In this classic period of deflation (Dec 2008), one must be wondering why I am writing about Inflation. But the fact is, as soon as the economy bottoms out, inflation will strike back again. Once again the purchasing power of dollar will go down and people will again recall those good old days when gas use to be $1.50.
One wonders as to how actually the money is getting devalued. Money is supposed to be a store of value, an asset which a human preserves by refraining him/herself from immediate consumption. Yet it defies the very definition and loses its value gradually.
The major reason, as any economist in the world would suggest, is increase in the money supply. The simple logic they refer to is supply/demand equation. The number of dollars (or any other currency) has increased at a rapid rate compared to other assets whose value is being analyzed. The number of dollars has particularly gone up when we consider the money in the sense of M3 (Physical currency + Checking Account + Time deposits + Money Market funds). (For more discussion on Money-Supply click here)
But this explanation to me is oversimplification of a complex issue. The fact of the matter is no wealth is created unless we have inflation. Wealth is defined as: "anything that has utility and is capable of being appropriated or exchanged". Increase in wealth includes:
1) Any new thing that is useful for humanity
2) Increase in production of existing things to satisfy the need of growing population.
Hence, growth of wealth is necessary for the survival of growing population as well as to make human life more comfortable.
Let us analyze the role of Central Banks in this increase of wealth. For a moment lets assume that Central Banks stops minting (or printing) more money and assume Human being will continue on their mission to increase wealth and population. In such case, the money (dollars) will become scarce compared to the total human wealth. Purchasing power of money (dollar) will increase over time and big investors and common public alike would like to store their wealth in dollars. Ideal scenario isn’t it? No! Because this would lead to lack of investment leading to an actual decrease in wealth and hampering of production cycle, unemployment will rise and standard of living for many people will fall apart.
This is where the Central Bank comes into picture. They dilute the demand of money (dollars) by printing more money leading to a re-establishment of balance between the wealth and number of dollars. This dilution of dollar demand will lead investment bankers and common public to think about preserving their purchasing power by investing their surplus capital into the production system.
Thus, dilution of dollar demand is key to creation of new wealth. One might wonder if the job of Central Banks is to establish equilibrium between number of floating dollars and the wealth then why is the value of individual items (like gasoline) is rising? Why is gasoline more expensive now than in 1972 (if Central Bank is doing what it is supposed to do)?
The answer to this is:
The number of goods that were available in 1972 was far fewer than what we have now. Think about all the I-phones/G-Phones/Hi-Tech computers/Fax-machines/Advanced weapons etc., we did not have them in 1972. The equilibrium is being established between aggregate wealth and the number of dollars (not between individual item and the number of dollars). The reason for this inflation in individual commodity (like Gasoline) is that the rate of growth of it has been lower as compared to the rate of growth of dollars. The reason being as state above is the creation of new goods. Had it been that we had same number of items and the same technology that we had in 1972, then the central bank would have increased their money supply in such a way that the cost of each item would have been almost the same.
However, one needs to remember that Economics is an inexact field. The Central Bank doesn't have an exact measure of what the wealth of each year is (especially when you include the service sector in wealth computation). So the effect of their dollar-printing activity will have uneven effect on different commodities/goods.
So, it is unjust for people to blame Central Bank for inflation because the creation of new wealth, sustenance of growing population, and desire for increased human convenience requires central bank to do what they are doing (i.e. printing more dollars and diluting the dollar demand). However, this does not mean that Central Banks (Federal reserves) are perfect organizations; it has got many drawbacks which will be discussed in a separate post.
Some people (especially from Austrian school of economics) argue that markets take care of themselves. They will themselves establish the equilibrium between the number of dollars and the wealth. But the fact of the matter is it will be very chaotic if the markets were left to bring this equilibrium. Great depression of 1928 and the frequent booms/busts before it (in late 19th century and early 20th century) clearly shows that market do figure out this equilibrium but in a very painful way.
Of course there is one (impractical) way of stopping inflation and that is:
1) Human beings should stop improving their standard of life.
