Tag Archives: Money

Why are cereal prices high?

This is priceless. ROFL stuff. Article 1 says that the Central Government is not allowing export prices of wheat to fall below a certain level. That level, incidentally, would make their minimum support price look ridiculous by placing a huge subsidy (that only means much bigger than the current one) burden on government, but that’s my observation, not the article’s. As per the article, it is ministers of the Central Government who are refusing to allow wheat export prices to fall below the prices at which the Central Government sells wheat to biscuit manufacturers.

And then there is Article 2 that blames State governments for prices not falling and for stocks piling up and rotting in godowns. It even cites economic theory by mentioning that record stocks should send prices crashing down and ends by saying that the fact that they are not must be because of hoarding.

Ah! There it comes!!! The evil hoarder is responsible for all the miseries of the common man and government is the saviour. Let the crackdown start and let’s have punitive punishment meted out to the greedy people who are ready to watch millions starve.

Yes! Repeat after me until you really believe it!! Government manipulation of the money supply and its tampering with the price mechanism have nothing to do with high and ever rising prices. If you repeat it enough times, it will become the truth. So repeat it blindly without thinking.

Fixing Inflation

This article raises an issue very relevant to the times we live in – fixing inflation. Summarising what Mr. Subbarao says, inflation is a supply side problem. That means that according to him, inability of the system of production to keep up with the ever-rising demand for goods and services is responsible for steadily rising prices. This inability, he implies, is due to fiscal policy failures and a slow pace of reform dragging economic growth down. The responsibility for fixing the problem, as per Mr. Subbarao, lies with the government. In his opinion, there is precious little that the RBI can do to stimulate growth without stoking the fires of inflation.

Mr. Chidambaram, on the other hand, believes that he has done what he could and was expected to do, i.e., keep fiscal deficit under control, to keep inflation under control, and that the ball is now in the RBI’s court. He believes it is time for the RBI to cut interest rates and tinker with other parameters in its control (like CRR and SLR) to boost growth.

What do we, as ordinary people, make of this debate happening in rarefied environs? Let me make a beginning by focusing, in this article, on inflation.

What is inflation?

The commonly accepted definition of inflation is the steady rise in prices, which is measured through price indices like WPI and CPI. The Classical (Original) definition of inflation, however, is the increase in money supply. This might come as a surprise to many of you because all you may have heard is the commonly accepted definition given above. So here, here, here and here are some links that confirm what I am saying.

Which of these is meaningful and useful?

Only the Classical definition of inflation is meaningful and helps us understand real world phenomena like ever-rising prices while the commonly accepted definition is utterly useless.

Why is the Classical definition meaningful and useful?

Money is a commodity like any other. It has a price too. That price is determined, like it is for all other commodities, by the forces of supply and demand. When money supply increases, the price of money falls. When the price of money falls, the prices of goods and services denominated in that money rise. A steady rise in the supply of money causes a steady rise in prices. Thus, the Classical definition of inflation helps us understand the real world phenomenon of rising prices from fundamentals and is therefore meaningful.

Why is the commonly accepted definition of inflation useless?

Defining inflation as the steady rise in prices tells us nothing about what caused prices to rise in the first place. Explanations like the demand-pull and cost-push theories, and structural/built-in inflation are based on elementary economic fallacies and errors. For instance, if we say that prices are rising because demand is rising, what caused the demand to rise in the first place? If we say prices rise because costs rise, aren’t costs prices themselves? Are we then not bound to explain what caused THOSE prices to rise first? If we do not, would we not be guilty of engaging in circular reasoning by saying that rising prices cause prices to rise? And is saying that some price rise is “built-in” not a negation of economic theory itself, especially price theory, which seeks to explain prices from fundamentals?

A small point of caution while using the Classical definition of Inflation

It often happens that productivity improvements send supply of goods and services up so rapidly that we do not see rising prices but stable or even mildly falling prices. In such cases, it is important to bear in mind that in the absence of inflation, prices of these goods and services would have been much lower than they currently are. So, merely observing stable, slowly rising or mildly falling prices in the face of increase in money supply does not negate the Classical definition of inflation.

What causes money supply to increase steadily?

As explained in my previous post, the banking system that we live with is the fundamental and most proximate cause of inflation. Fractional Reserve Banking is based on creating money many multiples of the monetary base we start with. A banking system with a 10% reserve ratio can multiply every Re. 1 into Rs. 10. The Rs. 9 is addition of money supply by the banking system.

Central Banks (like RBI) make matters worse. They have reserve ratios of their own based on which they lend reserves to banks. The US Fed, for instance, has a reserve ratio of 35%. This means that the Fed multiplies the banking system’s monetary base by 1/0.35 or 2.9 times. Combined with the banking system’s reserve ratio, every $1 can be multiplied into $29. The inflationary potential of the banking system is thus magnified by Central Banks.

Government spending draws resources from the private sector through taxation and borrowing. All this leads to a pressure to keep increasing money supply.

It is these 3 factors – the Banking System, Central Banks and Government – that are responsible for causing inflation (as per the Classical definition).

What does this help us do?

At the very least, it helps us pin the blame for the phenomenon of ever-rising prices. At a deeper level, it gives a solution to the problem. All it takes to solve the problem of inflation is for the triumvirate identified above to stop engaging in inflation (as per the Classical definition).

The question is, would they? And if they would not, why is it so? These are important questions that we will find answers to in subsequent posts.

Key Concepts in Economics – 11 – Indirect Exchange and the Money Economy

In all my posts till date, I have explained concepts based on the assumption of a direct exchange economy. In such an economy, recipients in an exchange accept only goods that they intend to use. However, there are some serious and fundamental limitations that such an economy will face. One of them is the double coincidence of wants.

