Playing catch-up

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Pre-cursory notes (skip):

Blog 5: Running at a day’s delay, not convinced with the understanding I’ve developed about this topic and I think it shows. Hope to know and do better in the next one. Although to be fair —no one seems to know all answers anyway.

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Economics study begins with hard core numbers and strict rules. But as you dig deeper, it delves more and more into psychology, making bold assumptions about human behaviour to keep the wheel rotating. These assumptions, are of course valid. If demand goes up, prices would rise in the short run and supply should catch up soon for an equilibrium- that makes perfect sense.

Though ask a few questions and ample ambiguities start surfacing. For example, it baffles me that the amount of money in the ecosystem keeps increasing, always. Why not keep the money supply constant, at least one constant in a world full of variables?

The first thing to understand here is that the world is not a zero sum game. The demand for resources keeps on increasing through upticks in population and human desire to always have more than before. A constant amount of money chasing higher resources would drive prices way down, and make the logistics hard. Additional money is pumped into the ecosystem to catch-up with the growth in demand and maintain steady prices.

Inflation occurs when rise in money supply outpaces the growth in economic output. Extended periods of high inflation, introduce uncertainty in the economy, it leads to unintended redistribution of purchasing power, blurred price signals, and tougher planning.

Let’s say you notice that the price of wheat has gone up 50% in the last week. In a hyper inflationary period, it becomes difficult to decipher whether the price increase is because of an increase in demand, decrease in supply or just due to the constant inflation? The inability to understand these price signals drastically affect the efficiency of the market.

However, inflation is not intrinsically bad. Consider in the “land of funny money” (as Khan Academy calls it) where the economy is witnessing 10% inflation, if wages of every single person are raised by the same exact 10% instantaneously, the purchasing power of each actor in the ecosystem is retained.

These wages in turn depend on the status of the job market. Central banks try to control unemployment through changes in interest rates. Lowering interest rates leads to an increaser in economic activity, and thus an increased demand for jobs. With lower unemployment, employees can unionize and seek higher wages.

At the outset, it seems that maintaining a 0% inflation rate would be ideal. That’s where human behaviour comes in.

Imagine again a land of funny money, with non existent inflation. Here, you receive say Rs. 1000 as salary monthly, and are able to sustain a rich lifestyle. With 0 inflation, there is no reason to believe that in future, these Rs. 1000 may not be enough. Complacency kicks in, there’s a lack of motivation to grow and earn more. A similar situation occurs at a wider scale in the economy, stalling societal improvements.

A steady, low inflation rates pushes you to reach for higher or go into dirt. It prompts you to make purchases now, else see your money devaluing. Consumers expect prices to increase in the future and thus purchase sooner, spurring economic activity. An increase in production and employment follows along, bumping up wages and purchasing power, thus pushing prices even higher.

Seen this way, expectations of inflation is the primary driver of inflation. It’s not a zero sum game but a circular loop, a self fulfilling prophecy that’s working out well. Inflation is good when it is mil, a low and steady rate produces a good business environment. The RBI targets keeping inflation at a steady 4%.

And so the money supply in the economy keeps growing. First to catchup with growth in demand, but then some more — which is when the tables turn and economic growth starts playing catchup with money supply.

How exactly does the money supply increase? Coming up next.