economics for educatorseconomicstexas.org/wp-content/uploads/2011/10/binder13-14.pdf · 75...

Economics for Educators Revised Edition Lessons 13 & 14 and 5E Model

Robert F. Hodgin, Ph.D. Texas Council on Economic Education

ii Economics for Educators, Revised

Copyright © 2012 Texas Council on Economic Education All Rights Reserved

Texas Council on Economic Education

75 Economics for Educators, Revised

Lesson 13: Money and Prices Money Imagine a long-ago time where money as we know it did not exist. Consider a desert scene where two haggling nomads try to barter one ox for an equivalent value in food and clothing. Then multiply that vision times every transaction in the land. Money’s invention as a medium of exchange was destined to occur as a solution to inefficient bartering. Yet, that “solution” is not perfect. True coinage in the form of imprinted metal, commonly silver or gold pieces of predetermined weight, is first attributed to the kings of Lydia around the 8th century B.C. From that era forward, the means of exchange became more efficient as money’s use lowered the barriers of barter. Coinage, with all the benefits of dramatically reduced transaction costs in economic exchanges, also carries with it the scourge of fraud and debasement. As a practical matter, money’s use as a medium of exchange is validated when parties accept as payment coins and currency they believe others will honor.

Roles of Money � Medium of exchange—permits commodity values to be easily divided � Measure of value—a standard way to meter value � Store of value—easily kept for later use � Means of deferred payment—recognized as valid for future payment

Characteristics of Money � Stable in value Durable � Portable Uniform in unit size � Divisible into units Recognizable

Measuring Inflation In a barter economy, where the mutual exchange of goods occurs in the absence of an accepted money form, it is logically impossible for general prices to rise. There can be no inflation in a barter economy because each transaction involves commodity exchange equivalents uniquely defined by the parties in each transaction. Absent a common money form as a measure of value, a good’s worth in one exchange has no effect on other barter transactions.


In advanced economies like the US, the dollar as designated currency meets all requirements to qualify as money. Checkable accounts in banks also have emerged as a large component of the US money supply over the past 100 years. The wide acceptance of checks as payment makes them money. Currency and coins comprise about 50 percent of what is defined and accepted as money. Checking deposits in commercial banks made up the 50 percent remainder of the US money supply of $1,832.42 billion in


2010. In 1913, the US centralized control of the US money supply control through the Federal Reserve Act. Since that time, it has been the prime responsibility of the Federal Reserve System (the Fed) leadership to manage the volume of money in circulation. Inflation often can be traced to a common source—excess money compared to the quantity of money households hold to purchase goods and services in an economy. To the extent that is true, if the central monetary authority successfully controls the money supply, it can strongly influence the overall level of prices and interest rates in an economy.

Inflation–a rise in the average level of prices; equivalently, a fall in the value of the money supply. As long as the purchasing power of the money held by the public changes so slowly that it does not alter perceptions of the future, the economy functions effectively. But when prices begin to increase at a rate that is unanticipated and too rapidly erodes the currency’s purchasing power, citizens begin to panic as institutional processes falter. The difficulty with unanticipated inflation is that it assaults our usual protections against it. For example, if you open a savings account making annual deposits that earn 5 percent toward the expected cost of sending your child to college and average consumer prices begin rising unexpectedly at 10 percent annually, your prior expectations of affording those future college-related expenses evaporate.

US Consumer Price Index [CPI] Year US CPI-U Percentage Price Change 2009 to 2010

1982-1984 100.02009 217.22010 220.3

(220.3 – 217.2) X 100 = 0.47%

217.2 Source: www.BLS.gov

The US Bureau of Labor Statistics is charged with the task of measuring inflation. Among several related measures is the popular consumer price index (CPI). The BLS also tracks other price indexes like the producer price index, the wholesale price index and the GDP deflator, the broadest of the inflation measures.

Consumer Price Index (CPI)–a measure of the average change in prices over time, paid by urban consumers for a market basket of goods and services.

