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PAGE ONE Economics
the back story on front page economics

NEWSLETTER

March ■ 2013

Money and Inflation:
A Functional Relationship
Scott A. Wolla, Senior Economic Education Specialist
Economists like to argue that money belongs in the same class as the wheel and inclined plane among
ancient inventions of great social utility. Price stability allows that invention to work with minimal friction.
—Federal Reserve Chairman Ben S. Bernanke, February 24, 2006

In its broadest sense, money is anything generally accepted in exchange for goods and
services. In other words, money is defined by the functions it serves in the economy. In fact,
while money has taken many forms over the ages—cowry shells, furs, beads, even large stone
wheels—useful forms of money share three basic functions.
First, money is a store of value, which means that it holds its value over time. You can put
money in a drawer today and spend it next year, when it will buy approximately the same
amount of goods and services (minus inflation). Second, money is a unit of account, which
means it is a standard measure of value. Listen to a conversation between two people about a
recent purchase and you are sure to hear prices quoted in terms of money, not as hours worked
or the equivalent value of the purchase in corn (or some other commodity). Third, money is a
medium of exchange, which means it is generally accepted as a method of payment. I accept
my paycheck in U.S. dollars because I know dollars are readily accepted for payment at the grocery store, gas station, and nearly anywhere I want to buy goods and services.

Money Versus Barter
You might not think of it often, but money facilitates transactions in amazing ways. Think
of conducting an economic transaction without money—a situation called barter. For barter
to work properly, you would need to find someone with the good or service you want; in turn,
that person would need to want to trade for what you have to offer. A difficult task to be sure.
The situation in which two people want to barter with each other is known as the double
coincidence of wants. Imagine an accountant who needs her car fixed. Under a barter system
she would need to find someone who needed some tax advice in exchange for car repairs. She
might find it difficult, and time consuming, to make such a transaction. Such searches for barter
partners are inefficient and wasteful.
So, how does money solve the double coincidence of wants problem? In an economy based
on money, the accountant provides her accounting services to whoever is willing and able to
pay money for them. She then uses the money she earned to pay for car repair services from a
mechanic, who is more than willing to accept cash for car repairs. Both parties to the transaction are willing to exchange goods or services for money. In the end, everyone involved is more

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Federal Reserve Bank of St. Louis

NEWSLETTER

NOTE: The year-over-year inflation rate over the past 10 years has fluctuated from a high of 5.5 percent in
July 2008 to –2 percent (deflation) in July 2009. The consumer price index is a measure of inflation.
SOURCE: Federal Reserve Bank of St. Louis FRED (http://research.stlouisfed.org/fred2/graph/?g=eYT).

readily satisfied. Using money allows a more efficient outcome because it cuts down on search
costs, and it allows workers to specialize in what they do best.

Money and Inflation
Even when you have money available to purchase goods and services, as in the accountant/
mechanic example, money’s ability to serve its functions has limits. High rates of inflation, for
example, make money less useful in many ways. First, when inflation rates are very high, the
longer you hold money as cash, the more value it loses, so you attempt to spend it immediately
rather than hold it. In this situation, money does not function as an effective store of value. In
fact, if people expect high rates of inflation and the rate of their transactions increases as a
result, inflation will increase even further. Second, if inflation rises to very high rates, money’s
usefulness as a unit of account diminishes. If prices are changing rapidly, communication
between buyers and sellers becomes complicated. Comparing prices becomes complex if all
prices are rising rapidly. Third, inflation reduces the usefulness of money as a medium of
exchange. In the case of extreme inflation (hyperinflation), people may abandon the use of one
currency for a more stable one. In Zimbabwe, for example, the inflation rate rose from 24,411
percent in 2007 to an estimated 89.7 sextillion (89,700,000,000,000,000,000,000) percent in
November 2008 (Waller, 2011). Hyperinflation was so problematic that people abandoned the
Zimbabwean dollar, preferring to conduct transactions in U.S. dollars or South African rands.
The Zimbabwean currency became nearly useless as money and was removed from circulation
in 2009 (Central Intelligence Agency, 2013). However, a market in Zimbabwean dollars has
since developed for currency collectors and souvenir seekers—you can buy a Zimbabwean
$100 trillion dollar bill for approximately 5 U.S. dollars (McGroarty and Mutsaka, 2011).

