Inflation deflation-fed-fiat-currency-monetary-supply-and-money-multiplier1


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Inflation deflation-fed-fiat-currency-monetary-supply-and-money-multiplier1

  1. 1. INFLATION. STAGFLATION.DEFLATION. FED AND FIAT CurrencyLast year you were able to buy a dress for $100. You haven’t checked the prices this year. What could be the 3possibilities, as it relates to this year’s price for the same dress? 1. Same as last year 2. More than last year 3. Less than last year1 – Is called zero inflation 2 – is called inflation and 3: negative inflation ordeflation.Another way to say prices have gone up {inflation} is -> the VALUE OF MONEYHAS GONE DOWN. In that, the same $100 now is able to buy less than itused to – before.The adjoining graphic depicts the erosion in the value of money {value goingdown means erosion in value} since 1776 in the USA. From the graph, one cansee: having $1 in 1776 meant a hell lot more. In today’sterms, to match the buying power of $1 in 1776 you wouldneed to come up with $1/0.04 = $25.Natural question is: why is that so: How come thesame dollar is less-dollar today? And the answer is -> Inflation– prices moved up.BUT why? -> Dollar like many other currencies is a FIATcurrency – in that it’s a representative currency. Its VALUE isnot fixed to something tangible – it changes, it represents what it can BUY. This depicted the story of inflation andwhat a fiat currency means. And that is all. It really is all, there is nothing more mysterious._______________________________________________________________________________________________________________The Relationship between Money Supply and Inflation: 1. Money Supply = Supply of money. More Money supply = more money circulating in the economy -in our hands + in our BANK accounts 2. When the Central Bank reduces interest rates { see here} -> more people take loan { more credit} => more money in our hands +> more money to BUY things: Jeans, Beans, Jewelry, Laser skin resurfacing et all 3. When we have more money chasing the same amount of goods to buy – the prices go up. When prices go up – we say inflation has come._______________________________________________________________________________________________________________Buzzwords and Jargon + The measures of money: Total money {Coins + notes} in any nation =notes + coins – with people + notes and coins – held in banks ->in UK is called monetary base. M0 is the symbol Monetary base has exploded – means – more notes and coins are in circulation - that really is all. M1 - now people also have traveler’s cheques and CDs /fixed deposits – add em all up – viola – you get M1 M2: Take M1 and add – all the savings deposits: so, M2 = M1+ (sum of all savings deposits) M3 = M2 + large time deposits – FED likes to keep this number secret
  2. 2. Now, what the hell is Money Multiplier and why it’s important? Take M2 from [4] above and take M0 from [1]above. Divide M2 by Mo: M2/M0 = money multiplier Money is a FIAT currency- it is CREATED. It’s not fixed. It’s artificial in that its represents some legal tender which allows us to buy things WITH. Anything that is CREATED needs to be managed. There is a risk of creating more than the right amount or less than the right amount. The Central bank monitors and controls the money multiplier. The FED wants to ensure 2 things: [a] that the money multiplier is not too much and [b] MM is not too low. Any talk of too much or too low, implies that there must be a RIGHT amount. MM is a ratio, of money. Its a number – so how about another measure – a number – that gauges if MM is at the right level or not? Well, the number talked in [3] above is the inverse of the “reserve requirement”Formulas:The money multiplier, m, is the inverse of the reserverequirement, RR:Just what the hell is RR – the reserve requirement: Lets understand what money-multiplier means or signifies,in a plain language: How much money is in your wallet – say its $X. How much money is in your bank account savings account: say, its $ Y Money multiplier = X /Y - in other words MM = a ratio of (money in hands/money in banks savings). The bank where you parked your money, can’t lend more than what it has available to lend. The maximum it has = the maximum deposits you have made = $Y What does the bank do with YOUR money - $Y lying in YOUR savings account? see below_______________________________________________________________________________________________________________Let’s see what are the possible answers for the point [3] above: but before that let’s see what a bankdoes: A bank is a business. A business that exists to make money. Making money means – making profits. Most businesses make money by selling their products for more than it costs them. {Revenue – Costs = Profit}. A bank does not have any *products* to sell. So, how would they make money? below is how A bank takes money from YOU ($Y) promises you a return say 3% (means you get $1.03Y) -> invests your money in the stock markets and other investments -> hopefully makes more than 3% – so say, it made 13% - > gives you back 3% that it promised you –> pockets 13-3 = 10% as profits from operations -> so that’s how banks make money
