Explain how inflation affects the functions of money.
Inflation is the general increase in the price level over a period of time. Money is something that is generally acceptable in the exchange of goods and services.
When inflation occurs, the value of money decreases as the same amount of money can’t buy the same amount of products like before. The purchasing power of money decreases. If the inflation rate is high and unanticipated, lots of problems can occur. People can lose confidence in money as it can not continue to keep its value. People will not save their money to invest further. Money loses its store of value function. People will tend to keep real assets like lands to retain their wealth. Money can not serve as a medium of exchange, too because people rather use solid products like clothes or jeans to exchange for goods than the worthless money. Banks and other institutions tend not to lend money to others because the money paid back is worth less, making them lose money. Money can no longer be a standard for deferred payment. In this way, investment, borrowing and lending are discouraged. Businesses in need of cash to buy equipments to start up, to expand and to overcome cash flow problems can not get enough finance so they will produce less output and salary to workers. Moreover, the prices now can not show the real value of goods and consumers can be confused about the real value of products sold. Money loses its unit of account function as well during periods of high unanticipated inflation.
On the other hand, when the inflation is low and stable (especially demand-pull inflation), it actually helps the economy and encourages money to function better. Price rise motivates businesses to expand output and hire more workers for higher production level. With more people having more salary and increases in wages to compensate the rate of inflation, people’s purchasing power actually may increase and they will buy more products. Money continues...
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