Tag Archives: Money Prices

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 – 12 – Money Prices – Their meaning and their determination on a free market

In this article, I shall attempt to lay out the basic concept of money price of a good and explain the process by which money price of a good is determined on the free market, i.e., a system based on voluntary exchange. Before that, however, it is important to clarify a few important points.

  1. Man’s real revenues, costs and profits are all psychic and not monetary. This is simply because what man seeks to get through his action is the satisfaction of his ends. His revenue is the satisfaction of the ends he chooses to satisfy. His costs are the non-satisfaction of the ends he had to forego in order to do so. His profits are the net satisfaction assessed as revenue “less” costs, both of which are psychic, thus leaving profits to be a psychic figure as well.
  2. On a free market, every seller seeks the maximum price he can get while every buyer seeks the minimum price he can get. This is simply because the sole purpose of means to man is that they may be used to satisfy his ends. Every unit of means that could be obtained or saved but is not means the foregoing of the satisfaction of an end. The greater the price a seller manages to get for his wares, the greater the psychic revenue he may obtain. The lower the price a buyer manages to get for the goods he procures, the fewer the ends whose satisfaction he has to forego.

Money Prices – Their Meaning

In an earlier article, I had mentioned that price is an exchange ratio. Using the example of wheat exchanging for rice, I had explained that the wheat price of rice is nothing more than the ratio of the quantity of wheat offered per unit of rice being offered in exchange while the rice price of wheat is the ratio of the quantity of rice offered per unit of wheat. In the particular example used, where 2 bags of wheat were exchanged for 1 bag of rice, the prices were as below

  • Wheat price of rice – 2
  • Rice price of wheat – ½

Since money is just another commodity that has evolved into a medium of exchange primarily because of its extremely high marketability, it too has to be exchanged in some ratio. This ratio is called the money price of the good being exchanged. For instance, if silver were the money commodity, then if one offers a 1 ounce coin for a bag of rice, the money price of rice is 1 ounce per bag. If the same 1 ounce of silver could get 2 bags of wheat, the money price of wheat would be ½ ounce per bag. In either case, the money price is the ratio of the quantity of the money unit being received to the quantity of the good being offered.

  • Money price of rice = 1 ounce silver coin / 1 bag of rice = 1 ounce silver coin per bag
  • Money price of wheat = 1 ounce silver coin / 2 bags of wheat = ½ ounce silver coin per bag

Money Prices – Their Determination on a Free Market

As in the case of the direct exchange economy, money prices too are determined by the interplay of demand and supply schedules of each good at different exchange ratios while the demand and supply schedules in turn are determined by the value scales of all the individuals who constitute the market for the good concerned.

Consider a hypothetical market consisting of 3 buyers, A, B and C, of a product, say butter. Let their value scales be as given below.

Table 1 – Value Scales of 3 buyers A, B and C

A B C
7 milligrams of gold 6 milligrams of gold 5 milligrams of gold
(1st kg of butter) (1st kg of butter) 4 milligrams of gold
6 milligrams of gold 5 milligrams of gold (1st kg of butter)
5 milligrams of gold (2nd kg of butter) 3 milligrams of gold
(2nd kg of butter) 4 milligrams of gold (2nd kg of butter)
4 milligrams of gold 3 milligrams of gold (3rd kg of butter)
3 milligrams of gold 2 milligrams of gold 2 milligrams of gold
(3rd kg of butter) (3rd kg of butter) (4th kg of butter)
2 milligrams of gold (4th kg of butter) (5th kg of butter)
1 milligram of gold 1 milligram of gold 1 milligram of gold

Before we proceed to working out the demand schedules of A, B and C, let us pause for a moment to understand the meaning of the table above. In the case of A, for instance, he values the utility of 7 milligrams of gold as higher than that of the 1st kg of butter. The reasons for this could be

  1. Higher use value for the 7 milligrams of gold than for the 1st kg of butter
  2. Higher utility for the other good that 7 milligrams could get than for the 1st kg of butter
  3. Higher utility for the presence of 7 milligrams of gold in his cash balance, i.e., higher utility for the goods he can get in the future than for the 1st kg of butter he can get now

This means that A will not to give up 7 milligrams of gold to get the 1st kg of butter. However, the utility of 6 grams of gold is less than the utility of the 1st kg of butter (for the converse of one or more of the 3 reasons given above). Therefore, A will be prepared to give 6 milligrams of gold for the 1st kg of butter, though he may actually give up less than that.