2) Human beings should stop increasing their population.
Any comments/criticism is welcomed.
One wonders as to how actually the money is getting devalued. Money is supposed to be a store of value, an asset which a human preserves by refraining him/herself from immediate consumption. Yet it defies the very definition and loses its value gradually.
The major reason, as any economist in the world would suggest, is increase in the money supply. The simple logic they refer to is supply/demand equation. The number of dollars (or any other currency) has increased at a rapid rate compared to other assets whose value is being analyzed. The number of dollars has particularly gone up when we consider the money in the sense of M3 (Physical currency + Checking Account + Time deposits + Money Market funds). (For more discussion on Money-Supply click here)
But this explanation to me is oversimplification of a complex issue. The fact of the matter is no wealth is created unless we have inflation. Wealth is defined as: "anything that has utility and is capable of being appropriated or exchanged". Increase in wealth includes:
1) Any new thing that is useful for humanity
2) Increase in production of existing things to satisfy the need of growing population.
Hence, growth of wealth is necessary for the survival of growing population as well as to make human life more comfortable.
Let us analyze the role of Central Banks in this increase of wealth. For a moment lets assume that Central Banks stops minting (or printing) more money and assume Human being will continue on their mission to increase wealth and population. In such case, the money (dollars) will become scarce compared to the total human wealth. Purchasing power of money (dollar) will increase over time and big investors and common public alike would like to store their wealth in dollars. Ideal scenario isn’t it? No! Because this would lead to lack of investment leading to an actual decrease in wealth and hampering of production cycle, unemployment will rise and standard of living for many people will fall apart.
This is where the Central Bank comes into picture. They dilute the demand of money (dollars) by printing more money leading to a re-establishment of balance between the wealth and number of dollars. This dilution of dollar demand will lead investment bankers and common public to think about preserving their purchasing power by investing their surplus capital into the production system.
Thus, dilution of dollar demand is key to creation of new wealth. One might wonder if the job of Central Banks is to establish equilibrium between number of floating dollars and the wealth then why is the value of individual items (like gasoline) is rising? Why is gasoline more expensive now than in 1972 (if Central Bank is doing what it is supposed to do)?
The answer to this is:
The number of goods that were available in 1972 was far fewer than what we have now. Think about all the I-phones/G-Phones/Hi-Tech computers/Fax-machines/Advanced weapons etc., we did not have them in 1972. The equilibrium is being established between aggregate wealth and the number of dollars (not between individual item and the number of dollars). The reason for this inflation in individual commodity (like Gasoline) is that the rate of growth of it has been lower as compared to the rate of growth of dollars. The reason being as state above is the creation of new goods. Had it been that we had same number of items and the same technology that we had in 1972, then the central bank would have increased their money supply in such a way that the cost of each item would have been almost the same.
However, one needs to remember that Economics is an inexact field. The Central Bank doesn't have an exact measure of what the wealth of each year is (especially when you include the service sector in wealth computation). So the effect of their dollar-printing activity will have uneven effect on different commodities/goods.
So, it is unjust for people to blame Central Bank for inflation because the creation of new wealth, sustenance of growing population, and desire for increased human convenience requires central bank to do what they are doing (i.e. printing more dollars and diluting the dollar demand). However, this does not mean that Central Banks (Federal reserves) are perfect organizations; it has got many drawbacks which will be discussed in a separate post.
Some people (especially from Austrian school of economics) argue that markets take care of themselves. They will themselves establish the equilibrium between the number of dollars and the wealth. But the fact of the matter is it will be very chaotic if the markets were left to bring this equilibrium. Great depression of 1928 and the frequent booms/busts before it (in late 19th century and early 20th century) clearly shows that market do figure out this equilibrium but in a very painful way.
Of course there is one (impractical) way of stopping inflation and that is:
1) Human beings should stop improving their standard of life.
2) Human beings should stop increasing their population.
Any comments/criticism is welcomed.
