I am so surprised how money perplexes people.

My friend at First Principles wrote in his blog post “The mystery of inflation, deflation and printing money”:

The RBI weekly inflation figures are out, and inflation in India is pretty much around what it was last week. So prices continue to rise at a steady rate despite rapid decreases in interests which have pumped crores of Rupees into the economy.

How do we explain the puzzle.

He then proceeds to explain the phenomenon using the “velocity of money” (the frequency at which money changes hands), saying that during recession people start to save more therefore the velocity of money decreases, and then he talks about a Keynesian prescription (although I am not sure whether Vipin supports it or not, or he is merely talking about it) for sending people checks to increase the velocity of money.

The best part of Keynesian theories is their appeal to common sense and the examples they use. But it is the common sense approach of Keynesian theory which makes them so wrong. Lemme give you an example on how Keynesian theories work.

Let’s say you and John M Keynes are traveling in a car with your chauffeur at 30 miles per hour on a smooth road with no other traffic. After traveling for some time, you encounter a steep uphill, the car’s speed comes down to 15 miles per hour because of the uphill, and the slow speed clearly frustrates you. Keynes suggests that if we push the needle of the speedometer down to 10 miles per hour, this will fool the driver into thinking that its traveling really slow, so it will try to apply more power and thereby more acceleration onto the car and the car will get out of this slow speed period which he terms as “the slowdown”.
Then the Car reaches the top of the hill. The driver still thinks he is driving at 15 miles per hour, but the car’s actual speed is 45 miles per hour, and there comes a downhill slope, and now the car is over speeding at 60 miles per hour, so the smart guy Keynes’ reply is that now we should leave the speedometer’s needle as is to reflect the actual speed.
At this point the driver suddenly realizes that he was over speeding, so he starts applying break, the car skids, swerves uncontrollably and slows down. To which rather than suggesting that car should be allowed to stop and to be fully controlled by the driver, Keynes shows a smug smile saying “See that is even more reason why we cannot trust the driver to drive the car, we are slowing down now push the speedometer needle down so that the driver will start applying more power on the engine”, and so another cycle of dangerous driving starts. People note down the amazing speeds this car is able to reach. You hire Mr Keynes to act as the guy who controls the speedometer because otherwise the driver is really stupid, and he will end up totally stopping the car and the car will never start again.

It sounds very logical for anyone who has never driven a car that its really common sense to play with the speedometer needle in order to control the speed of the car. But anyone who has actually driven a car knows that a driver is the best person who can drive the car, if its an uphill he will automatically change the gear to a lower setting and apply more power but not more acceleration to the car.

Our economy is exactly like this car, and the driver are the various entrepreneurs and businessmen(the participants of the economy). The speedometer needle is the interest rates, and other indicators of the economy, and mainstream economists are the faulty believers that playing with the speedometer needle actually helps in regulating the speed of the car.

Coming back to the topic, what really is money, and what is it so mysterious.¹

Money is basically just another commodity. Money is not a “special” commodity which does not follow any “special” economics rules. Money is THAT commodity which evolved in the market as the common medium of indirect exchange.

Every commodity is exchanged with respect to Money, and money becomes so mysterious because people always forget that money also follows the rules of supply and demand.
If Commodity’s supply is more and demand less, then its value would fall, and if its demand is more and supply less, its value will rise.

But since every commodity is exchanged with money, the supply of money equally counts.
If supply of money is more, and demand less, then the value of the money will fall, if demand is more and supply is less then the value of money will rise.

So in the exchange of money and commodity, if supply of money is more then more money will be transferred for the same quantity of commodity, that means the number which we use to represent the unit of the money will rise.
If the supply of money is less than the demand of the money, than less units of money will be exchanged for same quantity of commodity.

In simple words:

1. If the price of a commodity rises, it could be because either of the following two reasons:
   1. The supply of commodity has been reduced, and/or demand of commodity has risen
   2. The supply of money has been increased and/or the demand of money has fallen
2. If the price of a commodity falls, it could be because either of the following two reasons:
   1. The supply of commodity has been increased, and/or the demand of commodity has fallen
   2. The supply of money has been reduced and/or the demand of money has increased

So how do we tell by looking at the rise of prices of a commodity whether the demand and supply of that commodity has changed or the demand and supply of money has changed? Well if the prices of almost all the commodities you see around are increasing, then the chances are its not because the demand of every commodity has increased, rather its the money whose demand and supply has changed.

Despite of things looking that simple, mainstream economics and general public almost NEVER consider the demand and supply of money into the picture. Take for example last summer when the oil prices rose really high, George W Bush came out and blamed it on increased consumption of Indian and Chinese people.²Well the price of Oil has fallen down from $90 per barrel to $30 per barrel, does that mean now Indian and Chinese people have reduced their consumption to 1/3rd??

The truth is, that the oil and rice prices rose that much because they are highly transacted commodities in international market, and they are(especially Oil) universally traded in dollar. So if the supply of dollar increases, the per unit value of Oil in dollars will also increase. It has nothing to do with increased consumption or reduced supply of oil. I used to hear Bill O’Reilly almost everyday cursing the Oil companies for reducing their oil production strategically, when the oil prices were rising really high.

Now coming down to what is a recession, because apparently in Keynes world, recession occurs when driver falls asleep on the steering wheel and forgets to push the gas pedal. This is totally false. Recession occurs because the federal reserve stops inflating the money supply. So why does Federal Reserve stop inflating the money supply? The reason is that if Feds don’t stop inflating the money supply it will result in hyperinflation.

I would like to quote from my old post:

1) At first when price rises people think “Well this is weird, the price of this product has gone too high, but there might be some emergency, I will buy when the prices come down”, a housewife who needs a frying pan at this stage thinks the same and postpones her purchase of Frying pan for a later date when the prices drop.
2) Sooner or later, the people, and our housewife in the above example realizes that the Government plans to keep on inflating the money supply, and therefore the prices are going to rise more and more. Then she reasons: “I do not need a new frying pan today; I shall only need one next year. But I had better buy it now because next year the price will be much higher.” If more and more people think like that then everyone rushes to buy more and more stuff. People buy more and more rice to store for future when the prices will be even higher. The demand of Money falls down considerably and demand of products rises up even more. At this point the government is called to “relieve the money shortage”.
3) Soon the country reaches to a stage of “crack-up boom” where people say: “I must buy anything now — anything to get rid of money which depreciates on my hands.” The supply of money skyrockets (like last week Bush administration with a Joint opposition effort decided to mail everyone a check of $600), the demand plummets and price rise astronomically. Production falls sharply, as people spend more and more of their time finding ways to get rid of their money. The monetary system has, in effect, broken down completely, and the economy reverts to other moneys, if they are attainable — other metal, foreign currencies if this is one-country inflation, or even a return to barter conditions. The monetary system has broken down under the impact of inflation. This stage is also called Hyper-inflation.

If you are regularly perplexed by the mysteries of Money, or if you are unable to understand why is that when RBI is slashing the interest rates, the inflation is also going down, just follow the rules I wrote above in bullets, and remember that Money is just like any other commodity and it follows all the rules of demand and supply. Also slashing interest rates is like pushing the speedometer needle down. It does not really changes anything, but it just fools the drivers of the economy into thinking that they are going faster or slower than the actual speed they are going at.

1. “The Story of money, what causes inflation”, A good introduction would be to read [↩]
2. George W Bush claims growing India and China are responsible for inflation [↩]