person’s savings.

Unit of Account

• Money is a unit of measure for the value of goods and services in an economy.  The value/worth of different goods and services can be compared in relation to money. Transactions are recorded in monetary terms.
• Monetary value be distorted and as a result, utilizing money as a unit of account can be an issue as people may become unsure about the correct value of money.

Standard for deferred payments

• Some goods can be payed for at a later date and this is called a deferred payment. An example of a deferred payment is a debt and a “standard of deferred payment” is a way of settling a debt. This means that the seller is able and willing to accept payment in the form of money in the future.
• As mentioned in Introduction to Inflation, inflation helps borrowers and those in debt as their wages and incomes will increase but their debt would remain the same. They will pay back money that will buy less than it did when they borrowed. “Over time, the amount repaid has less purchasing power than the amount borrowed”

Consequences of Inflation

There are several different unwanted effects of inflation that may affect households, firms and the economy such as reducing purchasing power, reducing the value of savings, increased business costs, balance of payments problems and increased in government spending

Reduces purchasing power

As inflation rises, the purchasing power of money reduces. This means that people aren’t able to buy as much with their income as they had been able to before. Although, it may not pose a problem if incomes/wages rise at the same rate or faster than inflation. If incomes/wages rise at a slower rate compared to prices, then there will be a reduction in purchasing power.

Increased Business Costs

There are a number of costs that inflation can inflict on a business.

• When inflation occurs, this can often result in higher production costs which affect firms negatively. Higher production costs for resources such as raw materials, advertising, insurance, etc will result in a decrease in profit. In order to maintain their profit margin, firm may raise their prices.
• As a result of inflation, purchasing power is typically reduced. If wages and incomes do not rise, when purchasing power is reduced so is the standard of living. This can create conflict between the employers and trade unions as there will be a demand from the trade unions for higher wages that may result in strikes, etc.
• Menu costs are costs to a firm when they have to update menus, brochures, websites, etc. as a result of inflation. Firms will need to increase their prices repeatedly when inflation is rapid as customers must be informed of such changes.
• Shoe leather costs of inflation are cost of the time and effort people spend trying to counteract the effects of inflation by trying to search for the lowest prices and best values for their money.

Balance of Payments Problems

It might be difficult for firms to sell in overseas markets if inflation is higher in their country compared to other countries because the prices of exports may increase. Demand for exports will probably decrease when there is an increase in the price of exports and as a result there will be a negative effect on the current account. Excess/surplus on the current account will decrease and a shortage/deficit will be increased. Although, there would be a greater negative effect if it were the other way around and exports were cheaper than domestic goods. If demand for imports rise, there will be a greater negative effect on the current account.

Increases in Government Spending

A large portion of government spending is linked to inflation so as a result, government expenditure increases when inflation occurs. Government benefits such as state pensions are index linked and will increase or decrease depending on inflation and the RPI. Consequently, depending on an increase or decrease in the RPI, the government must alter state pensions to meet the changes. Wages of public sector workers such as teachers, government officials and police officers are linked to inflation as well.