The idea behind the CPI is to measure consistently the price of representative consumer purchases in a particular year compared to prices for the same items prevailing in a “base” year. The CPI market basket contains 200 goods and services in 8 major groups. From the table above, in 2009, average consumer prices were 117.2% higher than in 1982-1984. As a consequence, to have the same purchasing power in 2009 as in 1982-1984, your income would need to more than double over that same period. Between 2009 and 2010, average consumer prices rose less than one-half of one percent (see table above). The “base” year choice for a given price index series is arbitrary and does not alter the results.



US Gross Domestic Product Deflator

Year Current GDP (Billions)

GDP Deflator(2005 = 100%)

Real GDP(Billions)

2009Q4 $14,277.3 1.09665 $14,277.3 / 1.09665 = $13,019.0

2010Q4 $14,870.4 1.11118 $14,870.4 / 1.11118 = $13,382.6

Source: www.BEA.gov The CPI adjusts for prices in a consumer’s market basket of goods. A different index (see the table above), the GDP Deflator is used to adjust prices for all goods and services produced. A base year, currently 2005, is selected and subsequent year’s GDP output is valued using the 2005 base year prices. Using that technique allows the government to measure real GDP—actual goods and services produced, without the effect of price changes. Inspect the “GDP Deflator” column in the table to see that 2010 4th quarter prices are 11.1% greater than in the 2005 base period. To adjust the 2010Q4 current dollar value GDP figure (where both output and prices have changed from 2005) divide the 2010Q4 deflator value into the current GDP of $14,870.4 to get $13,382.6 billion in real GDP. Hence, between 2009 and 2010 fourth quarters, US real GDP grew by $363.6 billion ($13,382.6 minus $13,019.0). Inflation’s Winners and Losers While it is easy to typecast inflation as evil, in moderation—about 2 or 3 percent per year—it has beneficial economic effects. Entrepreneurs like modest inflation when they decide to invest, because they expect higher prices for their company’s product in the future. Some leading economists credibly claim that moderate expected inflation helps stimulate economic growth. The difficulty with inflation is its drain on purchasing power and wealth among citizens and institutions in the economy. There are recognizable groups who lose and other groups who gain from inflation. Persons on fixed incomes, or whose incomes increase much less rapidly than the inflation rate, lose relative purchasing power through time. Creditors also can fall into the category of inaccurate inflation forecasters. If a bank or mortgage company lends funds at 5 percent per year and the inflation rate over time turns out to be 5 percent annually, the lender will be paid back a fixed quantity of money with the same purchasing power as was loaned. But if future inflation is greater than 5 percent, the lender is paid back in dollars of lesser purchasing power. Taxpayers can also lose during inflationary times in a more subtle way. An inflated personal income level can fall into higher tax bracket, making the tax filer pay more federal tax dollars.


Inflation’s winners appear as debtors who can pay off loans in less valuable dollars, especially if their own incomes are among those keeping pace with the inflation rate. Owners of inflation-sensitive assets often win during inflationary times when they sell the price-inflated asset. Landowners and homeowners may see the value of their homes rise, though their property taxes also may increase.


Taxing authorities may gain from inflation, for example, through property taxes based on current appraised valuations, if the taxation method does not adjust for inflation’s effect. Controlling Inflation Moderate and relatively steady inflation of a few percentage points per year does not appear to be detrimental and can help stimulate economic growth. But at what point does a relatively benign inflation rate become worrisome or destructive? The US record during the 1970s shows that inflation rates above 10 percent per year cause significant resource dislocations, arbitrary redistributions of wealth and general unrest. Labor unions during that time discovered that attempts to neutralize inflation’s effects by holding out for wage increases equal to expected inflation will ultimately fail if future prices rise faster than the newly bargained wages. Two serious risks for government policy makers are that the inflation will become institutionalized, so strongly built-in to contracts, interest rates and expectations that reducing inflation becomes extremely difficult, or reach uncontrollable levels that literally exhaust the economy as citizens rush about making hasty transactions and seeking shelter from exploding prices. World events for other countries have shown that hyperinflation episodes, where annual inflation rates crest 100 percent or more, destroy confidence in the government as businesses, citizens and institutions fail to cope. An excessively high inflation rate must be addressed via an equally heavy “cure”. The economic and political costs of getting prices under control can be large, yet not taking action can be ruinous. The government faces the dilemma of launching a credible anti-inflationary program when they are perceived as most responsible for the inflationary spiral. Fundamentally, the central monetary authority must consistently reduce the volume of money in the economy. Unfortunately, the economic price of a restrictive money policy usually is a recession, perhaps a deep one. Harsh and sustained reductions in the money supply make nominal GDP fall as companies lay off workers due to uncertainty about future economic adjustments and the central bank’s will to sustain its anti-inflationary stance. More, the policy-induced poor business outlook makes investment fall even as inflation-padded interest rates remain stubbornly high. The recession’s length and depth will directly reflect how long it takes people and institutions to dismantle the inflationary protections they erected during the period of rising prices and to, once again, regain their pre-inflation level of social trust.



