National Content Standards Addressed:

Standard 11 - Money makes it easier to trade, borrow, save, invest, and compare the value of goods and services.

Standard 12 - Interest rates, adjusted for inflation, rise and fall to balance the amount saved with the amount borrowed, which affects the allocation of scarce resources between present and future uses.

Standard 19 - Unemployment imposes costs on individuals and nations. Unexpected inflation imposes costs on many people and benefits some others because it arbitrarily redistributes purchasing power. Inflation can reduce the rate of growth of national living standards because individuals and organizations use resources to protect themselves against the uncertainty of future prices.

Standard 20 - Federal government budgetary policy and the Federal Reserve System's monetary policy influence the overall levels of employment, output, and prices.

Lesson Objectives (7)

1. Define money in terms of its functions.
   • Refer back to discussion of markets and the role of money in reducing transaction costs.
   • Give examples of types of money.

2. Inflation is a general increase in the level of prices throughout the economy.
   • The most widely recognized measure of inflation is the Consumer Price Index.
   • The special Boskin Commission, after studying the measures of inflation, reported its conclusion that the CPI is overstated by about 1.1% and recommended revision of the method of measurement.

3. Unanticipated inflation alters the incentives normally created by price signals in the economy. (Refer to examples from the mentor teacher activity, "The Trial of Ms. Ann Flation," which immediately precedes the lecture.)
   • The incentive to save diminishes as inflation erodes the value of savings accounts and fixed incomes.
   • The incentive to spend and to accumulate debt increases as consumers act in anticipation of rising prices and wages.
   • Inflation creates additional uncertainty.
   • Predicting the future is more risky and mistakes are more costly.

4. Long-term and/or expected inflation may cause individuals and firms to alter their behaviors in response to anticipated changes.
   • Interest rates rise to cover the expected inflation rate.
   • Investors search for "inflation proof" investments.
   • Unions demand cost-of-living clauses in contracts.

5. Inflation rarely occurs except as a consequence of rapid increases in a society’s stock of money.

6. The Federal Reserve System, an agency independent of but established by the federal government, controls the stock of money in the United States through monetary policy.
   • The Fed enacts monetary policy by changing the discount rate, by changing the reserve requirement, and/or through open market operations.
   • The Fed often faces political pressures from government, private interests, and the media to follow policies that cause the money stock to grow too rapidly for price stability.

7. The use of price controls in the aftermath of an increase in the money supply disguises inflation without eliminating it, and may lead to complete disruption of the system of resource allocation.

Teaching and Discussion Ideas:

1. Refer to the "Trial of Ms. Ann Flation," mentor teacher activity conducted in the session immediately preceding this lecture. Ask students to identify ways in which the witness/victims might have altered their behavior in the face of continuing inflation.
2. Note: On Friday, some of the mentor teachers use an activity called "Foreign Currency and Foreign Exchange," which relates to the problem of the purchasing power of inflated currency. If the mentor teacher does not intend to use the activity, the following can be incorporated into the lecture:
   • Sell 3 candy bars or other small items during the lecture. Sell the first at auction (and do not let the students know that you have more, at this point), for U.S. coin or currency, and record the price.
   • Sell the second candy bar for U.S. coin or currency and/or a student’s IOU, and record the price.
   • Sell the third candy bar for U.S. coin or currency, IOU, and/or play money which you’ve distributed liberally throughout the class, and record the price.
   • Lead a discussion about the resultant increase in price.
     • Was this inflation? (Technically, no, because it is a price rise of a single product, not a general price increase, but the rise in price can be used for illustrative purposes.)
     • Why did the price rise? (Credit and play money)
     • How could the price be kept stable? (increase production, limit credit, and don't pass out play money)
     • If play money is acceptable in exchange for the candy bar, is it money?
   • This discussion leads in nicely to the role of the Fed and the components of monetary policy.

Sample Small Group Discussion Problems:

Pose a problem in which students must calculate the potential impact of inflation on their own lives.

1. Suppose that your parents saved $50/month for your college education, beginning in the month you were born. A wise investment counselor has managed to earn about $5,000 with that money over the last 16 years. It currently costs about $5,000/year to attend your local state university. Inflation is heating up and is expected to run 5%/year. Will you have enough money to go to college?

Definitions

Consumer Price Index (CPI) - The most commonly used measure of inflation, calculated by comparing the price of a designated "market basket" of goods and services in the current year to its price in a base year. The CPI is compiled by the U.S. Bureau of Labor Statistics.

Discount rate - the interest rate charged to member banks on funds borrowed from the Federal Reserve.

Federal Reserve System - The "Fed" was created by Congress as an independent agency in 1913. It serves as the nation’s central banking organization; its functions include processing checks, serving as the government’s banker, and controlling the rate of growth of the money supply.

Incentives - Rewards or punishments for behavior.

Inflation - An increase in the overall level of prices over an extended period of time.

Interest rate - The price paid for borrowing or saving money.

Money - The accepted common medium of exchange for goods and services in the marketplace that functions as the unit of account, a means of deferred payment, and a store of value.

Money supply - The narrowest definition of the money supply includes all paper bills and coins in circulation, currency, travelers checks, and checkable deposits (M_l). A broader definition, M₂, includes M_l plus such near moneys as time and savings deposits, money market mutual fund balances and Eurodollars.

Open market operations - The buying and selling of government securities by the Federal Reserve System.

Reserve requirement-- The requirement by the Federal Reserve that banks hold a minimum percentage of deposits on reserve, unavailable for lending.

Copyright © 1999 Foundation for Teaching Economics
Permission granted to copy for classroom use.