Chapter 12: Problem 3

Does inflation, which is an increase in the price level, affect the three functions of money? If so, how?

Short Answer

Expert verified

Yes, inflation does impact the three functions of money. High inflation can create uncertainty slowing the exchange of goods and services, distorts the measurement of value in terms of goods and services, and erodes the purchasing power of money stored for future use.

Step by step solution

Understanding Inflation

Inflation is a general increase in prices and fall in the purchasing value of money. To put it simply, inflation is when the price of goods and services in an economy is going up.

Recognizing the Three Functions of Money

The three functions of money are: Medium of Exchange - Money can be used to exchange goods and services; Unit of Account - Money provides a standard measure for prices; Store of Value - Money holds its value over time and can be saved and used later.

Impact of Inflation on Medium of Exchange

Inflation can affect the function of money as a medium of exchange. High inflation can create uncertainty about the value of money, which can slow down the exchange of goods and services. It's important to note, however, that for most developed economies, small and steady inflation rates do not dramatically affect this function.

Impact of Inflation on Unit of Account

Inflation also affects money's function as a unit of account. When inflation is high, it distorts the measurement of value because the worth of goods and services is not consistent over time.

Impact of Inflation on Store of Value

Finally, inflation affects money's function as a store of value. In fact, inflation erodes the purchasing power of money over time, meaning consumers might need more money to buy the same goods or services in the future. Therefore, in an environment with high inflation, money is not a good store of value.