In Sum

� Money is denoted by the government as legal tender and the public validates it by honoring it in transactions.� Money fulfills its role as a useful medium of exchange as long as its value does not change rapidly.� Inflation cannot manifest in a barter economy because each transaction involves different commodities and different people.� Inflation is a rise in the general level of prices over time.� Consumer goods inflation is measured by the Consumer Price Index (CPI) as the change in value from a given base year for

a market basket of typical goods.� The GDP Deflator is used to adjust all of a given year’s GDP to the prices prevailing in another year.� Inflation’s “winners” and “losers”

o “Winners” include debtors, tax collectors, holders of inflating real assetso “Losers” include creditors, fixed income earners, income tax payers

� Inflation nearly always owes its origin to prior increases in the money supply.� “Curing” inflation requires systematic and consistent reduction in the money supply, which can cause a recession.


� “Hyper-inflation” is particularly damaging because it is very difficult to break and overwhelms economic institutions.


Lesson 14: Money and Interest Rates

Money’s Official Definitions The US government officially denotes the dollar as currency to be legal tender and society validates that designation by accepting it in exchange for goods and services. With the rise of banking as an institution, checks—legal instruments accepted for payment called demand deposits—have found their way into the operational definition of money. Printing physical currency and stamping coins is the responsibility of the US Treasury. Accommodating the volume of money the economy needs is the duty of the Federal Reserve System, the US central bank. The difficulty in defining and controlling money in the economic system is due to the many creative ways people can use cash or “near” cash. Demand deposits (checking accounts) pass as a medium of exchange. It is less clear how to interpret “checkable” savings deposits that earn some nominal interest rate. The discerning question becomes at what point is money closer to an illiquid asset versus easily accessible cash? These and related questions compel economists to adopt more than one money definition.

M1 = (coins & currency) + demand deposits = $1,832.2 billion, held by the general public in January 2010. M2 = M1 + savings accounts and checkable time deposits, held by the general public = $8,816.4 billion in January 2010.

Money is Not Credit

Many Americans seem to think that credit cards are money. The truth is they are not. Credit cards are short-term promissory notes permitting the holder a line of credit for a fee called interest. The monthly balance on the credit card is paid using money, commonly a personal check drawn against the cardholder’s bank account, a demand deposit. The credit card balance, a short-term loan, can for a while, run ahead of the cardholder’s ability to pay the total balance in money—check or cash. Over time, either the cardholder’s credit balance is paid in full or the consequences range from card cancellation to personal bankruptcy. Indiscriminate credit card users also pay higher interest rates. Money’s Scarcity Preserves Its Value Goods and services satisfy basic human needs. Money is merely a means to economic ends. If the central monetary authority were to increase the money supply so that each citizen could fill their pockets and purses with it, then prices for goods would rise dramatically as shop owners witnessed a mad rush of cash-laden customers scrambling to outbid their neighbors for available goods. Ruinous inflation would inevitably result.