  3. 3. Now, what do you think can happen? How about the following scenario:You walk in the bank and yell” I know i deposited my $100 with you in my savings -but I can’t wait for 1 year forthat 3% return, i need $100 for emergency – give me my money back”. Now, if this happens – the bank isOBLIGATED to give you your $100 back 1. What if the bank had invested ALL your money (all of $Y) in the stock markets? The bank will have to say NO to you. This happened in 1929 and is called BANK RUN. This possibility of [1] happening – is NOT acceptable to the FED – not anymore. 2. To ensure that a customer is never turned down – the FED MANDATES all banks – to maintain a RESERVE cash amount. Put simply, the Central Bank says to the commercial bank: ‘ you cant invest all that was deposited -you need to keep some money in your RESERVES’. In other words – a commercial bank, is not allowed to invest all of $Y but a fraction of $Y – say, R*Y 3. This number R – is a fraction (less than1). R is dependent on the RESERVE RATIO (RR) dictated by the FED -> (cash lying in the bank) / (total cash – lying + invested: in and by the bank)._______________________________________________________________________________________________________________The purposes of having this ratio are: To ensure that banks do not lend all the money the bank received from consumer deposits – avoid bank runs. To control the money multiplier -> if FED says – ‘ increase your reserve ratio’ => less lending => less money in circulation => less M0 ( lower money base) => lower money multiplier => yes – less money in our hands => prices cant go up => a downward pressure on prices => reduction in inflation numbers. And, we all want Jeans and Beans to cost less – not more right? – Viola – that’s why the central bank controls and dictates the RRIf the FED wants to increase the money supply -Fed can ‘decrease the RR’ and the rates. Here is a line from FED:the FED wants Elastic Currency: Currency that can, by the actions of the central monetary authority, expand orcontract in amount warranted by economic conditions -> Control RR up/down and see what happensRecap: lets see the intuition quantified through an equation: –> here M = money multiplier. RR is in the denominator. SO, if RR increases, 1/RR decreases => m –the money multiplier decreases => less money circulating in the economy => contraction in the GDP => reductionin inflationFew Noteworthy Points: about the FED AND THE MONETARY POLICY LEVERS:It seems counter intuitive – on the one hand we want GDP to increase, but on the other hand we are saying thatthe central bank would do something that would tantamount to a contraction in the economy. This, now deservesan exclamation mark. When would the central bank want to limit the money multiplier? -below are thesituations when the FED would like to restrict the money supply: 1. If the FED sees that the economy is overheating { when the money supply is high enough to increase the probability of inflation} 2. If the FED believes that the asset prices have gone beyond what could be supported by the underlying fundamentals – Housing bubble, stock market valuations are recent memories to chew upon
  4. 4. 3. If FED believes there is – or that there is a high probability – of Financial Instability. Financial instability is the collapse of the financial system itself. Two things cause this -[a] adverse selection [b] moral hazard – read here for an example applied in housing:So, what is stagflation? Stagflation is an economic phenomenon: Usually when prices are rising { ie. there is inflation} – the economy – measured by GDP – is rising. Stagflation is a period where prices rise, but the GDP doesn’t. This happened in the 1970s – and the culprit was ’supply shock’.What the hell is a supply shock? 1. Its the name given to an event that suddenly changes the price of something that is SUPPLIED as an input cost to other industries – like Oil is used in transportation – think airlines suddenly paying more for the price of oil to run the jets 2. Why the word shock? – well, people are shocked when the input price goes up – so soon – so fast 3. Imagine, you own all the Oil fields: and you decide to shut down the valve? – what would happen is that the supply of oil – will be reduced 4. What happens – when supply goes down but the demand – stays the same? – yeah – price goes up – see below Sudden jump in supply => move from AS1 TO AS2=> Price move from P1 to P2S: is for supply, D – for demand, AS => aggregate supply. AD: aggregate demandAggregate: means -> sum of all..