Inflation

Consider a simple economy. It has two people,  A and B. And there’s the government (or state) G. Person A’s net worth is $100 in cash, and person B’s net worth is $0. This economy run on fiat money. Meaning, G has the power to print money whenever it feels like it.

Suppose G is concerned about inequality and prints $100 and gives it to B. The amount of stuff  in the economy that can be consumed has not changed. What the increase in money supply by $100 does is to raise the prices of stuff. General increase in the level of prices is called inflation. The same amount of goods but twice the amount of money chasing thoe goods. Inflation is therefore 100 percent.

By printing money, G simply transferred half of A’s purchasing power to B. Thus G “buys” B’s support using A’s money. This is a commonly used mechanism by governments that issue fiat money. Favored groups are given money that the government steals from A.

An alternative mechanism would have been if G had taxed A’s savings (50 percent) and transferred the revenue to B. The end result would have been the same as inflation. Inflation is disguised taxation.

Another mechanism that G could have used was to borrow $50 from A and transferred the money to B. Then G would have had to service the debt by raising taxes later. This scheme is better for A than printing of money because A will get back what he loaned but eventually A (and perhaps B) will have to pay taxes to service G’s borrowing. In all thee cases, the purchasing power of money goes down, which is the same as inflation.

Inflation is bad for people who hold cash but not those who hold real assets. Suppose a person has some tangible asset such as land. The price of the land increases with inflation — and therefore in real terms, the person is shielded from the negative effects of inflation. However, poor people usually keep their savings in cash, while the rich can buy real assets. Thus inflation is particularly bad for the poor.

One simple indicator of government mismanagement (if not government malfeasance) of the economy is inflation. If the curreny continually loses value against other currencies, it shows that the government is stealing from the people by printing money. High rates of inflation should tell people to get rid of the government. But that’s perhaps asking too much of the people.

Here’s an excerpt from a post from Nov 2010 – A Tale of Two Countries. Quote:

Singapore and India. Here are some numbers. In 1965, the exchange rate between the Singaporean dollar and US$ was 3 (that is 3 S$ = 1 US$). By 2009, S$ had appreciated to 1.45 — more than doubling in value relative to the US$. How did India do? Against the US$ it went from 4 Rs to the US$ to 48 Rs per US$. In other words, relative to the US$, the Indian rupee dropped to one-twelfth its value during the same period that the S$ appreciated against the US$. What a contrast.

India not only could not keep its position, it actually fell even further behind in the race. You could buy 1 S$ for Rs 1.55. In 2009, you needed Rs 33 to buy one S$. The strength of a country’s currency is an indication of how robust the economy is, and it appreciates if the growth trend is positive. India decelerated relative to pretty much all major economies.

Within one lifetime, Singapore transitioned from third world to first world status. India, during the same time, moved from being a state with great promise to . . . a state with great promise. Lee Kuan Yew said not too long ago, speaking for Singapore’s leaders (himself being the most important), “We did not become rich, but Singapore became rich.” Flip the statement around, substitute India in there, and you will have the equivalent statement which any Congress leader can make, “India did not become rich, but we became rich.”

End quote.

 

Author: Atanu Dey

Economist.

5 thoughts on “Inflation”

  1. Two points:
    1.) Your analysis that printing money causes rise in prices assumes a stagnant economy. Most economists today argue that printing money, and spending it on creating stuff, leadings to increase in demand in the economy, and this is exactly what ramps up production. Leading to more income creation and more employment. This is especially true in case of an economy in recession, where resources are being underutilized already. Prices rise when demand increases in the condition of full employment of resources.

    2.) Your claim that printing money leads to depreciation of foreign exchange rate is false. It used to be true in the times of fixed exchange rate system, when the value of currency used to be tied to commodities like gold. So printing more money in country A lead to gold becoming more expensive. If country B didn’t inflate during this time, and the currency of both countries derive their value from gold, then currency of country A will exchange for less than it used to for currency of country B.
    But we don’t live in that era.
    We live in the era of floating exchange rate. So for example, exchange rate of dollar in terms of rupees, is contingent on the demand and supply of US dollars.
    Which in terms is contingent on our exports, imports, foreign investment, tourism, unilateral transfers et cetera. It has little to do with Indians printing more currency. In fact, in all these years, Indians have not printed obscene amount of currency at all. And last I heard, FRBM Act forbids printing of currency in India to finance government debt. While the US keeps on printing, and yet, value of rupee has been falling ever since we remember.

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