In simple terms, the term double coincidence of wants refers to a basic requirement that needs to be fulfilled for an exchange to happen. For A and B to engage in a direct exchange, A should want what B offers while B should simultaneously want what A offers. The wants of A and B need to coincide, failing which no exchange can happen between them. As a simple example, let’s say that A offers wheat in exchange for B’s eggs. However, if B desires butter in exchange and not wheat, there is no scope for an exchange between A and B.

How can A and B overcome the double coincidence of wants on a free market?

Let us say there is a third person C who wishes to consume wheat and offers butter in exchange. Now, A may exchange his wheat with C, offer the butter received in exchange to B and obtain the eggs that he desires. In this process, A, B and C are all better off as they have obtained the good they each sought in order to satisfy their own respective ends.

What we can note is that A accepted the butter from C not because he intended to use it but because he wanted to further exchange it for B’s eggs. Thus, to A, the butter was not a consumers’ good that he wished to consume to directly satisfy an end but a medium of exchange that enabled him to get the actual consumers’ good that he desired, i.e., eggs.

However, we also see that the butter could serve as a medium of exchange only because it was already in demand by B. This is a basic requirement that any good should fulfil for it to serve as a medium of exchange – it should be a good that is already desired for consumption by people in that society. The more widely desired a good is in a society, the more capable it is of serving as a medium of exchange in that society. What serves as a medium of exchange in any society also depends on the conditions in that society.

For instance, during World War II, cigarettes served as the medium of exchange in prisoner of war (POW) camps. In ancient Abyssinia, salt served the role of medium of exchange. In fact, the term salary that we use to refer to regular income comes from the use of salt as a medium of exchange and payment. In certain fishing communities, fishing hooks have served as a medium of exchange. A variety of goods such as tobacco, sugar, cattle, nails, copper, beads, tea, cowrie shells, etc., have been used as a medium of exchange.

From medium of exchange to money

The more marketable a commodity is, the more widely it is likely to be used as a medium of exchange. A commodity that is in general use as a medium of exchange is called money. The term money is not as precise a definition as medium of exchange is. However, we see that there is a strong impetus on a free market for a highly marketable commodity to come into wider and wider use and eventually become a generally used medium of exchange, i.e., money.

The advantages that money confers on an economy

The emergence of a commodity as money greatly increases the scope of specialisation and division of labour possible in an economy. To understand why this would be so, let us take a hypothetical case where a man, A, wishes to build a house for himself and seeks to employ the services of a carpenter, a mason and many other tradesmen and labourers for the purpose. Every one of these people he employs is offering their labour in exchange for which A will have to offer them a certain quantity of a good they wish to consume to satisfy their own ends.

Each of these people could have different ends and might hence seek different means for their satisfaction. For instance, the mason may want rice, the carpenter linen, the labourers wheat, fish, eggs, leather, etc. In order to do so, A has to either produce the particular combination of goods that these people want or procure these goods from other people who produce them by offering them goods that they in turn want, in which case he will have to produce these goods first. Production takes time. Given that at the time of commencing the production, A has no way of knowing

  • which individuals will be in possession of the goods he wants so that he may produce the goods they want
  • which individuals he will actually employ so that he may then produce those very goods that these individuals want

Seen from the eyes of the mason, the carpenter and all the other labourers, how are they to know which particular employer of their services is likely to be in possession of the very goods they seek to consume? How then are they to decide to develop skills such as masonry or carpentry given whatever their ends are?

These problems, insurmountable as they seem in a direct exchange economy, are solved easily in an indirect exchange or a money economy. Since there are commodities that function as media of exchange, A can pay every person he employs in the form of a medium of exchange. Each person in turn can use this medium of exchange to buy the particular goods that he wishes to consume. That too is made possible because the sellers of these goods can in turn use the medium of exchange to buy the producers’ and consumers’ goods that they wish to procure.

With the confidence that he can earn a certain quantity of the medium of exchange which he could then use to satisfy his own ends, a person can now decide to specialise in the trade of masonry or carpentry or plumbing or any other trade where he feels he is likely to do well. Thus, the existence of a medium of exchange makes specialisation possible. This specialisation makes division of labour among all these specialists possible.

It is the emergence of money that, therefore, permits the mind-boggling level of specialisation and division of labour that makes the modern, industrial and technologically advanced economy possible. It makes it possible to have a complex structure of production with multiple stages of production, each producing producers’ goods that are used in further stages of production till, many stages and lots of time later, consumers’ goods are produced and exchanged for money. Every producer in every stage of production may use money to buy the factors of production and in turn sell the goods they produce for money. Without money, it would be very difficult indeed for any economy to proceed beyond the primitive level.

Another important benefit that stems from the emergence of money is the very possibility of economic calculation. Without money, it would be impossible to estimate if one is making a profit or a loss by venturing into a business. It would be impossible to know how to allocate resources and move them from less profitable lines of production to more profitable ones. With money, everything is now priced in terms of money. By keeping an account of how much money is earned and how much spent, it is possible for a business to know if it is earning profits or incurring losses. Calculation using money can also help entrepreneurs evaluate a business opportunity even before investing in it. Money makes comparison of investment opportunities possible and is thus indispensable in making wise investment choices.

Thus we see that the emergence of money is an event of monumental significance in human evolution. Contrary to opinion widely held, money is not the root of all evil. It is the thing that makes possible all the well-being that we experience today. In subsequent articles, I shall explore the economics of an indirect exchange or a money economy.