The practical objective of the central monetary authority is to supply the economy with a quantity of money that satisfies the needs of commerce, and no more. As average prices rise, the value of the dollar falls, and the opposite is true. Preserving a currency’s value and moderating average prices, requires the monetary authority to maintain a relatively constant ratio between the volume of goods and services produced and the quantity of money in circulation. So why is this objective so difficult to achieve? Market economies are dynamic, leaky and fickle. First, business momentum can bring unanticipated swings in overall activity. Second, money leaks outside of the economy through international transactions, especially when the US buys more from other countries than it sells to them. Perhaps most vexing of all, the amount of money businesses and households hold—the demand for liquidity—to meet transactions needs and uncertainty is entirely up to them. Changes in the quantity of money held can be unexpected, swift and large. These three forces: economic shifts, currency leakages and changes in money demand, make knowing how much money the economy needs difficult to predict and to accommodate. Time’s Value is the Interest Rate The interest rate is the measure that links the value of an economic good tomorrow to its value today. In normal economic times the rate is positive, indicating that if we choose to wait for a future good, we insist on some reward for doing so. At the personal level, it makes sense to keep a certain amount of our income in a checking account where the money is immediately accessible but earns little or no interest. It is also prudent to keep some money in a savings account, where funds are somehow restricted but earn a higher interest return. Savings accounts offer a positive interest rate to entice savers to deposit funds into financial institutions. We each carry a personal interest rate with us and it shows up in our current consumption-to-saving behavior. If we consistently spent all of our income today, we would be showing little preference for the future. Then by implication, our personal interest rate must be higher than the market savings rate. If, instead, we engage in a steady savings plan with some of our after-tax income that earns 4% in a certificate of deposit, then our personal interest rate for short-term savings must be less than 4 percent. The interest rate similarly serves to allocate business investment spending. Before making an investment, business decision-makers analyze the proposition by estimating the expected future dollar profit returns as a percentage of the total investment cost in today’s dollars. They then compare that rate of return to the interest rate cost of borrowing. If the anticipated investment rate of return exceeds the cost of borrowing, the investment may be a good one. To the extent that an investment pays a return above all costs including the cost of borrowing, today’s income gets converted into tomorrow’s wealth.


Funds for investment come from household savings, business savings (as undistributed corporate profits). Without savings somewhere in the economy, investment is not possible. The prevailing interest rate represents the macro trade-off between consumption today and consumption tomorrow. From the saver’s view, it is the reward for postponing consumption today. From the borrower’s view, it is the cost of gaining command over resources today rather than waiting until tomorrow. In the financial marketplace, as net savers supply funds and net borrowers demand funds—the market rate of interest is determined.


Banks and financial markets exist to permit the orderly transfer of funds from holders of excess income to borrowers with a deficit of available funds. Interest rates, as a cost of credit and as a reward for not consuming, are determined in financial markets by the interplay between demanders of loanable funds and the suppliers of loanable funds. In Sum � M1, the official money supply definition equals coin + currency in circulation, bank vault cash plus demand deposits in commercial

banks.� Credit cards are not money. Credit cards are short-term financial contracts mandating repayment with interest.� The central bank’s main objective is to preserve the value of the currency by providing only that amount necessary to meet the

needs of commerce as it helps the economy achieve full employment.� As average prices rise, the value of the currency falls and as average prices fall, the value of the currency rises.� The interest rate simultaneously is a reward for saving and a cost of borrowing to invest. � The orderly interaction of savers and borrowers through the financial system determines the interest rate.


� Leakages of money out of the economic system, swings in economic activity and changing demands to hold money make controlling the money supply difficult for the central monetary authority.

1801

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3)65

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Page

| 41

Less

on 1

3M

oney

an

d P

rice

s, p

age

& L

esso

n 1

4 M

oney

an

d I

nte

rest

Rat

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pag

e 8

0

Eng

age

Bef

ore

clas

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repa

re 1

00 “

mon

opol

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oney

” si

zed

$1 b

ills.

You

will

use

exa

ctly

50

at a

tim

e. (

Kee

p th

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use

in a

ll cl

asse

s.)

Als

o ac

quire

two

iden

tical

obj

ects

th

at m

ight

cos

t ab

out

$1.0

0, t

hat

stud

ents

sho

uld

wan

t (p

en,

mec

hani

cal p

enci

l, ca

ndy

bar

etc.

