Economic Functions Of Money, Risk, And Cost
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What are the functions of money? Is there a link between inflation and how well money fulfills each of these functions? Money has three functions. The first is a medium of exchange, an item that buyers give to sellers when they want to purchase goods and services I like the definition from Wikipedia better, an intermediary used in trade to avoid the inconveniences of a barter system. As a medium of exchange money helps to facilitate the flow of goods and services by eliminating bartering and coincidence of wants (we all want money!). The second is a unit of account, a yardstick people use to post prices and record debts. When we want to measure and record economic value we use money as a unit of account. By assigning everything a dollar value we can have a better idea of what the value of the item might be. It also helps us compare the value of similar items. The third function of money is a store of value, an item the people can use to transfer purchasing power from the present to the future. Money essentially enables us to transport value into the future. There is a link between inflation and how well money fulfills each of these functions. Inflation affects all three functions. In regards to a unit of account, inflation can cause relative prices to vary more than they would otherwise and thereby distort markets. Imagine post World War I Germany and hyperinflation. It would be hard to use the deutch mark as a unit of account because prices were increasing rapidly every day. Inflation forces a good to be priced higher than it would under on inflation. Using the deutch mark would be an ineffective way of gauging the value of item or comparing its value to another. Inflation would affect money as a store of value as well. Once again look to post W.W. I Germany. A deutch mark on Monday would be worth much more than a deutch mark on Friday pressuring people to spend while it still holds value. Inflation deteriorates moneys function as a store of value. Even today, for money to be a true store of value you would need a return on your money that at least equals the rate of inflation. If inflation is 4% a year then $100 a year from today is worth $96. Inflation also affects how money is used as a medium of exchange. If people using money as medium of exchange believe that its value will rapidly decrease over time they may require more money for the exchange then they normally would or might require some other medium of exchange For example, Euro’s may be requested over dollars. Also, the victors of W.W. I required Germany to pay its reparations in gold and not marks as they were losing value and it was essentially not recognized as an effective medium of exchange.
What types of risk are involved with stocks? Bonds? Can the risks for an investor be reduced? If yes, how, if not, why not? The risks associated with stocks are market (aggregate) and firm (idiosyncratic). Market risk is risk that affects all companies in the stock market. An example would be the current financial and credit turmoil. The damage has affected the whole market and not just those stocks associated with the financial sectors. Firm risk is risk that affects only a single company. Imagine if your IRA or 401K held only Enron. For bonds the risks are default risk and interest rate risk. Default risk is the risk of a corporation, municipality, or household not being able to repay the obligated principle and or interest associated with a bond or mortgage. Interest rate risk is the risk of the interest changing while you are already committed to a bond. For example, if you acquire a bond paying a 5% interest rate there is risk that the market interest rate may go up and new bonds will be issued at 6%. The risk is in losing out on a higher paying bond. There are also interest rate risks for mortgages. If rates fall then borrowers will refinance their current mortgage. Also, if rates rise borrowers will not refinance reducing the demand for loans. Some of the risk for investors can be reduced. For stocks, the biggest way to reduce risk is to diversify. To reduce firm specific risk you will need to invest in more than once stock or fund. The risk of a stock portfolio falls as the number of stocks held increases. Avoiding market risk is hard, but it can be somewhat achieved by diversifying in different markets. For example, you could invest your money in numerous foreign exchanges (Hong Kong, China, Japan, UK, France, etc.). For bonds it is harder to reduce risk. Many bonds have ratings from the good AAA to the not so good Baa. A bond with a higher rating has a lower chance of default. So you can reduce default risk by choosing what type of bond you want. A bond from Boeing or a bond from a poorly performing company. A bond rated AAA with a lower interest rate or a bond rated Baa with a higher rate. By taking the Baa bond you probably lower your interest rate risk but increase your default risk. It is hard to reduce interest rate risk. One possible way it to either acquire shorter term notes or the first two tranches of a CDO.
In recent years Venezuela and Russia have had much higher nominal interest rates than the United States while Japan has had lower nominal interest rates. What would you predict is true about money growth in these other countries? Why? The rapid rise on nominal interest rates in Russia and Venezuela can be attributed largely to a recent influx of cash into both economies. Both countries hold vast energy reserves and have enjoyed increasing revenues that coincide with an increase in global price and demand for oil. Since the nominal interest rate is very high in Russia and Venezuela one could expect to see the inflation rise as well. The Fisher effect, whereby the inflation rate and nominal interest rate adjust one for one. Inflation is high in both countries, double digit, and much lower in comparison to the U.S. and Japan (I looked it up on the IMF website). Money growth in Russian and Venezuela is higher than in the U.S. and Japan as the nominal interest rate essentially shows how fast the number of dollars in your bank account rises over time. I would expect the real interest rate to be lower in Japan and the U.S. as our inflation rates are much lower than in either Russian or Venezuela. Since there is such as large influx of capital into the Russian and Venezuelan economies the supply of money is increasing. There may be disequilibrium in Russia and Venezuela between the amount of money supplied and the amount of money demanded. As more money is pumped into both economies the equilibrium value and price of money will fall. Basically, if the nominal interest rate is very high in Russia and Venezuela then we can expect the inflation rate to be high as well (compared to the U.S. and Japan) due to the Fisher effect. If the inflation rate is high then we can expect that the quantity of money supplied is increasing in both countries