The Kenkey Economist series on Inflation

The Kenkey Economist series on Inflation: Prices rise when the government prints too much money.

Part 1: The Functions of Money in the Economy

Much of human activity is driven by a desire to earn money. More money is often equated to greater prosperity or higher levels of affordability for desirable goods and services. However, the link between the amounts of money people have and the purchasing power or affordability that their money commands can break down when money does not retain its value. In periods of high price increases (inflation) having more money may not improve the amount of goods and services that one can afford. The Kenkey Economist series on inflation is designed to explain the causes and distorting effects of inflation in the economy. The series starts with an overview of the key functions of money in an economy.
Money facilitates exchange. Every person, no matter how talented, derives great value from having an ability to obtain goods produced by others in exchange for his own production or income. The most important function of money is to serve as a widely accepted medium of exchange to facilitate transactions. There are other ways to exchange goods. For example, it may be possible to exchange a car for a plot of land or a house but unlike money, other means of exchange may not be widely accepted. Throughout history, various instruments (forms of money) have been developed to facilitate exchange. The concept of money as a widely accepted means of exchange is only possible when there is a high level of public trust in its authenticity. When the public loses trust in the authenticity of money, for example when there is a perception that there could be a large number of counterfeit currency in the system, money may no longer be acceptable for transactions. In order to be widely accepted for exchange, money has to be convenient to store, carry around and divisible into smaller units of value.
Once money becomes widely accepted for exchange, it also becomes a measure of value. As a measure of value, money enables a farmer to quantify the value of his annual harvest. It enables the kenkey seller to determine the value of her daily labour. As a measure of value, money provides an objective basis for taking all economic decisions. Producers set prices to reflect the value of their goods. In deciding which goods to buy and how many to buy, consumers compare the price of an item to the value they derive from it and the level of their income. When an item becomes more expensive (compared to one’s income), a person may react to the higher price by buying fewer quantities of that item. When an item becomes cheaper, people may be more interested in buying more of that item.
Money has the potential to serve as a store of value or an avenue for saving. Most people have a desire to save a portion of the income they generate from their current employment or investment activities. Since money’s most important function is to serve as a widely accepted medium of exchange, storing one’s excess income in the form of money could increase the flexibility to which one can use his savings. There are many other avenues to save. For example, a corn farmer may decide to store his excess harvest. In many countries, people keep precious metals such as gold and silver as a means of long term saving or investment. In Ghana, many workers invest their excess income into real estate which may also be a durable store of value. When money becomes an unreliable store of value, other forms of savings become more prevalent in an economy.
In the next chapter on the inflation series, The Kenkey Economist will discuss essential properties required for money to perform these key functions.

Author: The Kenkey Economist (kenkeyeconomist@yahoo.com)
The Kenkey Economist is a Chartered Financial Analyst, a graduate of Brown University (USA) and Oxford University (UK). The Kenkey Economist publications promote economic literacy to support stronger governance standards.