Subject: ECO-1

Week Number: 7 (January 18 January 24, 2014; January 18, 2014; January 24,
2014)
Name: Charleen Pearl L. Rayos
E-mail (Primary): charleen_pearl@yahoo.com
Course: AB Communications
Student Number: 2014-10092
Country: United Arab Emirates
Suggested Activities
Why do people hold money? How will an increase in the interest rate influence the
amount of money that people will want to hold?
There are three reasons why people hold money:
a. The Transactions motive: We make day-to-day transactions and therefore need
to hold cash in our hands.
b. Precautionary motive: We hold money in case of emergency situations where we
need to spend it.
c. Speculative moves- People have to decide how they are going to hold their
money. There are a number of different ways, which can briefly split it into interest
bearing assets or non-interest bearing assets.
A rise in the interest rate decreases the quantity of money that people plan to hold.
1. Can interest rate hike help fight inflation?
Yes, it can. As interest rates are lowered, more people are able to borrow more
money. This results into consumers having more money to spend, which causes the
economy to grow and increase inflation. On the other hand, as interest rates are
increased, consumers tend to have less money to spend. With less money to spend,
the economy slows and inflation decreases.
2. Differentiate cost-push or demand-full inflation?
Cost-push inflation, also known as stagflation occurs when the price of inputs increases.
Businesses must acquire raw materials, labor, energy, and capital to operate. If the price of
these were to rise, it would reduce the ability of producers to generate output because their
unit cost of production had increased. If these increases in production cost are relatively
large and pervasive, the effect is to simultaneously create higher inflation, reduce real GDP,
and increase the unemployment rate. Meanwhile, demand-full inflation occurs when
spending on goods and services drives up prices. Demand-pull inflation is fueled by income,
so efforts to stop it involve reducing consumer's income or giving consumers more incentive
to save than to spend.
3. Explain monetary policy measures to fight deflation.
Monetary policy can play a role in avoiding deflation and recession.
Zero interest rates. Firstly Central BANKS can reduce base interest rates to zero.
Lower interest rates reduce cost of borrowing. However, with deflation, zero interest
rates will not be enough to avoid a fall in economic growth
Quantitative Easing. The Central BANK can electronically create money and use this
to buy bonds (both government and other financial bonds). This helps to:

 Increase the money SUPPLY. BANK reserves should rise; in theory this
should encourage them to lend more.
Lower interest rates on long term bonds. By purchasing bonds, the
Central BANK will reduce interest rates on bonds. These lower interest rates
can help to encourage lending and spending. E.g. in 2011, the US
Fed unveiled operation twist this involved buying mortgage securities to
reduce interest rates on mortgage bonds. The hope was this would
encourage mortgage lending
1. Inflation Target. The Central BANKS can make it very clear they are targetting
positive inflation. They could even increase the inflation target from 2% to 3%.
Increasing inflation expectations help to avoid the pressure of deflation

4. There are always gainers and losers from inflation and deflation. Discuss. Comment
which is more damaging for the economy as a whole and why?
Both inflation and deflation have gainers and losers.
First, we must consider what inflation is, a general increase in prices and a
corresponding decrease in moneys purchasing power. So who gains from inflation?
Borrowers benefit from a general increase in prices or a reduction in purchasing
power. When individuals, businesses, and governments borrow, it is usually at a fixed
rate of interest that had some expected level of inflation built into it. If higher than
expected inflation occurs, the real value of debt is reduced. To put it simply, the
money that was lent was more precious than the money being repaid. Another group
that benefits from inflation are the producers. Consumer prices rise but employees
salaries remain stable. This allows producers to experience higher profits for a time
until wages adjust to reflect the higher prices consumers are paying. Losers for
inflation would be lenders and savers. Both earn interest rates that assume some
rate of inflation, and when the actual rate exceeds the expected rate, savers and
lenders are harmed. Inflation is thought to be harder on those with lower and fixed
incomes. For the poor, inflation exacts a heavier toll because it destroys the value of
their main asset, which is cash.
In deflation, pensioners with private pensions, borrowers, traders, merchants are
losers while state pensioners, savers, rail travelers, and the fixed-income groups are
the gainers. Traders, producers, borrowers, etc. lose because they purchase their
goods at a higher price only to sell them at a lower price because of deflation. Fixedincome groups gains from deflation because wages do not decrease with the fall of
price and equity holders lose during deflation while debentures holders gain when
prices fall.
Based on the articles that I have read, deflation is more damaging to the economy
rather than inflation. Deflation, if it becomes entrenched, is more dangerous than
most forms of inflation. When prices fall consumers put off their purchases in
anticipation of even greater bargains later, condemning the economy to a vicious
cycle of weak spending and sliding prices. In heavily indebted economies falling
prices would increase the real burden of consumers' and governments' debts. It is
also harder to fight than inflation. There are also some problems in deflation: It
discourages consumers to spend. When this happens, the growth of the economy will