).

Ask

the

cla

ss if

any

one

thin

ks,

in g

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al,

they

eve

r ha

ve “

enou

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pas

s ou

t H

ALF

of

the

$1 b

ills

(exa

ctly

hal

f—50

of th

em)

rand

omly

to

stud

ents

. Som

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ne o

r 1,

som

e ge

t 2

or 3

(th

at’s

life

!).

Then

hav

e th

e st

uden

ts “

bid”

on

the

obje

ct b

ased

on

the

(fak

e) m

oney

the

y ha

ve in

th

eir

hand

s. H

owev

er,

NO

“po

olin

g” o

f fu

nds

betw

een

stud

ents

is a

llow

ed.

Aw

ard

the

obje

ct t

o th

e hi

ghes

t bi

dder

and

TAKE

the

bidd

er’s

mon

ey.

The

n w

rite

the

PR

ICE

for

whi

ch t

he o

bjec

t so

ld o

n th

e bo

ard.

Of

cou

rse,

th

e an

swer

is “

no.

”

Exp

lore

Now

han

d ou

t th

e ot

her

HALF

of

the

$1 b

ills,

by

givi

ng e

ach

stud

ent

who

hol

ds o

ne

or m

ore

bills

DO

UBLE

the

am

ount

the

y ha

ve (

less

the

price

pai

d fo

r th

e fir

st o

bjec

t)

Then

rev

eal t

he s

econ

d (a

nd id

entic

al)

obje

ct a

nd a

uctio

n it

off as

bef

ore.

Ask

the

cla

ss w

hy t

his

occu

rred

and

list

the

ir r

espo

nse(

s).

The

win

nin

g b

id p

rice

WIL

L b

e h

igh

er t

han

th

e p

rio

r w

inn

ing

bid

! W

rite

it o

n

the

bo

ard

.

Of

cou

rse,

th

e am

ou

nt

of

mon

ey d

oub

led

so

the

pri

ce w

ent

up

. I

f th

at

occ

urr

ed f

or

all g

oo

ds

in t

he

eco

no

my,

we

wo

uld

cal

l it

infl

atio

n.

Be

sure

to

lin

k th

at d

edu

ctio

n d

irec

tly

to t

he

volu

me

of

mo

ney

in c

ircu

lati

on

!

1801

Alle

n P

arkw

ay *

Hou

ston

, TX

770

19 *

(71

3)65

5-16

50 *

Fax

: (71

3)65

5-16

55

Em

ail:

tcee

@ec

onom

icst

exas

.org

* w

ww

.eco

nom

icst

exas

.org

Page

| 42

Exp

lain

Ask

the

stu

dent

s to

write

dow

n w

hat

they

saw

hap

peni

ng.

Ask

the

m if

the

pro

duct

had

cha

nged

in a

ny w

ay,

shap

e or

for

m?

W

hy h

ad t

he

pric

e ch

ange

d?

Ask

the

stu

dent

s w

hat

this

cha

nge

was

cal

led?

Ask

whe

n th

e va

lue

of m

oney

was

gre

ater

-the

first

rou

nd o

r th

e se

cond

and

why

.

Then

mak

e th

e p

oin

t th

at I

F p

eop

le r

ecei

ve m

ore

mo

ney

th

an t

hey

per

ceiv

e th

ey n

eed

, th

ey w

ill t

ry t

o s

pen

d it

: ei

ther

by

mak

ing

mo

re p

urc

has

es o

r m

akin

g m

ore

inve

stm

ents

; in

eit

her

cas

e th

at a

ctio

n d

rive

s u

p t

he

pri

ce o

f th

e g

ood

.

So,

wh

ile a

sin

gle

per

son

MA

Y b

e ab

le t

o sp

end

th

eir

exce

ss c

ash

wit

ho

ut

con

seq

uen

ces

(a r

ise

in p

rice

s);

all

peo

ple

in

th

e ec

on

om

y ca

nn

ot

do

so

. T

his

is

th

e p

arad

ox

of in

flat

ion

!

