EXERCISE 4. Prepare short reports on the following topics. The reports are to be translated in the class

· Economic ideas of P. Samuelson and M. Friedman.

· Types of taxes.

· Problems of taxation in Russia.

10. MONEY AND FINANCIAL INSTITUTIONS

What Are The Causes Of Inflation?

Demand-Pull Inflation. A situation in which there is "too much money chasing too few goods" is often described as demand-pull inflation. When demand increases faster than industry's ability to satisfy that demand, prices will increase. During the Vietnam War, for example, government spending for military goods served to increase the purchasing power of many Americans since it was not accompanied by a tax increase. Meanwhile, factories that might have been producing consumer goods turned to the production of goods for use in the war. The result was an increase in the demand for goods and services at the very time that industry's ability to satisfy that demand was being redirected. Since it was not possible to increase output to satisfy demand, prices rose.

Cost-Push Inflation. A period of rising prices due to an increase in the cost of production is calledcost-push infla­tion. When, for example, labor unions win wage increases greater than the workers' increases in productivity, manage­ment may choose to raise prices to maintain profits. With prices going up, other unions and workers might demand wage increases to keep up with the increased cost of living, and so on, and so on, in an inflationary spiral. Similarly, efforts by producers to increase profits by increasing prices rather than by reducing costs could also trigger an inflationary spiral.

Although "demand-pull" and "cost-push" explain how certain rounds of inflation begin, there are other factors to consider. Sometimes, for example, sudden unexpected shortages of a basic commodity can cause price increases. This happened in 1974 and 1980 when OPEC oil boycotts ran the price of petroleum up to record levels, creating severe cost-push inflation.

Who Suffers Or Benefits From Inflation?

Inflation affects people differently: some suffer, while others benefit.

Those Who Suffer from Inflation. Those most likely to suffer from inflation are people living on relatively fixed incomes, savers, lenders and business.

· People living on relatively fixed incomes. During periods of inflation the cost of living increases. There­fore it is necessary to earn more just to maintain your present living standard. How much of an increase is necessary? At least as much as therate of inflation— the increase in the cost of living. In other words, if the cost of living increased by 10 percent in 1991, a person with a $20,000-a-year income in 1990 would have to earn $22,000 ($20,000 + 10 percent) in 1991 just to stay even. Certain groups, such as those living on fixed retirement pensions, cannot increase their incomes enough to offset the effects of inflation. When this happens their standard of living will decline. To protect people on fixed incomes, Social Security benefits are adjusted for the effects of inflation.

· Savers. Some people put their money into savings accounts or bonds that guarantee a fixed rate of return (usually called "interest"). Unless the rate of return is at least as high as the inflation rate, the money returned to a saver will purchase less than the sum he or she set aside.

· Lenders. Those who lend money are in the same posi­tion as those who save. If during the term of a loan infla­tion increases, the money returned when the loan comes due will be worth less than the original loan, unless the interest rate on the loan was greater than the rate of inflation.

· Business. Busi­ness is hurt by infla­tion because it causes uncertainty and makes it hard for managers to predict future costs. It also raises produc­tion costs.

Those Who Benefit from Inflation. Those who can easily increase their incomes, borrowers and government can benefit from inflation. Here are some reasons why.

· Those who can easily increase their incomes. Certain professions, industries and labor groups find it easier to increase prices and wages during periods of inflation than at other times. If the increases are greater than the infla­tion rate, those people will be better off than before the run-up in prices. A case in point is the retail jewelry trade. During periods of inflation the price of jewelry has gener­ally increased faster than the cost of living. The result has been higher profit margins for jewelers during these periods.

· Borrowers. Those who borrow during a period of infla­tion will be returning money that is worth less at the end of the loan period than it was at the beginning. If the interest charged on the loan is less than the inflation rate, those who borrowed will benefit from the difference.

· Government. The federal government and certain state governments collect graduated income taxes. This means the tax rate increases as one's income increases. During inflation, people tend to earn higher incomes, putting more taxpayers into higher tax brackets. In this way people with a 10 percent increase in income may find their taxes increase an additional 12 or 15 percent. This is called bracket creep. For this reason government can benefit from inflation.

