Monday, December 6, 2010

The Currency Conundrum…What’s the real worth -1

“He who tampers with the currency robs labor of its bread.” ~ Daniel Webster

The brashness with which the Central Banks across the globe, well really in the States (openly) and in Japan and the Euro area (covertly) are printing money raises the questions as to the real worth of the currency or rather more fundamentally from where does the currency attains its value. I would be less opinioned in this part of the article and would just talk about one most the most fundamental tenet of economy “The Currency”.

I would like to divide this topic into two parts, in this part I would talk about the fundamentals and basics of currency and as I said by being less opinionated (although would be hard….) and in the second my opinion on the endgame of the current situation. Nevertheless it is critical that the readers must understand that there is difference between working for money (that’s what most people end up doing) and working for wealth. Working for money is a complete fallacy as money can be printed in as much quantity by the Central Banks and thus keeping money in cash is the biggest mistake that working class people fall for. Ok more on it in the next article let’s discuss about currency now……..

Some four decades back Milton Friedman came up with a simple but an epic equation PQ=MV, not only it produced déjà vu with another great work of E=mc2 but following the monetarist approach of Friedman the world came out of the stagflation era by early 1980s. However please remember that like any economic variable growth (represented by Q in the equation) also responds to the relationship of marginal utility of money i.e. growth may increase as an increasing function of money growth followed by relationship of equality and finally as a decreasing function of monetary growth i.e. the relationship is linear only for certain period.

So after a sufficient history lesson let’s check the variables… (P – Price, Q-Growth, M-Money Supply and V-Velocity of money) the velocity of the money is generally a constant over the short and medium term except in cases of hyperinflation or severe deflation when it spikes and infact is the most important determinant of these two situations. Now the first question to answer is if returning to something like a gold standard would work. Well the answer to that is an affirmative ‘No’ because it is simply too restrictive. Let’s see how does the monetary policy accommodates for growth. Assume an economy X produces 100 units of goods/unit of asset, each costing 1 $ and let there be 100 $ in circulation (assume velocity of money to be 1) owing to some discovery or investment (IT, better production knowledge, education, roads etc.) to an increased productivity and this causes the economy to produce 150 units of goods/unit of asset. To support this if the currency under circulation is not increased then this could have a serious deflationary impact (since velocity of money remains constant over short and medium term period) and this could hamper growth. So the Central bank should increase money supply. Having a gold standard can cramp up this growth as that would mean that the currency supply can increase only marginally.

What this means is that the value of the currency actually maps the productivity. Let’s take a hypothetical example of two countries X and Y a labour in country X produces 2 units while in country Y produces 1 unit and let’s assume there is just one unit of labour available. Now if the value of currency is same in both the countries then it would imply that a citizen of country Y can buy 2 units while the citizen of country X can buy just 1 unit. Well not really all this would do is that the citizens of country X would not be ready to sell anything to country Y at that price and this would lead to a devaluation of the currency of country Y.

Now there are certain ways of bringing about this devaluation and this is what I am going to discuss next

- Market demand and supply: In a floating rate regime the currency would automatically adjust under market forces
- A Sovereign Decree: In a fixed rate regime a decree can be issued changing the rate of the peg.
- Printing more money: A weakened currency can have several consequences:
- It will no doubt make your goods attractive by bringing a nations currency more inline with its productivity
- It can reduce the value of the internal liabilities
- It may increase the value of external liabilities
- It may increase notional value of assets (not real value) atleast temporarily and may lead to internal inflation and in some cases global inflation
- More importantly it can have severe effects on the critical component called ‘Velocity of Money’ and if that happens it simply means that the Central Bank basically has lost control over its monetary policy.

Let me emphasize that ultimately the foreign currency must find its way to the issuer in exchange for some goods or services. If the productivity is of that country is less, then its currency has to depreciate to make it a fair exchange and infact market forces generally ensure this to be the case at most times in a floating rate regime.

I have tried to set the context in this article about currency and monetary policy, in the next part I would explore the critical relationship between Money Supply and Velocity of Money and comment upon the current monetary policies.

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