Having obtained the first pound of butter, the marginal utility of the 2nd unit of butter would clearly be less than that of the 1st. As per the table, A values 5 milligrams of gold higher than the 2nd kg of butter. So, he will not pay a price higher than 4 milligrams for the 2nd kg of butter. Following the same analysis for A, B and C, we may now be able to work out all their demand schedules as given below

Table 2 – Demand Schedules for the Value Scales depicted in Table 1

Price A’s Demand B’s Demand C’s Demand Cumulative Demand
1 3 4 5 12
2 3 2 3 8
3 2 2 1 5
4 2 2 0 4
5 1 1 0 2
6 1 0 0 1
7 0 0 0 0

Let the market also consist of 2 sellers X and Y with value scales as given below.

Table 3 – Value Scales of 2 sellers X and Y

X Y
(7 milligrams of gold) (7 milligrams of gold)
(6 milligrams of gold) (6 milligrams of gold)
6th kg of butter (5 milligrams of gold)
(5 milligrams of gold) (4 milligrams of gold)
5th kg of butter (3 milligrams of gold)
4th kg of butter (2 milligrams of gold)
(4 milligrams of gold) 6th kg of butter
3rd kg of butter 5th kg of butter
(3 milligrams of gold) 4th kg of butter
2nd kg of butter 3rd kg of butter
1st kg of butter 2nd kg of butter
(2 milligrams of gold) 1st kg of butter
(1 milligram of gold) (1 milligram of gold)

Once again, before drawing out the individual and cumulative supply schedules, let us make sense of the table above. From the Law of Diminishing Marginal Utility, it is clear that foregoing of the first unit of a good results in non-satisfaction of the least valued end that could have been satisfied with that additional unit of the good. Hence, the marginal utility of the 1st kg of butter foregone is the lowest while every subsequent unit of butter foregone has greater marginal utility.

Further, as per X’s demand schedule, at a price of 2 milligrams of gold, he would not be prepared to offer even 1 kg of butter for sale while at a price of 6 milligrams or more of gold, he will be ready to offer 6 kgs of butter for sale. Y, on the other hand, will not offer even 1 kg of butter at a price of 1 milligram of gold while he will offer 6 kgs of butter for sale at any price equal to or greater than 2 milligrams of gold.

Based on this, the individual supply schedules of X and Y and the cumulative supply schedule for the entire market may be worked out as below.

Table 4 – Supply Schedules for the Value Scales depicted in Table 3

Price X’s Supply Y’s Supply Cumulative Supply
1 0 0 0
2 0 6 6
3 2 6 8
4 3 6 9
5 5 6 11
6 6 6 12
7 6 6 12

For clarity’s sake, let us also draw the demand-supply curves with money prices as per tables 2 and 4.

Fig 1 – Demand-Supply Curves with money prices

We see from Tables 2 and 4 as well as the Demand-Supply Curve in Fig 1 that the equilibrium price will be between 2 and 3 milligrams of gold per kg of butter. If the unit of money is not divisible any further, the price would be either 2 or 3 milligrams. If it were further divisible, say into ½ milligram, a price of 2 ½ milligrams may be set. The quantity exchanged at equilibrium would be 8 or 6 kg if the money unit is not further divisible and around 7 kg if the money unit were further divisible.

What we learn from this analysis

Money prices of all goods on a free market are determined in the same manner as the exchange ratios of any pair of goods in a direct exchange economy – starting from the individual value scales of all the buyers and sellers in the market. At the equilibrium price, the market is cleared, i.e., quantity supplied would be equal to quantity demanded. Thus, we see that money prices too evolve from the Law of Diminishing Marginal Utility, which in turn evolves as a logical corollary of the Action Axiom.

Ref: Man, Economy and State with Power and Markets, Murray N Rothbard, Chap 4