Sunday, March 30, 2008

Decoding the relation between Money Supply, Inflation and Growth

The cutting of interest rates by the Fed has raised the inflation and inflation expectation of people. This has prevented other Central Banks particularly that of the Euro zone, Bank of England and the RBI to resist in cutting of interest rates. While I have given my views on this topic in the previous article, over here I am going to discuss one fundamental dilemma in economics that of money supply on Inflation and growth. Are they truly antagonistic and if not in what scenario.

Assume a small slow growing economy Torts from tortoise having just 3 players A B C each having 1 kg of wheat. Let’s put a monetary cost to their produce at Rs. 10/- . In such a scenario the economy would remain stagnant and the growth of the economy is going to be 0%. Now seeing this perilous scenario an angel descends on their world with the name ‘The Party Pooper Bank of Torts’ – PPBT. The bank says that it is prepared to lend Rs. 5/- to anyone for 1 year but wants Rs. 5.5/- in return. A is the entrepreneurial type of guy. He comes forward and takes the offer. Now at the end of year one the following 3 scenarios can occur:

First of all in all the 3 cases let’s convert their wheat stock to Rs. 10/- per kg unless otherwise mentioned. A toils his land and produces rice. Now he can sell his rice at any price between Rs. 0-10, let’s take 2 cutoffs of 5.5 or less and more than 5.5, in the scenario where A is able to sell his rice at more than Rs 5.5, he is able to make a profit on his venture. Let’s say A is able to sell his rice at Rs. 10 so the GDP grows at 33.33%.

Let me add that this scenario also answers one of the basic questions in economics: ‘Why do economies grow’. This economy grew because of 3 factors:

Capital (Money from PPBT)
Land (Asset which is natural resource in this case)
Labour (The effort put in by A)
Entrepreneurial spirit (As shown by A)

A would have equivalent of Rs 20/- , B would have equivalent of Rs. 10/- and C would have equivalent of Rs. 10/-. Now A can buy some of the goods from C at Rs 10 or more. If A knows that B has just Rs 10 with him then he would buy the goods at Rs lets say at 10.05, so the inflation in the economy stands at 0.5%. However in a normal scenario there is ‘information asymmetry’ in the market and so A may jack up the price to as high as Rs 14.5/- for the product of C causing inflation to shoot up to 45% !!!. So its important to understand that the culprit here is not the monetary policy but information asymmetry.

In the next scenario wherein A gets Rs 5.5 or less A makes no profit however the economy still grows at 18.33%, any surplus liquidity is absorbed and so inflation menace doesn’t raises its head. Well this looks like the perfect scenario which has no excesses, the only problem is that if this scenario continues for long it will generate 2 problems. A would loose any interest in investing in the venture and also A would have no surplus capital of his own to invest.
In the last scenario A takes the 10 rupees and jacks up the price of the product of C to Rs 20. This causes the inflation to rise at 100% and GDP growth is 0%. Later on in order to repay the loan when A tries to sell back the product whose value is supposedly Rs 20/- but only C has the capacity to buy, however there is no reason for C to buy back the product he sold a little earlier (Velocity of money comes into picture) the value of the product crashes. This might lead to cutback in supply leading to negative GDP growth.

One question that can come to mind is why on earth would A behave in such a manner. The reason can be mainly two fold:

- The inflation is very high and so he feels that he needs money just to consume
- The inflation expectation is very high and he wants to buy products today expecting a rise in prices in the future

So it’s important to understand that printing money in itself is not inflationary. Inflation happens because there exists an information asymmetry and high inflation expectation. Printing more money in such scenario could be disastrous.

In countries like Zimbabwe which is suffering from hyperinflation is clear case in this regard. The supply crunch led to inflation and higher expected inflation, to top it all the government printed more money thus creating hyperinflation and causing the nation to go in a tailspin.

I conclude this article with two points that must be amply clear while taking the decision of printing more money and thus making sure that this money results to higher growth rather than inflation:

- Information Assymetry should be minimal
- Extra money to be used in capital assets and not in consumption.

If inflation expectations are high then the money supply would go into consumption instead of creating assets and hence leading to further inflation at the cost of growth (as players would first be concerned with consuming goods to survive and then think about creating capital assets). …………………..

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