May
6
Whole world is facing the steep inflation. People wonder what the causes of
this inflation are. Some believe that inflation is a good thing and if stable and controlled it shows progress. But majority of middle class suffers the fears of high prices.
Let me explain you the whole concept of Money and Inflation with an example.
Let’s assume a small city called San Andreas located on an island of Andreas. It’s a fully self-sustained city, and it produces everything it needs. Barter system works here. If a tailor needs food then he exchanges it for the clothes he made from the farmer who grew wheat and needed clothes.
The problem came when people’s need grew up and they needed more products, now a doctor could not take 20 suits in exchange for providing health care to a tailor, because he simply does not need 20 suits. So tailor had no way of paying doctor, as it’s really difficult for him to acquire all the things doctor requires. So what he does is, exchanges suits in exchange of cigarettes, even when he does not require cigarettes. He exchanges cigarettes because everyone wants cigarettes, so he would exchange the cigarettes to someone who needed cigarettes and provided something he required.
Even when the other person who lets say in this case made metal tools does not need cigarettes he will still take it in exchange of giving his tools because someone else might accept it.
In this whole situation, cigarettes act like a currency. People don’t really need the product as such but they just accept it anyways because other people are ready to take it.
Soon the problem with Cigarettes arrived. You can’t really store cigarettes for long, and you can’t create smaller units or combine them to make larger units. Plus if you need to buy a car from it, you will have to supply a truck full of cigarettes which is inconvenient.
So People soon found out that metals prove to be a really good currency, they are malleable, they are ductile, sturdy and they can survive extreme temperatures. So soon people started to make currencies out of say like copper, and tin, when better metals came up, people started to use Silver and Gold as the currency because they fit in all the requirements of a currency perfectly. You can store gold for long, it doesn’t rust, and it’s very malleable and ductile.
Let’s get back to San Andreas, the gold smith of San Andreas made gold coins of a specific weight which carried a specific value. If you wanted to take the services of a teacher, you pay him in those coins, if a teacher wants to buy the shoes you made, he pays you in gold coins.
There is a goldsmith in San Andreas called Mehta Jewelers, deal with a lot of gold so they did the job of molding a gold coin, and printing its weight on it. They buy other stuff from people, like a bullock cart, wheat etc and gave them these gold coins in return because it was much easier to take a gold coin from the jeweler with its weight printed on it rather than taking an unmarked piece of gold, weighing it, testing it and then completing the transaction.
Soon everybody starts accepting only Mehta Jewelers gold coins, if someone had a piece of gold they want to exchange with, they went to Mehta Jewelers, who measured it and provided them with equal amount of marked gold coins, and then later turned that piece of gold in further marked gold coins.
Now the thing is Mehta Jewelers does not really owns a lot of gold, he just basically takes gold, turns that into marked gold coin and gives it back to the person who brought it to them.
One day, Mrs. Mehta was going through the market and she really liked an Elephant which was for sale. She came back and demanded Mr. Mehta to buy her the elephant, but Mr. Mehta wasn’t that rich to buy her an elephant, but since she insisted a lot so he thought of a clever trick, he took some spare metal which looked like gold, mixed it with some copper and bronze and created a coin which looked like gold, and marked it with equal weight of gold, and used it to buy that elephant.
Now you would call it as counterfeiting or forgery. But wait isn’t Mr. Mehta was suppose to be the one to make the gold coins? So if Mehta jewelers made that coin, it can’t be called as forgery or fraud? Haha, I am sure nobody is going to buy that reasoning. Mehta Jeweler is a fraud. As soon as someone in the city uses Archimedes principle to measure the weight of that coin they will find that it’s not made of pure gold. So this is what happens, someone in the city finds out that this coin is not real. People approach Mr. Mehta and he is found guilty of committing fraud and his status is taken away. Same holds true for any jeweler in place of Mr. Mehta, if they try to forge coins they will be caught some day.
A new Gold Smith called, Patel Jewelers take place of Mehta Jewelers as appointed by the city. Now Mr. Patel in order to deal with the “problem” of cumbersomeness of gold coins and the fact that physical transfer of those gold coins is too dangerous, Patel Jewelers started to introduce promissory notes, a bond on which Patel Jewelers signed that they will provide the producer of this note the specified quantity of gold.
