Money and Price Level EDBA 2016

Paper Money Does Paper Money have any intrinsic value? What is money then? Why is it important? If there was no money then we would have to barter For barter to work – trade is said to require the double of coincidence of wants.

The history of money Mesopotamian civilization developed a large scale economy based on “Commodity money” Many other cultures also developed commodity money Tobacco in America, Shells in India, Spices in Europe, Alcohol in New South Wales If you were in prison, what would be good forms of money to smuggle in.

3 important functions ofmoney Medium of exchange – Anything that facilitates trade by being generally accepted by all parties in payment for goods and services. Unit of Account – A common unit for the measuring the value of every good and service. Store of Value – Anything that retains its purchasing power over time.

The characteristics of Commodity money Durable Portable Divisible Uniform Quality – Gresham’s law – people tend to horde good money and trade away the rest. Low opportunity cost Value of money should not fluctuate erratically.

What is commodity money Money that takes the form of a commodity with intrinsic value Intrinsic means that the item would have value even if it was not used as money. Money without intrinsic value is known as Fiat Money

Too much money vs Too little money The fall of the Soviet Union – The ruble experienced hyper inflation. – Value of the ruble fell dramatically – Russians demanded other hard currency Sanctions against Panama – The Panamanians depended on the dollar – The US did not permit them to trade. – People started hording dollars. – Started taking money out of banks. – Finally people resorted to barter – Panama’s GDP as a result fell 30% in 1988

Why is inflation Unpopular Higher inflation means you have to spend more? When viewed from the income side – – Higher inflation means You get paid more You get more for your factors of production. UNLESS PRODUCTIVITY INCREASES HIGHER WAGES MEAN HIGHER PRICES Who are hurt the most because of inflation – Individuals whose incomes are fixed in nominal terms – Pensions, EPF

Factors of Inflation Increase in the money supply Decrease in the demand for money Decrease in aggregate supply of goods and services. Increase in aggregate demand for goods and services.

Cost push inflation Basically means that prices have been pushed up due to the increase in the 4 factors of production. Higher production costs Companies cannot maintain profit margins Costs are passed on to the consumer Prices rise Rising Prices mean inflation has increased.

Demand pull inflation Occurs when there is an increase in aggregate demand When the four sectors of the economy increase their consumption – Households, Government, Firms, Foreign buyers They bid prices up Increased prices = inflation.

Is inflation bad? Practically every economist will tell you that – a little bit of inflation is a good thing – a lot of inflation is a bad thing A little bit of inflation is like a tax on idle money. It prompts people to get their money out of the mattress (or low interest accounts) and put it to work on investments. A lot of inflation prompts people drives money out of economy-driving investments and into inflation-proofing investments (gold which does nothing for the economy). Deflation makes idle money profitable so no one, not the Fed or economists, wants to see deflation. If deflation was a risk today, you would see the Fed trying to fight it.

International Trade 1912 Trade Routes

The production possibilities frontier Australia can produce either 100 Agricultural products or 50 electronic products Malaysia can produce either 40 agricultural products or 50 electronic products.

World Output The need to specialize! When countries specialize world output increases.

Comparative advantage. The ability of a country to price a good at a lower opportunity cost than another country. The ability of a country to produce a good using a fewer resources than another country. Absolute Advantage.

Free trade vs Fair Trade Free Trade – The flow of good and services between countries without restrictions. Fair Trade – a county should only reduce its barriers to entry if the other country does not have some sort of “unfair competitive” advantage. And also provided that the other country also reduces its trade barriers. Type of protections – Embargo – Tariff – Quota

Common arguments for protection The infant industry argument – New domestic industries need protection because it is not yet ready to compete. National Security argument. – A nation should not be dependent on other countries for defense. Employment argument. – Job increases in protected industries. Cheap foreign labor argument. – Other countries have cheaper labour, it is difficult to compete.

Free Trade Agreements ASEAN – Association of South Eastern Asian Nations EEC – European Economic Community NAFTA – North American Free Trade Agreement. APEC – Asian Pacific Economic Cooperation.

Supply and Demand for foreign exchange. When the SL Rupee is low or depreciates. – Sri-Lankan goods and services will cost foreign consumers less. – Foreigners will buy more SL products. – For Sri-Lankans foreign products become more expensive. When the SL rupee is high or appreciates. – SL goods will cost foreign consumers more. – Foreigners will buy less SL products – Sri-Lankans will buy more foreign products.

4 shifts in supply and demand of a currency. Taste and Preference. Relative Incomes Relative Price levels Relative Real Interest Rates Depreciation – A fall in the price of one currency relative to another Appreciate – A rise in the price of one currency relative to another.

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