Econ 353 Money, Banking, and Financial Institutions Spring 2006
Dzmitry Asinski
Homework Assignment 12 solution.
1. (1 point) Explain why inflation can be damaging to an economy?
High level of inflation creates risk – it is typically more difficult to predict what the
actual inflation will be in the future if one expects inflation to be high (e.g., if the
expected inflation is 15% it wouldn’t be unusual to observe the actual inflation of
20%, whereas it would be unusual to observe 7% inflation if the expected level is
2%). The inflation risk is systemic and therefore not diversifiable. In addition,
constantly changing prices reduce the effectiveness of money as a store of value
(people would prefer to hold other assets). Money can even lose its ability to
perform the role of a means of payment if the inflation is very high (hyperinflation)
– people may stop accepting currency because it loses value so fast. Money should be
able to perform all its functions for the whole financial system to function smoothly
(which in turn is necessary for non-financial economy to perform well).
2. (2 point) Explain how the emergence and growth of electronic money (like
PayPal) will affect the ability of central banks to control inflation?
The ability of a central bank to control inflation ultimately depends on its ability to
control the amount of money in circulation. Central banks have considerable
amount of control over the amount of money in their respective economies because
they have monopoly over printing currency and creating reserves (this control is not
perfect, especially in more developed countries). At the same time central banks do
not have any control over electronic money (electronic money is not issued by
central banks) so their ability to manage inflation are diminished because of the
spread of electronic money.
3. (2 points) The main goal of most central banks in the world is price stability.
However, some central banks (Federal Reserve, for example) do not specify what
exactly “price stability” means. Others (like European Central Bank) define
explicit objective expressed in terms of rate of change in specific price index.
What are the advantages of the two strategies?
A central bank that sets explicit objectives (like target level of inflation) is clearly
more transparent and accountable. This strategy gives credibility to the central
bank itself and its policies. Credibility reduces risk – if a central bank says that the
inflation will be between 1 and 3% and the inflation always is between 1 and 3%,
market participants will tend to believe statements made by the central bank. If a
central bank never promises or (worse) promises but never delivers on the promises,
there would be no reason to expect that inflation will fall between 1 and 3%. If
inflation is less predictable – there is more risk.
