PRINCIPLES OF ECONOMICS

TOPIC:
MONEY AND INFLATION
MATTERS

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 What is money
 Money anything which is generally
acceptable
is by a society as a medium of
exchange and means of settling debts
Evolution of Money
 Before the discovery of money, people were
used to exchange commodities for commodities
in a system known as barter trade system.
However this system encountered the following
problems;
 Lack of double coincidence of wants.

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Cont..
 Lack of measure of value. It was very difficult
to decide how much quantity of one commodity
should be exchanged for another commodity.
E.g. it was very difficult to decide how much
quantity of rice should be exchanged for cow
 Lack of store of value. It was difficult to store
perishable goods like vegetables for exchange
with other commodities in future
 Indivisibility of some items. It was not possible
to divide some commodities (such as cow) into
smaller units in order to exchange with units of
other commodities
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Cont..
 Difficult of transporting some commodities.
Due to poor means of transport and immobility
of some items, it was difficult to transport
some items from one place to another for
exchange
 At present times, notes and coins are the
popular forms of money, and they have solved
all the problems of barter system.

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 How has money solved the problem
of barter system?
 People can store their assets in form of money.
In this case, even perishable goods can be
stored for a long time in form of money
 By using money, there is no need of double
coincidence of wants. E.g. if a person has
wheat and wants cloth, he/she does not need
to find a person who has cloth but want wheat,
instead he can sell wheat and use the money
generated to buy the cloth
 The fact that money can be broken into smaller
units has also solved the problem of
indivisibility of commodities.
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Cont..
 Money is easy to carry, hence it can be used to
transfer immovable commodities.

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 Characteristics/ Qualities of Money
 Notes and coins are money because they possess the
following essential characteristics. For money to be
functional, it must have the qualities of good money
I. Acceptability. Currency is money because it is
generally acceptable as a medium of exchange. A
person accepts currency in exchange for the
products he/she sells because he/she is confident
that others will also accept it in exchange of goods
and services.
II. Relative scarcity. The value of money, like
economic value of any asset, is a supply and
demand phenomenon. Money derives its value
from its scarcity.
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Cont..
III. Legal tender. Paper money has been designated
legal tender by government. Paper money is fiat
money, that is, paper money is money because the
government says it is. However, a decree by the
government alone does not make currency money.
General acceptability is more important because
whenever people lose confidence in currency
(mostly due to inflation), a legal tender fails to
function as a medium of exchange.
IV. Portability. Money is small, transportable and
transferable. What if cows were accepted as
commodity money. One can imagine walking
around with a cow in his/her pocket.
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Cont..
V. Durability. Money must have long life span.
Coins last long and even paper currency is
very durable. If a paper currency is ripped in
half it can be taped back together and will still
be worth the same
VI. Divisibility. Money can be broken down into
small units of measure to allow small
purchases and thus make transactions easier.
Can you imagine a cow scenario whereby a
cow is acceptable as money? Its not like you
can rip off a leg if the whole cow wasn’t
necessary as payment.
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Cont..
VIII.Stability of value. Money, despite the
influences of inflation and deflation remains
fairly stable in value. In traditional barter
economies when one needed goods he would
trade other goods say crops. If there was a
drought, however, the value of said crops
would shoot up. This does not obvious happen
with money because monetary authorities
ensure that money is stable in value.
IX. Hard to Counterfeit. A good money must be
difficult to copy by unauthorized moneymakers
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 Functions of Money
I. A medium of exchange. The most
important function of money is to serve
as a medium of exchange when it passes
from hand to hand in exchange for
goods and services or in payment of
debt.
II. A store of wealth/ value. Money is used
to store values of goods and services for
future use especially when people can
convert goods and services into money
with an aim of using the money for
future transactions.
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Cont..
III.Unit of account/ money is a measure of value.
Money is used to measure the value of goods
and services. Prices of goods which are the
indicators of values of goods are expressed in
terms of money For example, if the price of a
car is TZS 10 million, then this amount
represents the value of the car.
IV. Money also serves as a standard of deferred
payment. Money is used to make future
transactions, in this case money facilitates
credit transactions whereby people can borrow
and pay in future in installments.
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Cont..
V. Transfer of items. Money can be used to
transfer assets from one area to another
area especially immovable materials like
buildings and land. A person owning such
asset in one area can dispose the asset and
use the money to buy the same kind of
asset in another area.

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 Inflation
 Inflation refers to persistent increase in the
general, average, price level of goods and
services in the economy.
 Note that inflation is an increase in the
overall average level of prices and not an
increase in the price of any specific product.
 The opposite of inflation is deflation which
is a decrease in the general, average, price
level of goods and services in the economy.