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NEWSLETTER

So, if high inflation is bad, is an inflation rate of zero best? What is the optimal inflation
rate? The Federal Reserve has determined that a 2 percent rate of inflation is most consistent
with its dual mandate (the goals created for it by Congress) of maximum employment and
price stability. Two percent is considered a low rate of inflation, which only slightly distorts
the functions of money discussed previously. And, if the inflation rate is stable, people come to
build 2 percent into their expectations of future prices, and wages and interest rates can adjust
accordingly.
If the low inflation rate of 2 percent is good, why not have an even lower rate of zero? When
the inflation rate is less than 2 percent, the danger of deflation exists. Falling prices might sound
appealing, but falling prices would likely lead to falling wages as well—and deflation is associated
with very weak economic conditions (Board of Governors of the Federal Reserve System, 2013).
An inflation rate greater than zero maintains an “inflation buffer,” which reduces the chances
of deflation should the economy start to weaken (Bernanke, 2010). On the other side of the
Fed’s dual mandate (maximum employment), it is generally agreed that economic growth and
employment are enhanced when inflation is low and stable (Bernanke, 2006).

Conclusion
Money facilitates transactions in ways that keep the economy functioning well, but not so
well when inflation is high and volatile. In contrast, a low and stable rate of inflation helps
ensure that money performs its functions efficiently. ■
REFERENCES
Bernanke, Ben S. “The Benefits of Price Stability.” Speech presented at The Center for Economic Policy Studies and on the
occasion of the Seventy-Fifth Anniversary of the Woodrow Wilson School of Public and International Affairs, Princeton
University, Princeton, New Jersey, February, 24; 2006;
http://www.federalreserve.gov/newsevents/speech/bernanke20060224a.htm.
Bernanke, Ben S. “Monetary Policy Objectives and Tools in a Low-Inflation Environment.” Speech presented at the Revisiting
Monetary Policy in a Low-Inflation Environment Conference, Federal Reserve Bank of Boston, Boston, Massachusetts, October
15, 2010; http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm.
Board of Governors of the Federal Reserve System. “Why Does the Federal Reserve Aim for 2 Percent Inflation Over Time?”
Current FAQs, January 3, 2013; http://www.federalreserve.gov/faqs/economy_14400.htm.
Central Intelligence Agency. “Zimbabwe.” The World Factbook, January 22, 2013;
https://www.cia.gov/library/publications/the-world-factbook/geos/zi.html.
McGroarty, Patrick and Mutsaka, Farai. “How to Turn 100 Trillion Dollars Into Five and Feel Good About It.” Wall Street Journal,
May 11, 2011; http://online.wsj.com/article/SB10001424052748703730804576314953091790360.html.
Waller, Christopher J. “Independence + Accountability: Why the Fed Is a Well-Designed Central Bank.” Federal Reserve Bank of
St. Louis Review, September/October 2011, 93(5), pp. 293-301;
http://research.stlouisfed.org/publications/review/11/09/293-302Waller.pdf.

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NEWSLETTER

GLOSSARY
Barter: Trading goods and services for other goods and services without using money.
Dual mandate: The Federal Reserve’s responsibility to use monetary policy to promote maximum employment and stable
prices.
Double coincidence of wants: Each participant in an exchange is willing to trade what he or she has in exchange for what
the other participant is willing to trade.
Deflation: A general, sustained downward movement of prices for goods and services in an economy.
Inflation: A general, sustained upward movement of prices for goods and services in an economy.
Medium of exchange: Anything generally accepted in exchange for goods and services.
Money: Anything generally accepted in exchange for goods and services. Money serves as a store of value, unit of account,
and medium of exchange.
Price stability: A low and stable rate of inflation maintained over an extended period of time.
Search costs: The financial and opportunity costs consumers pay when searching for a counterparty in a transaction.
Store of value: The ability of a currency, commodity, or other type of capital to retain its worth over time.
Unit of account: A common measurement used to compare the value of goods and services.

Page One Economics Newsletter from the Federal Reserve Bank of St. Louis provides an informative, accessible economic essay written by our economic
education specialists, who also write the accompanying classroom edition and lesson plan. The newsletter and lesson plans are published 9 times per
year, January through May and August through November.
Please visit our website and archives http://research.stlouisfed.org/pageone-economics/ for more information and resources.
Views expressed do not necessarily reflect official positions of the Federal Reserve System.


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