Everything was going fine until one day Mrs. Patel who was going through the market saw a very expensive dress in the market, that dress was really costly and she went back to her husband and demanded that he buy her that dress. Now Mr. Patel didn’t really have that much amount of actual gold, so what he did was he printed a paper on which he promised to pay the bearer the specified amount of gold even when he didn’t have that much amount of gold actually. He hoped that since there won’t be any demand for all the gold in one time, so he will never have to worry about not having that much gold with him, but then this thing goes on and on and soon there are too many promissory notes out there and simply not enough gold to back it all up.
So one day, though its a rare circumstance, there is a rush to the jeweler and everyone presented the promissory notes they had to the Jeweler, the Jeweler is not able to pay them all the Gold, this is considered as a fraud and Patel Jewelers is punished by the city for committing fraud.
Now the city council is too furious that these things are happening so they decide to take matters in their own hand. The city council decides that now they are going to print the notes. But there is a catch, since the city council does not have their gold of their own; they issue these notes without any gold backing.
Of course no single person is in charge of city council so nobody is directly printing the notes for their personal use. But here is what happens. The overall business of the city goes down because of insufficient rains, so the city council sees it as a recession and since people are crying so they decide to deal with it by providing a stimulus package, basically they issue more promissory notes to the people, since these notes do not necessarily reflect actual labor and people who receive them(usually poor people or city council workers) they spend it and buy stuff which is not through actual labor.
Lets go a bit deep in this part of example, lets say there are 100,000 Andorra (the currency of San Andreas) out there in market. Every Andorra is supposed to fetch 10 gms of gold back in the days of Patel Jewelers. Now there is a recession so the city council prints 10,000 Andorra more and give it to the poor.
Now what has happened that any poor guy who was not able to buy a quintal of rice because the price has gone up to 10 Andorra from 2 Andorra(remember, it didn’t rain well this year that means lesser production of rice, so higher prices).
So government gives 100 Andorra to every poor guy(100 poor guys) they all are now able to pay 10 Andorra for the price of per quintal, but wait!! Do we really have that much rice to be sold to the people, just because government printed more money? NO! So what happens is that the price of every quintal of rice has gone further up from 10 Andorra per quintal to 20 Andorra per quintal, effectively making rice out of reach of the poor people again(so no matter how much money city council prints, the price of rice will go up and up).
At the same time, people want to buy other products too so their prices will also go up. Overall this is called inflation, and more the government prints the money, more it goes up.
Now what I have written about inflation, this holds true if the market is really dynamic, but this is not the case, it takes time for inflation to be reflected everywhere. The prices of Rice will not go up in one day, so the people who get this newly printed money (usually the “poor”) and the salaried individuals employed by city council, they get the quickest advantage. They spend the money and buy the products, now the burden is shifted to the person on whom they bought the product. These people then spend money on something else, and this spreads all over the economy and hurts till the person who tries to spend the money the last, or who saved a lot. His money is now of less value because the prices of everything has gone up.
Another harsh reality you have to keep in mind that the poor people aren’t really the most productive people of a free society, basically anyone who gets the advantage of economic stimulus package did not deserve it, and it harms the more productive man who works really hard and saves a lot of money, because once government prints more money, his savings are now worth less than they should have been. If he saved 100 Andorra, after introduction of those newly printed Andorra, his savings are now only 100*100,000/(100,000+10,000)=90 Andorra.
So he lost 10 Andorra out of nowhere, because City Council (or in real world the Government) printed more money.
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715 views19 Responses to “The story of Money; what causes Inflation.”
Leave a Reply
Japmeet Says:
May 6th, 2008 at 1:06 pmNice post, you explained inflation pretty well with all your examples, but, the post was pretty long as well.
Anyways
Cheers!
Great Blog
Japmeet
Ron Lemon Says:
May 6th, 2008 at 1:23 pmthat’s a very well written article :)
unpretentious_diva Says:
May 6th, 2008 at 1:29 pmI know none of you read it with intentions of understanding it.
It explains alot.
In India, governemnts falls on the name of inflation.