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Cont..
 When there is inflation, the value of a currency
in terms of the goods and services it buys
persistently declines.
 That is, continuous price increases erode the
purchasing power of money.
 Types of Inflation.
 According to the rapidity with which prices
increase, there are main four types of inflation.
 Each one of these types (of inflation) differs
from the others by the speed with which prices
move in an upward direction.
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Cont..
1. Creeping inflation. Occurs when prices
rise within a range of 10% over a
decade or around about 1% p.a. some
economists argues creeping
occurs when prices inflation rise by
than 3% p.a. not more
 It is considered to be a favorable for
it stimulates economic activity rather
than disrupting the economic balance.

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Cont..
2. Walking inflation. occurs when prices rise by
more than 10% and within a range of 30% to
40% over a decade, or by 3% or 4% a year
the rise in prices becomes more pronounced as
compared to a creeping inflation.
 Walking inflation presents a warning signal
for the occurrence of running and galloping
inflation.
3. Galloping inflation. Also called hyperinflation, is
inflation where prices rise every moment, and
there is no limit to the height to which prices
might rise.
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Cont..
 Normally, a tends to rise by 100% a year
price
causing people to lose confidence in the
currency.
4. Running inflation. When the movement of price
accelerates rapidly, running inflation emerges.
 It may record more than 100% increase in
prices over a decade. Thus, when prices rise
by more than 10% a year, running inflation
occurs.

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 Types of inflation.
1. Demand-pull inflation. Occurs when Aggregate
demand (C+I+G+(X-M)) increases at a rate
faster than the capacity of the economy to
produce goods and services i.e. AD>AS. This
increase competition for goods and services
drives up their prices.
 Note that in the market economy prices
determined
are by supply and demand
demand-pull
forces. inflation when supply is So
occurs adequate to meet or
nottoo much money
demand chasing
too few goods.

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Cont…

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Cont…
 An increase in demand shifts the aggregate
demand curve to the right, from AD1 to AD2
pushing up the price level from P1 to P2.

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Cont…
 Demand-pull inflation can be caused by various
factors such as:
 Anticipation of inflation. Once people expect inflation,
they will buy things now before prices go up further
in the future. This increases demand, which then
create demand-pull inflation.
 Growing economy. When families feel confident that
they will get better jobs, that their investments will
increase in value, and that the government is doing
the right thing in guiding the economy, they will
spend more instead of saving, thus creating demand-
pull inflation.

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Cont…
 A reduction in direct or indirect taxation: If taxes are
reduced consumers will have more disposable income
causing demand to rise. A reduction in indirect taxes
(taxes on goods and services such as VAT) will mean
that a given amount of income will now buy a greater
real volume of goods and services.
 High levels of foreign investment increases
employment, income, consumptions and ultimately
Aggregate Demand.
 Monetary too much credit in
economy. A relaxed
consideration – monetary
the policy leads to a
reduction in interest rates leading to an increase in
Aggregate Demand and thus prices.

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Cont…
2. Cost push inflation. Is an increase in the
general price level resulting from an increase in
the cost of production.
 Cost Push Inflation occurs when prices are
pushed up by rising costs to producers who
compete with each other for increasingly
scarce resources. The increased costs are
passed onto consumers.
 The increase of the world price of oil in 1973, and
then in 1979, are examples of price increases causing
cost-push inflation.

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 Causes of cost-push inflation.
 Any input may become a major cost to business eg:
wage increases lead to higher production costs.
 Labour shortages in some sectors necessitate wage
increases in that sector, however it has a domino
effect leading to wage rises in other sectors.
 Inflation imported from abroad, eg: the rise in the
cost of intermediate goods and resources imported
from other countries flows through in the form of
higher prices domestically eg: oil prices.
 Government budgetary problems – an increase in the
cost of public utilities eg: electricity, water etc, leads
to higher costs to business and households.

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Cont…

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Cont…
 An increase in the prices of inputs shifts the
aggregate Supply Curve to the left, from AS1 to
AS2 pushing up the price level from P1 to P2.
3. Structural inflation. This occurs due to change
in economy structures such as privatization,
improved technology especially imported
technology. The change in technology from
simple to more sophisticated will cause firms
to raise the prices of their products to cover
the increased cost of production.

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 Effects of Inflation
 The economic effects of inflation are felt by
different section in the economy
I. Effects on the level of production
 In the short run moderate inflation will
stimulate production while in the long run it
will discourage production.
II. Effects on income distribution
a) Wage earners. This group is not that much
affected by inflation because their income will
be adjusted to compensate the increased
levels of price
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Cont..
b) Fixed income earners such as pensioners.
During inflation this group tend to loose
because their income does not increase while
the price of goods and services they consume
increases.
c) Profit earners. This group is not affected much
during inflation because they can adjust their
profit margins to cope with the increased costs
brought by inflation.
d) Government. Inflation increases nominal
income and thus the government will get more
tax revenue.
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Cont..
e) Lenders and borrowers. In general, borrowers
gain and lenders lose during the period of
inflation
f) Effects on the economic growth. Inflation may
increase or decrease the rate of economic
growth depending on the rate of inflation.