fall because we will save money waiting for items to be cheaper. ; It will increase real
value of debt. ; It increases real interest rates; and it can become entrenched and
difficult to end.
5. Explain how a contractionary monetary policy brings about price stability?
Contractionary monetary policy is used by the central banks in order to slow the pace
of the economy and reduce inflation by taking money out of the circulation and
making credit more difficult to obtain. Central banks reduce the money supply by
raising the discount rate, increasing the amount of money banks must hold in
reserve and selling government bonds which takes money out of circulation.
Web Exercises:
Read the July 2001 issue of economic review on Monetary Policy in Action at
http://ww2.publicbank.commy/cnt_review24.html.Focus Money, Prices and Output
and answer the following questions:
THE LINK IS UNAVAILABLE.
Name the two (2) major policies used by economist. Nations to stimulate economic
growth.
Monetary Policy and Fiscal Policy
List three (3) objective of monetary policy and briefly explain.
1. Full employment- it is an important goal not only because unemployment leads to
wastage of potential output but also because of the loss of social standing and
self-respect.
2. Price stability- One of the policy objectives of monetary policy is to stabilize the
price level. Both economists and laymen favor this policy because fluctuations in
prices bring uncertainty and instability to the economy.
3. Economic growth- One of the most important objectives of monetary policy in
recent years has been the rapid economic growth of an economy. Economic
growth is defined as the process whereby the real per capita income of a country
increases over a long period of time.
Differentiate and explain the possible outcomes between a good and a bad monetary
policy.
Monetary policy affects the prices of goods, asset prices, exchange rates as well as
consumption and investment. A good monetary policy will lead to an effective
defense against both inflation and deflation leading to a stable economy. A bad
monetary policy will contribute to both inflation and deflation and will result in the
demise of a country.
Explain the relationship between money and output
Money affects output because it is needed not only in purchasing the goods produced but
also in the production of the goods and services provided by producers.

References:

http://www.scribd.com/doc/25768615/3-Reasons-of-Holding-Money#scribd
http://economicsfreax.wikispaces.com/3.+Reasons+why+people+hold+money
http://www.econ.iastate.edu/classes/econ102/falk/lecture_23_money_demand_mode
l.ppt
http://www.investopedia.com/ask/answers/12/inflation-interest-rate-relationship.asp
http://www.economicshelp.org/blog/1053/economics/deflation-and-monetary-policy/

http://www.globalchange.com/inflation-and-deflation-winners-and-losers.htm
http://www.netplaces.com/economics/inflation/who-gains-and-who-loses-frominflation.htm
http://www.thebusinessowner.com/businessguidance/economics/2012/02/economics-primer-inflation-and-deflation
http://www.economicshelp.org/blog/978/economics/definition-of-deflation/
http://www.telegraph.co.uk/finance/budget/7810227/Economists-survey-of-the-UK-isinflation-or-deflation-a-greater-risk-to-the-economy.html
http://www.economist.com/node/16274363
http://www.cbsnews.com/news/the-fed-fears-deflation-more-than-inflation/
http://www.investopedia.com/financial-edge/0311/the-dangers-of-deflation.aspx
http://useconomy.about.com/od/glossary/g/Contractionary.htm
http://www.yourarticlelibrary.com/policies/monetary-policy-meaning-objectives-andinstruments-of-monetary-policy/11134/
http://www.investopedia.com/exam-guide/cfa-level-1/global-economicanalysis/monetary-policy-exchange-balance-payments.asp