The post shows that if you have some money right now, it will loose its value within some years if you won’t use it productively. Because to appreciate or depreciate the money is totally in the hands of government.
And government never acts on reason and rights.
Government acts on its political favor and often harms the honest hardworking citizen of country.
Prashant Says:
May 6th, 2008 at 4:09 pmThe problem with inflation is that anyone who saves is screwed up, and anyone who does not holds money or spends a lot benefits.
In any time(bust or boom) saving and investing is ALWAYS better than Spending, no matter what govt says.
Take for example, the American govt which is sending stimulus package to Americans want them to SPEND it, rather than SAVE it.
Dan* Says:
May 6th, 2008 at 10:53 pmnice Article …
Arun Kumar Says:
May 8th, 2008 at 8:12 ami’m not good in economy…n i always thought that ‘why our govt doesn’t print more n more money n become rich..??’
well this article explained…”Overall this is called inflation, and more the government prints the money, more it goes up.”
but why the mehta n patel story…??
was is written to show about how certain governments fell? i never understood…
Prashant Says:
May 8th, 2008 at 1:45 pmMehta-Patel stories has many goals, first of all it explains HOW DID WE end up at this stage.
When Mehta Jeweler made that coin out of the air, nobody believed him, and he was removed from his job.
When Patel Jeweler was printing his Gold backed note, the moment he tried to fool people by printing more than necessary he was instantly caught.(Point being that in a Gold Standard, this kind of counterfeiting will not work).
But when the city council or the City govt did the same, they were never caught. At max right now you are screwed in terms of rice price rise, or a few years ago for vegetables.
Funny fact is Govt keeps on printing empty paper currency year after year, and our Intelligent economists have made us believe hat a 3-4% inflation rate is perfectly alright.
Its not about CERTAIN GOVTS FAILING, its about ALL THE GOVTS FAILING.
Anyone and everyone should be free to print their own currency, and everyone should be free to accept or reject that currency. Today you cannot print your own Gold backed Aruns, and you cannot refuse to accept Indian Rupees as a payment(that is you cannot legally demand Gold in exchange for a payment).
Tina Says:
May 8th, 2008 at 2:37 pmall though i topped economics in colg…for some reason i really am not in to that subject…
But everytym i read ur post i see an almost indepth analysis…gr8 stuff
Keep it comin
Cheers
Tee
unpretentious_diva Says:
May 8th, 2008 at 3:43 pm@ Arun
The story tells allot and Mr. Mehta and Mr. Patel are essential part of it.
Ever heard of fake currency? Fake currency can be produced by two means. One is, some criminal gang provide fake notes in market, other is the government provide new notes disproportionately for the cause of short term political benefits like helping people/poor farmers etc.
On the scale of reason, both are economical crimes.
No government can help poor people but the poor themselves. Governments basically are Not made to help poor.
Governments are made to restrict crime. Governments are made to maintain Individual Rights to every citizen irrespective of caste, gender, religion, color, creed, class etc.
But most of the governments crosses their lines and starts defining laws, economic policies, religious policies, moral policies etc.
And that is crime, A governmental (a Statist Governmental) crime. We live under a criminal government.
For a free society, people like Mr. Mehta or Mr. Patel and the statist government, both are criminal.
You can read about Statism Here and Here/Wikipedia .
Just like it is crime, if someone induces fake currency in market (because it causes Inflation) same way it is crime of government whenever for its political gains it helps poor by printing more money (for same reason).
Government tries to restrict fake currencies by others and calls them criminals, punishes them. Yet, government does the same crime every now and then. And no one punishes government.
Other way of government for helping poor is by looting the producers and hard workers who by virtue of their honesty hard work talent and courage, makes wealth. That loot is called Taxation-Subsidies. Even by that loot, government can never help poor, because even in that process corruption comes.
The only way to help poor is to provide free chances and economical freedom for them to start any business or work by their own without any governmental hindrance. And that is only possible when Government strictly keep itself away from personal, social or economic matters.
“Government “help” to business is just as disastrous as government persecution… the only way a government can be of service to national prosperity is by keeping its hands off.”
“The only power any government has is the power to crack down on criminals. Well, when there aren’t enough criminals, one makes them. One declares so many things to be a crime that it becomes impossible for men to live without breaking laws.”
