Economic Impact of Inflation and Money Market Dynamics

Effects of Inflation

The effects of inflation depend on the intensity or degree of price growth. If inflation occurs without warning and the pace of price growth is different from that of wages and rents, it will have the following effects:

Loss of Purchasing Power of Money

Traders must pay higher prices for goods and services purchased, which reduces the purchasing power of money.

The loss of value of money produces a different effect on the wealth of individuals, since it will benefit those whose assets consist of physical or real property or who have many debts, but it damages the holders of receivables. This results in a redistribution of income and national wealth.

Uncertainty

Inflation, by altering prices, destroys its capacity to inform and produces uncertainty:

• Consumers do not know how many goods can be purchased from their income.
• Businesses do not know at what prices to sell their products to succeed.
• The public sector will find it more difficult to make forecasts of revenue and expenses that define its budget.

Loss of Competitiveness of Domestic Production Abroad

If the price level of our country grows faster than that of competing countries, our products will be more expensive, thereby reducing their competitiveness and lowering the volume of our exports of goods and services.

Unemployment

These are effects caused by the three factors mentioned above:

• If money loses purchasing power, consumption, investment, aggregate demand, output, and employment fall.
• If economic operators have to make decisions under uncertainty, consumption, investment, and employment fall.
• If exports fall, it reduces the number of workers required for production.

The Money Market

Demand for Money

This is the amount of money that individuals wish to maintain for the following reasons:

• Reason for transaction: The need to buy goods and services for daily needs and paying bills.
• Reason for caution: People demand money payments as a precaution against high or unexpected declines in revenues.
• Reason for speculation: To dispose of money when a good investment opportunity arises.

The money demand function represents the change in the total demand for money when the interest rate varies. If we represent these two variables, we get the money demand curve, which is downward-sloping:

• If interest rates rise, individuals prefer to have their wealth in deposits or securities instead of cash.
• If interest rates are low, they will prefer cash.

Money Supply

This is the amount of money in an economy, represented by the aggregates M1, M2, and M3. It is controlled by the monetary authority and does not depend on the interest rate.

The money supply curve is a vertical line, as its value is determined by the monetary authority and the interest rate does not influence it.

The Money Market Equilibrium

Equilibrium occurs when, for a specific interest rate, money demand matches the supply of money.

By increasing the money supply, the interest rate will fall; if the money supply is reduced, the interest rate will increase.