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 Anti-inflationary policies and practices:
monetary policy, fiscal policy, direct price
and wage control measures.
1. Monetary policy is a policy employed by the central bank
to control the supply of money ( including other highly
liquid financial assets that are close substitute for
money) available in the national economy in order to
achieve policy objectives such as:
 Regulating the overall rate of economic growth.
 Controlling the rate of increase in the general price
level (inflation).
 Managing the level of unemployment achieved by
stimulating total demand for goods and services by
manipulating the amount of money in the hands of
consumers and producers.
 Influencing the exchange rates.
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 Cont..
 The policy can either be
monetary
“expansionary” or “tight” monetary policy
based on the objective that the government
wants to attain.
 It is said to be easy/ expansionary when the amount
of money in circulation is being rapidly increased and
interest rates thus being pushed down.
 It is said to be contractnary/ tight when the quantity
of money available is being reduced (or else allowed
to grow only at a slower rate than in the recent past)
and interest rates thus being pushed to higher levels.

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 Monetary tools used to control
inflation and the economy as a whole
 In an attempt to control the size of money
supply in the economy, the rate of interest and
the availability of credit can be achieved
through the following instruments:
 Open market operations. This involves buying
and selling government securities through
which the central bank affects the supply of
money in an economy.
 For example during inflation how will the central bank
use OMO to slowdown inflation?
 How will the government use OMO to increase the
rate of investments and thus employment?
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Cont..
 Discount rate / Bank rate. It is the rate of interest at
which a central bank lends to commercial banks.
 So an increase in the bank rate discourages the
commercial banks from lending from the central
bank. In return the commercial banks will increase
the interest rate to their customers thereby reducing
money in circulation. The vice versa is true in case
the government wants to increase money stock.
 Reserve requirements. It is the amount that the
commercial banks are required by law to hold a specific
percentage of their deposits and required reserves with a
central bank, either in the form of reserve accounts or
as cash.

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Cont..
 Special deposits. These are special accounts which
are opened by commercial banks at the central
bank; during inflation the central bank instruct
commercial banks to increase special deposits in
order to reduce the lending powers of commercial
banks.
 Special credits. Here Commercial banks are
instructed to provide credits to only special sectors
which may increase production and thus reduce
inflation.
 Moral suasion. It refers to attempts of the central
bank to influence the behavior of banks and non-
banks by using all available means of communication.
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Cont..
2. Fiscal measures.
 Fiscal policy. It is the government policy
related to taxation and public spending.
 It is used by the government to influence the
level of aggregate expenditure with the
objectives of achieving high levels of
employment, sustainable economic growth and
price stability (control inflation).
 Fiscal policy can be either expansionary or
contractionary.

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Cont..
 Contractionary fiscal policy is more likely when
inflation is high. HOW?
 Increased direct tax reduces personal
income  reduces purchasing power of a
person  reduces demand for goods and
services  decline in prices.
 Decreased indirect tax reduces producer’s
cost of production  producers will sell
their goods at lower price/ they will reduce
the price of their products and thus
inflation will be reduced
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Cont..
 Also inflation, the government may
during its expenditures on things such as
reduce
wages thus leading to the fall in the purchasing
power and therefore decreases in the prices of
goods.

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Cont..
3. Price and wage control. When monetary and
fiscal measures prove ineffective in controlling
inflation, direct measures are adopted to
control inflation such as by decreasing the
minimum wage rate. Also a maximum retail
price of goods and services may be fixed above
which no one is allowed to sell any good.

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 Supply of Money
 The term “money supply/ money stock”
refers to the amount of money
(currency) in circulation and banks.
 It includes total number of coins and
notes which are in the economy.
 Money supply has three major
definitions:

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Cont..
 Narrow money (M1) = Currency (coins and
notes) in circulation + Demand deposits
( both interest and non-interest bearing
checking accounts) at commercial banks
and in similar depository institutions like
savings and loans associations, credit
unions etc.
 Broad money (M2) = M1 + Time deposits.
 The extended broad definition of money
(M3) =M2 + foreign currency deposits.

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 Demand for money
 Demand for money is the desire and ability to
hold money in cash balances rather than in
financial assets like bonds.
Motives for holding money
I. Transactions Motive. (i.e. the more people
expects to transact the larger amount of
money they are likely to hold and vice versa).
II. Precautionary Motive. People hold money as
a cushion against an unexpected events.

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Cont..
III.Speculative motive
 Keynes assumed that the expected return on money was
zero because in his time, unlike today, most checkable
deposits did not earn interest.
 At higher interest rates, individuals are more likely to
expect the return from holding a bond to be positive,
thus exceeding the expected return from holding money.
People will be more likely to hold bonds than money,
and the demand for money will be quite low.
 At lower interest rates, individuals will be more likely to
hold their wealth as money rather than bonds, and the
demand for money will be high.

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Cont..
 From Keynes’s reasoning, we can conclude that
as interest rates rise, the demand for money
falls, and therefore money demand is
negatively related to the levels of interest
rates.

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