Ayn Rand
Prashant Says:
May 8th, 2008 at 4:34 pmTina Said
all though i topped economics in colg…for some reason i really am not in to that subject…
But everytym i read ur post i see an almost indepth analysis…gr8 stuff
This is all from Austrian School of Economics, they don’t really believe in using a lot of numbers and figures.
What it is called is Praxeology, which is like the Conceptual root of Economics.
Austrians reject the usage of Observation to reduce the human actors to their component parts.
For example nobody can say “I value a High-Def Television 2.5 times more than a Standard-Def Television”, YET, economics try to look at the sales of HDTVs and SDTVs and conclude from the figures that “Since the price of HDTVs in the market is 2.5 times of SDTVs so an HDTV is 2.5 times more important to customer than an SDTV”.
Also humans get affected by the mere act of observation.
For example if you go and take a market survey on asking 1000 random men about what size of Condom they use, your research will indicate that there is a massive demand of Large and Extra Large condoms.
This is just an example, people also say they like Strong tight brewed coffee, but in truth many of them just like weak milky coffee.
These are the reasons why usage of numbers is highly discouraged in Austrian Economics.
Their whole Library is online on:
http://www.mises.org
And despite of never having a formal study of Economics I have rarely found their literature hard to comprehend.
Everything is approached on a Logical structure of Human Action.
Most of the modern Economics taught in the schools has a analytical basis from Paul Samualson.
Samualson LOVES to Mathematize Economics, a Mathematical model of abstract actors engaged in constrained maximization or minimization of an objective function; must be built, prove that the model has a stable equilibrium; show how the model’s equilibrium conditions change when its parameters are changed (the so-called method of comparative statics).
The problem with this method is, first of all its so dry that I bet you didn’t even read the summary I wrote in the last paragraph.
You just don’t feel that you are studying something which is suppose to be a model of how you would act.
Secondly, it dissociates the idea of Money from student’s mind.
People think Money is a commodity which everyone want more of at the end of the day. Money is simply a commodity for indirect exchange for labors of different people, how can the fact what you do with your labor be summed down in numbers.
Also, since Economics is solely made up about Numbers, if you don’t use Numbers, then people who have a hang on using figures just think you are telling stories.
Though they still can’t tell where the story is going wrong.
Another Austrian Economist Henry Hazlitt even went to the limits of Simplification and condensed whole Economics in one lesson.
His book “Economics in One Lesson” is an amazing read which you can pass on to your friends and family alike:
Economics in One Lesson
It explains so many things like how more Taxes are bad for the Economy, how Rate control, Minimum Wage, screws up with people, how the fetish of Full Employment is wrong, why govts should not save “x” industry.
Arun Kumar Says:
May 8th, 2008 at 5:24 pmthanx prashant n unpretentious diva for the explanation….
a lot of things i believed to be good were proved wrong by you guys…
geeeee….i’m getting more n more interest in economics nowadays….
CA.Siddharth Ranjan Says:
May 11th, 2008 at 4:36 pmThanks Prashant for the One lesson Economics :-)
Fiat Money Versus Gold Standard, Privatization of Currency! | Reason for Liberty Says:
June 4th, 2008 at 6:13 am[…] and Political Correctness - 2 viewsCase for Private ownership of Natural Resources - II. - 2 viewsThe story of Money; what causes Inflation. - 2 viewsSovereign State versus Sovereign Citizen - 2 views […]
Kiran Kumar Says:
August 8th, 2008 at 4:54 amHow do a middle class Hardworking HONEST Man becomes productive with out your so called “unproductive poor” — Your middle class Hardworking HONEST works in a building that’s constructed by the poor, he travels on the road laid by the poor, he drinks the water that’s drawn due to the poor man’s effort, wears clothes that are made by the poor… Your productivity’s real capital is not the money but the labour of the person who braves the sun, works in mines with minimal desires and with lack of basic amenities to live… By the way if the poor are given money whenever there’s drought like in your
“San Andrea” the poor wouldn’t be poor.. Just reflect on the thought how would the economy run without the infrastructure and food and tell me who is behind them?????? If you think you find the reason
renegade_division Says:
August 8th, 2008 at 5:19 amBuddy if you wanna argue on the rhetorics you have come to the wrong place. This is REASON for LIBERTY, not EMOTION for LIBERTY.
