A two part article on understanding money and monetary policy
Part 1 – Inflation is a Good Thing
Ask anyone and they will tell you that the increasing prices of goods bother them. Don’t we all wish that prices don’t change and stay the same every year, that is have zero inflation? If we had our way, we would want prices to fall, that is deflation. Wouldn’t that make goods cheaper and affordable for everyone? But why do the government and economists dread deflation and why do they target a positive inflation ? Did you know that India has set itself a target inflation of 4% till March 31, 2021? Why do we not set a target of 0% ? Read on to understand how money works and influences prices and economic growth. I also explain with examples why positive inflation is necessary for an economy.
Price Determination – Why your microeconomics teacher was wrong
In textbook microeconomic models when we learn the law of demand and supply to discover the equilibrium price, that price is not in terms of rupees or dollars but in terms of a numeraire good. So, when the model says that the equilibrium price for a kilogram of apples is say 10, it means that apples are equal in value to 10 units of the numeraire good. The concept of money is absent in these models. Here price changes are a result of changes in demand and supply. While this is what microeconomics teaches us, that is not the case in reality. In reality, the value of apples is expressed in terms of money. So, if the price of a kilogram of apples increases from Rs. 100 to Rs. 120, it could be because of an increase in the relative value of apples due to changes in demand/supply or due a fall in the value of rupees. Note that in recent times we saw the prices of onions shooting through the roof. That was due to change in demand/supply. To be precise, the supply of onions fell as farmers couldn’t harvest onions due to untimely rains in Maharashtra and Karnataka in latter half of 2019.
But when we say that the general price level in the economy has increased, it is due to a fall in the value of the currency and has nothing to do with laws of demand and supply. But note that price level refers to an average price level as measured by CPI and is different from prices of individual goods which are measured in rupees. Prices in individual goods are impacted by forces of demand and supply of that good and also by the value of currency. So, your microeconomics teacher wasn’t entirely wrong! But how does the rupee fall in value? Isn’t 1 rupee always 1 rupee?
When we talk of the value of rupee, we are again talking in relative terms. 1 rupee is still 1 rupee but the amount of goods you can get with a rupee, its purchasing power (a.k.a relative value) has reduced. How does that happen? To understand this, let us look at the original function for which money was invented; to help in exchange of goods. Let us take an example.
Say an economy has two groups of people, consumers and producers. Producers produce bananas and sell them for money while consumers have money and buy bananas with the money. Let us further assume that producers don’t consume and consumers don’t produce. This can be seen as an abstraction from reality; in reality there are many products produced and consumers also produce and producers also consume. Now, in our simple economy, the producers produced 10 bananas and consumers have a total of Rs. 100 with them. The consumers want to have bananas and have no other use for money apart from buying bananas while producers want to have money and have no use for bananas. So, they will engage in exchange and the market forces of demand and supply will set the ideal price to be Rs. 10 per banana (Rs.100 divided by 10 bananas) at which price consumers don’t have any more money (which has no use for them) left and producers have any bananas (which have no use for them) left. So, given the levels of banana production and money supply circulating in the economy, the price level is Rs.10. Say with improvement in production technology, the economy produced 20 bananas but no extra money is put in circulation. Now in the economy that has 20 bananas and Rs. 100, exchange will lead the price to be Rs. 5 per banana. This is deflation. But let’s say the money supply also doubled commensurate with the increase in output, then the economy has Rs.200 and 20 bananas, then price is stable as before at Rs. 10. But if the money supply increased faster than output to say Rs.300, then the price of a banana will be Rs.15 (Rs.300 divided by 20 bananas). Thus when money supply increases faster than growth of output, there is inflation and fall in the value (or purchasing power) of money.
Monetary policy is basically the function that determines how much money is in circulation in the economy. Now you can appreciate that this is not an easy task; to measure how much gets produced and to match the increase in output, more so when there are international factors also to consider.
Isn’t zero inflation the best ?
Now that we know how money supply relates to prices, shouldn’t we regulate money supply to match output and keep prices stable i.e. have zero inflation ? Amongst economists there are differing views regarding the pros and cons of inflation, deflation and stable price level. While the dominant economic thought today is that a low level of positive inflation (and not zero inflation) is ideal, I will explain briefly the pros and cons of each.
Deflation makes goods cheaper and so accessible to more people. Particularly after a sudden rise in prices, a period of deflation can be helpful to correct the price level. But, it makes debt costlier. Say, an entrepreneur borrows Rs.100 to be repaid after a year with 10% interest. He expects to use the loan and produce a good which will fetch him Rs.150. After repaying loan with interest, he will still have a profit of Rs. 40. Now, suppose the economy is hit with deflation and prices drop which will reduce his profits. In addition, the cost of debt is now higher. Although the cost is fixed at 10% interest rate, the amount of Rs. 110 that he has to repay is now worth more than what Rs. 110 was worth before deflation. This is because purchasing power of money has gone up and the real cost of the loan is higher. So, deflation impacts profits and increases the cost of debt. Businesses naturally dislike both of this. As a consequence, businesses cut down production, lay off workers and eventually a long period of deflation will reduce real GDP and employment. So, deflation is definitely not desirable for businesses and not desirable for workers if deflation persists.
Zero inflation is in fact best for money to serve its purpose as store of value and unit of account. 1 rupee today will be equivalent in purchasing power to 1 rupee a year from now and economists wouldnt have to bother with the headache of calculating real GDP or real costs. Real and nominal costs would be the same. But with zero inflation, there is always a risk of slipping into deflation and money cannot play any useful role to stimulate economic growth. We will see how money stimulates growth as we understand inflation better in the following paragraph.
Inflation’s cons are popularly discussed in mainstream media and it is of course that goods get expensive troubling consumers and/or workers. But it has its pros too. Building from the earlier example, it can be seen that profits of businesses rise with inflation. While input costs also rise, wages don’t rise as quickly and so inflation rewards businesses with extra profit (But do note that the purchasing power of the profit would have reduced a bit, but there will be a positive net benefit). In addition, it makes debt cheaper. Continuing our earlier example, the business will have to pay back Rs. 110 but the purchasing power of that money has reduced due to inflation and so the real cost of borrowing has gone down for the debtor. Needless to say, businesses love inflation and so does the finance minister. Businesses will now take credit, expand production, employ more people and GDP will grow. For the finance minister, it gives him freedom to borrow more and spend as inflation will reduce the cost of his borrowing. But hyperinflation is dangerous. If prices rise rapidly, people will lose trust in the currency and it can lead to fall of the entire monetary system as we saw happen in Zimbabwe where people began to use foreign currencies and abandoned the local currency.
In summary, a small level of inflation is seen as ideal as it can incentivise entrepreneurs. In our current economic system it is entrepreneurs who create economic growth and employment. So, although inflation is not desirable for fixed income earners and consumers, it is seen as necessary in all economies. So, with positive inflation we are rewarding entrepreneurs; as the dominant thought is that it is entrepreneurs who take an economy forward.
Read further the second part at Part 2 – Who fixes my Interest Rate ?