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What is money, and why should monetary policy target low inflation levels?

by Maryna Trifonova, Head of Content at Jax.Network

At a certain stage of the development of humankind, an urge to use a single medium of exchange in the form of coins and banknotes appeared. Fiat was chosen over all other goods because it was cheap to produce, easy to carry, and ultimately costly to counterfeit. We, humans, then created a set of institutions known as banks to ensure that everyone could trust this medium of exchange called money.

Characteristics of money

Let’s start with a simple definition of money. According to Cambridge Dictionary, “coins or notes (= special pieces of paper) that are used to buy things, or an amount of these that a person has” are regarded as money. Therefore, its primary function is to be a medium of exchange. However, this description isn’t complete yet. To be considered as money, these “papers” should also function as a store of value and a unit of account. In other words, money is anything that we believe can be redeemed for goods and services in the future.

Economists commonly single out the following characteristics of money:

  • Acceptability. Money should be accepted by all merchants and buyers as a medium of exchange. For example, you have a much higher chance to buy certain goods for dollars than seashells, even though they were used as money many centuries ago.
  • Durability. Money should survive through all weather conditions, miles of travel, etc. And if anything happens to it, it should be easily replaceable. For example, a cow is a bad example of money because it can get sick and die, leaving you broke.
  • Divisibility. Money should be easy to divide into smaller pieces. For example, $1 can be divided into two fifties, four quarters, ten dimes, twenty nickels, or a hundred pennies.
  • Limited supply. Money should have a limited supply in order to maintain its value. As a rule, there is a corresponding governmental body that regulates this process — for example, the Federal Reserve in the United States.
  • Portability. Money should be easily transported. Gold or any other precious metal is not convenient to carry around, while paper banknotes are lightweight and can fit in any pocket.
  • Uniformity. Money should be of the same shape, size, and value.

Beyond these characteristics of money, it also improves the utility of trade since it efficiently solves the problem of double coincidence of wants. For instance, assume Alice produces coffee and Bob wheat. Assume as well that Alice wants to have a portion of Bob’s wheat and Bob — a portion of Alice’s coffee. Without money, they need to agree upon how much coffee is worth 1kg of wheat. Barter creates more frictions for trade and, therefore, money was introduced to precisely reduce these frictions. Indeed, with money, you can introduce prices and people can evaluate these goods and decide for themselves.

Positive effects of mild inflation?

Economists agreed that beyond a certain level of price increases, or inflation, money loses too much of its purchasing power and harms the poorest part of the population the most. Inflation is mostly advantageous to debtors, who pay back their loans in the money that has a lower value than the money they borrowed. That increases the number of borrowings which, in turn, leads to much higher spending on all levels. In this context, some governments may have an incentive to issue more debt and increase money printing to lower the debt burden. Unscrupulous governments such as Zimbabwe have used this trick after the 2007 financial crisis and inflate their currency to the point of no return.

In Reinhart and Rogoff’s compelling study on financial crises, inflation is thoroughly studied. It is viewed as a modern form of money debasement when scraping the metal of coins would induce devaluation. They have a threshold of twelve-month high inflation of 40%. But, of course, price disturbances imply an impact on economic growth at much lower levels. For instance, based on Lagos and Wright’s model (2005), it is estimated that a 10% inflation rate costs between 1.4 to 4.6% of GDP yearly. In the Eurozone, the inflation target is below 3% year-on-year. It’s 2% in the Federal Reserve mandate. Beyond these levels, it is shown that inflation has a significant welfare cost since it makes economic decisions much more difficult. An investor can anticipate their returns only when money is stable, not otherwise.

On the other extreme, deflationary currency does not incentivize investment in other ventures. Ask yourself, would you hodl Bitcoin for another 5 years or build your own company from scratch if you were given the opportunity. Deflationary assets such as Bitcoin do not help the economy to grow and thrive if you’re just hodling.

We argue that money should be slightly inflationary for the sake of productivity growth and human progress. In a nutshell, inflation discourages saving because it decreases the purchasing power of money and stimulates people to spend or invest more. It also incentivizes people to be more productive, as they will be willing to work more. Sooner or later, that will lead to economic growth. However, the threshold is rather low as we have seen, and inflation above 2–3% levels can hamper investment decisions. Economist John Nash (2001) suggested to have a money supply rate more or less similar to the productivity gains in the industrial sector, so as to have money as stable in purchasing power as possible.

Conclusion

Money has been going hand in hand with progress and development, from ancient seashells to modern-day banknotes. Over time, it became obvious that not everything can be regarded as money. Therefore, money should have six main characteristics, such as acceptability, durability, divisibility, limited supply, portability, and uniformity, and be able to fulfill three main functions — act as a store of value, unit of account, and medium of exchange.

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