The

valu

e o

f m

on

ey w

as g

reat

er t

he

firs

t ro

un

d b

ecau

se t

he

stu

den

ts c

ou

ld

bu

y th

e o

bje

ct f

or

hal

f th

e am

ou

nt

of

the

seco

nd

ro

un

d.

Exte

nd

So

then

ask

the

cla

ss “

how

muc

h” m

oney

rea

lly I

S e

noug

h to

hav

e in

an

econ

omy?

[L

ist

resp

onse

s on

the

boa

rd.]

Use

the

MV =

PQ

exp

ress

ion

to d

emon

stra

te t

he g

ener

al r

elat

ions

hip

usin

g th

e ta

ble

belo

w.

Rec

all f

rom

thi

s Le

sson

tha

t V is

rel

ativ

ely

cons

tant

. A

lso

let

the

clas

s kn

ow y

ou w

ill a

ssum

e th

e ec

onom

y is

alrea

dy a

t FU

LL e

mpl

oym

ent

(Q =

Rea

l GD

P =

500

), s

o Q

will

cha

nge

from

tha

t le

vel.

Sol

ve f

or P

in e

ach

period

and

not

ice

the

upw

ard

Pric

e tr

end

from

Per

iod

1.

Period

M X

V

=

P X

Q

= N

omin

al G

DP

1

$100

5

?

$500

=

$

500

(B

ase

year

)2

$150

5

?

$500

=

$

750

3 $2

00

5

? $5

00

= $

1,00

0

1801

Alle

n P

arkw

ay *

Hou

ston

, TX

770

19 *

(71

3)65

5-16

50 *

Fax

: (71

3)65

5-16

55

Em

ail:

tcee

@ec

onom

icst

exas

.org

* w

ww

.eco

nom

icst

exas

.org

The

real

ity

is t

hat

it is

no

t so

mu

ch t

he

shee

r vo

lum

e o

f m

on

ey,

bu

t th

e ra

te o

f it

s in

crea

se (

cau

sin

g i

nfl

atio

n)

ove

r ti

me

or

the

rate

of

dec

reas

e (c

ausi

ng

a

rece

ssio

n)

ove

r ti

me

that

is im

po

rtan

t.

Hen

ce,

the

mo

net

ary

auth

ori

ties

mu

st

man

age

the

mo

ney

su

pp

ly s

o t

hat

bu

sin

ess

nee

ds

are

met

bu

t n

o m

ore

(an

d

no

less

).

Page

| 43

Sol

uti

on

s fo

r P

are

:

Per

iod

P

1

1

.0 B

ase

year

2

1.5

[In

flat

ion

= (

$7

50

- $

50

0)

/ $

50

0 X

10

0 =

$2

50

/$

50

0 X

10

0 =

5

0%

]3

2.0

[In

flat

ion

= (

$1

,00

0 -

$5

00

) /

$5

00

X 1

00

= $

50

0/

$5

00

X 1

00

=

10

0%

]

So

th

e re

sult

of

an i

ncr

easi

ng

mo

ney

su

pp

ly w

hen

th

e ec

on

om

y is

at

full

emp

loym

ent

(Rea

l GD

P =

$5

00

in P

erio

d 1

) is

hig

her

ave

rag

e p

rice

leve

l (P

),

i.e.

infl

atio

n.

Eval

uat

e

We

bega

n th

e cl

ass

with

the

que

stio

n: d

o yo

u ev

er h

ave

“eno

ugh”

mon

ey?

How

do

you

ans

wer

tha

t no

w?

Cite

thr

ee t

hing

s yo

u ha

ve le

arne

d in

the

less

on t

hat

help

ans

wer

the

que

stio

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The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices Program grant that allowed Economics for Educators, Revised Edition to be written and published.

The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to provide the staff development that utilizes content and skills provided in Economics for Educators.

Helping young people learn to think & make better economic & financial choices in a global economy.

1801 Allen Parkway Houston, Texas 77019 Telephone 713-655-1650 Fax 713-655-1655 Email: [email protected]

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