And the reason why the poor man who actually builds the road actually gets very little part of that road and building is because of his high time preferences.
Now what is the meaning of Time Preference? Basically everyone wants goods delivered to them sooner than later. How sooner or later is what defines as time preference. If you lend me $100 but you want it back within 5 days then that is a very high time preference, if you are willing to delay your enjoyment of those $100 for a year, then you have a low time preference.
Capitalism awards people for having low time preference. All the millionaires have low time preference.
A worker working in the factory, or constructing a building has a really high time preference, he cannot wait for the payment of his labor to the day when the whole building will be created and sold in the market. He wants his salary today. This is why he does not get anything proportional to the final value of the building. It might take 5 years for the building to be finished.
But since all the workers demand the money now than later, the cement and sand supplier is also not willing to weight, therefore they all get very little value for their money.
This is why you will be getting very little money from that million dollar building.
Only if a worker is willing to delay his pleasure he will get the proper labor share from the sale of the building.
Because ALL the workers want their salaries now than later, any builder who wants to build the building needs CAPITAL. And then the Capitalist comes in the picture who supplies capital for the salaries of workers, and price for the raw materials. Because the capitalist delays his pleasure, his enjoyment of his own money to the maximum, he gets the largest share from the building.
Now this is all rational argument, not emotional argument. If you can give a rational reply please proceed.
Pa Says:
November 18th, 2008 at 11:23 amJust curious: I am odds with the emphatic “NO!” in that quote. Don’t companies raise prices to not close shops & (more importantly to them) keep their net gain up? If they do not have enough ‘rice’ that is a completely different problem, not a universal ‘inflation’ problem. Companies wouldn’t raise prices more because the government gave out money, they would rejoice that people could now buy their product at the prices they ‘need’ to sell it at to meet their quaterley goals. Yes, there would be no labor done for all that money to be used, but the money is given to people that will spend it in this case. It would be a essential step to not let the problem ‘clog’ the whole system. ‘Clog’ as in
1> company in trouble so it raises prices.
2> people cannot pay those new prices.
3> companies cannot sustain without buyers and collapse.
But when you add in money given to spenders it solves problem 3 but does nothing about the first 2. These few days, weeks, or months of relief, though, might be the difference between recovery and complete collapse. Again, I am just curious, I know its months after the post but its meaning is still very prevalent.
renegade_division Says:
November 18th, 2008 at 3:03 pmI am sorry but I don’t think so that’s how profit loss and price system works.
Similar problem with your argument lies in point no 1 for your reasons for “clogging”:
This helps you to explain your point, but it hides the actual reason.
The company WOULD raise the prices if govt hands out money, its Supply-Demand 101.
If since morning suddenly twice the number of people start to come to my shop and by my product I WILL have to raise the prices, considering that my supply hasn’t raised a bit.
In this whole picture what you are failing to understand is, changes in the supply of CURRENCY, has no effect on supply of actual commodities.
We don’t consume dollars, we buy stuff from dollars, if you over produce dollars, its stupid to presume that somehow we will get more products to consume.
renegade_division Says:
November 18th, 2008 at 3:06 pmThe Price is a reflection of the final equilibrium of supply and demand of commodities, throwing money at it and trying to influence it is just like cooking the books, it does not change the reality.
Pa Says:
November 20th, 2008 at 10:27 amThis only occurs if they are already at their status quo for supply & demand.
In this scenario the company is below that point. Not even meeting supply & demand now, they will not raise the prices even -further- over what they were when the people could not afford them, just because the customers were given enough $ to reach that status quo of supply & demand.
Again, same as above. We are talking about a recession/depression/inflation situation ;p .
We are talking about people below the status quo to pay for their house or companies to pay for their sustainability.
You’ve made supply the problem in that case when we are talking about demand. That example is good for a cost to supply ratio but has nothing to do with getting up out of an economic disaster and recreating the demand that -was- there but very quickly deteriorated.
This is always a good reminder for this topic! And it goes both ways! We saw this post-USSR when the stores were stock-full of merchandise but no one had the rubles to pay for it.