Inflation and Money

Key Terms:

* Inflation
* Money
* Consumer Price Index
* Money supply
* Interest rate
* Federal Reserve System
* Discount rate
* Monetary Policy
* Open market operations
* Reserve requirement

Lesson Objectives

Inflation is a general increase in the level of prices throughout the economy.
The most widely recognized measure of inflation is the Consumer Price Index.

The incentive to save diminishes as inflation erodes the value of savings accounts and fixed incomes.The incentive to spend and to accumulate debt increases as consumers act in anticipation of rising prices and wages.Inflation creates additional uncertainty. Predicting the future is more risky and mistakes are more costly.

Long-term and/or expected inflation may cause individuals and firms to alter their behaviors in response to anticipated changes.
* Interest rates rise to cover the expected inflation rate.
* Investors search for "inflation proof" investments.
* Unions demand cost-of-living clauses in contracts.

Inflation rarely occurs except as a consequence of rapid increases in a society's stock of money.

The Federal Reserve System, an agency independent of but established by the federal government, controls the stock of money in the United States through monetary policy.
The Fed enacts monetary policy by changing the discount rate, by changing the reserve requirement, and/or through open market operations.
The Fed often faces political pressures from government, private interests, and the media to follow policies that cause the money stock to grow too rapidly for price stability.

Calculate the potential impact of inflation using this scenario.
Suppose that your parents saved $50/month for your college education, beginning in the month you were born. A wise investment counselor has managed to earn about $5,000 with that money over the last 16 years. It currently costs about $5,000/year to attend your local state university. Inflation is heating up and is expected to run 5%/year. Will you have enough money to go to college?

Definitions

Consumer Price Index (CPI) - The most commonly used measure of inflation, calculated by comparing the price of a designated "market basket" of goods and services in the current year to its price in a base year. The CPI is compiled by the U.S. Bureau of Labor Statistics.

Discount rate - the interest rate charged to member banks on funds borrowed from the Federal Reserve.

Federal Reserve System - The "Fed" was created by Congress as an independent agency in 1913. It serves as the nation's central banking organization; its functions include processing checks, serving as the government's banker, and controlling the rate of growth of the money supply.

Incentives - Rewards or punishments for behavior.

Inflation - An increase in the overall level of prices over an extended period of time.

Interest rate - The price paid for borrowing or saving money.

Money - The accepted common medium of exchange for goods and services in the marketplace that functions as the unit of account, a means of deferred payment, and a store of value.

Money supply - The narrowest definition of the money supply includes all paper bills and coins in circulation, currency, travelers checks, and checkable deposits (Ml). A broader definition, M2, includes Ml plus such near moneys as time and savings deposits, money market mutual fund balances and Eurodollars.

Open market operations - The buying and selling of government securities by the Federal Reserve System.

Reserve requirement-- The requirement by the Federal Reserve that banks hold a minimum percentage of deposits on reserve, unavailable for lending.