Reading for Enrichment

Inflation In Argentina

They change the menu every day at the Estrella de Oro restaurant in downtown Buenos Aires. Not for the reason you may be thinking — the dishes have been the same for several months. The reason the menu has to be changed is to allow management to raise the prices. You see, Argen­tina is experiencing a runaway inflation. By that we mean that the value of its currency is falling at an astonishingly rapid rate.

How rapid? In January, 1989, 17 australes (the austral is the Argentine unit of currency) were equal to one U.S. dollar. By May it took 175 australes to buy $1, and by September the austral had fallen to 615 to the dollar! Or, to put it another way, the bottle of soda that someone living in Buenos Aires could have bought for 7 australes in January was selling for 253 australes in September!

Inflation such as the kind that struck Argentina destroys the lives of many people. Those who set money aside for a special occasion (a college education, retirement, etc.) find that their savings are all but worthless.

With prices rising daily, the incentive to save is replaced with the urge to spend. Paychecks are cashed immediately and converted to dishwashers, TV's and refrigerators. Since no one will give credit in the midst of runaway inflation, consumers must pay cash for all their purchases.

When Americans read about the Argentine inflation, one of the first questions that comes to mind is, "Can it happen here?" Fortunately, for reasons that will be explained in this chapter and the next, we may answer with a confi­dent "probably not."

Financial Institutions

Most individuals and firms need the banking services offered by commercial banks and thrift institutions. Federal law defines abank as a "financial institution that accepts demand deposits and makes commercial loans." For that reason, bankers, economists and other professionals refer to savings and loan associations, mutual savings banks and credit unions asthrift institutions or "thrifts." They use the term "banks" only when they are referring to commercial banks.

The general public is rarely that precise. Most people today say "bank" when they are speaking of any financial institu­tion that accepts deposits and makes loans.

Financial Institutions Accept and Hold Deposits. A main function of banks and thrifts is to act as "financial middlemen." They do this by channeling money from depositors to investors, from those wishing to save money for future use to those wanting to spend it now. Deposits can be in the form of savings accounts or checking accounts.

Other Bank Services

Trusts. A trust arrangement exists when a bank provides safekeeping and management of funds for individuals, estates or institutions such as pension funds. The bank's job is to administer the money entrusted to it wisely and for the benefit of the owner. The bank receives a fee for managing these funds.

Currency Exchange. Banks can buy or sell foreign currencies for their own benefit or for their clients. Importers, exporters and travelers are major users of these services. Even domestic travelers may purchase travelers' checks issued by banks.

Safekeeping. Many banks rent safety deposit boxes in their vaults to persons seeking a safe and secure place for their valuables.

Credit Cards. Some banks derive significant revenues from operating bankcard programs. There is usually an annual fee to use the credit card, and the consumer pays interest on the unpaid balance. Merchants pay a fee to the bank as well.

Brokerage. In very recent times (and still on a highly limited basis) some banks have entered the brokerage business. As brokers they buy and sell stocks and bonds for their clients.

Insurance. In a number of states certain banks can sell their customers life insurance policies.

Letters of Credit. Banks may aid commerce by writing letters of credit. In these documents, the bank guarantees one party (such as a seller) that payment will be made if certain conditions are met (such as the delivery of merchandise). Letters of credit are common when goods are bought or sold abroad. There is a fee for providing this letter of credit.

Investments. Banks are permitted to buy U.S. government bonds for their own accounts. Banks may make money in trading such bonds and from the interest paid by the government to the holders of such securities.

Underwriting. When companies (or even units of government) raise money by issuing shares of stocks or by the sale of bonds, they use the services of certain financial specialists. Some very large banks provide such assistance, as do major brokerage companies.

Consulting. A growing business for banks is to give advice to other businesses. Especially significant in recent years is the assistance provided to firms involved in corporate mergers and takeovers.

The History of Economic Thought