Thursday, March 19, 2015

Some basics of currency, inflation, and deflation

We use currency a lot. It is different in every jurisdiction. In India we use Rupees. This article focuses on several questions regarding currency. What it is, how it is created, how it affects economy etc.

What is Currency?

The 1000 note says that the RBI Governer "promises to pay the bearer the sum of one thousand rupees". What would the RBI pay you if you were to take the 1000. Actually you will get another 1000. They would laugh at you if your note is not mutilated :-).

The Currency Notes are a form of receipt that the govt gives you for services rendered. Say you are a govt employee. They can be used to pay to the govt for the services that the govt renders to you. The govt collects tax as a payment for the services it provides you.

How is Currency created

The govt creates (or prints) the currency when it spends it on (or rather issues the debt to) its employees or buys stuff for the govt use, or uses services of other private entities. It destroys the currency (or the debt) when people pay taxes. In reality that same currency may be reused for payment. But it is easier and more accurate to think of the two as creation and destruction of govt debt. If the two balance, then no new currency is put into the market, and we can say that no (new) printing has occurred. This means that all the currency we see in the market is a debt issued by the govt. So for the people to use Currency as Medium of Exchange it must first be created by the govt, by over spending. So the budgets cannot really balance perfectly in a growing economy. There will be too little currency and there will be deflation. The concept of origination of inflation and deflation we will deal next.

Inflation and Deflation

In essence Currency Notes are a Debt Note that Govt issues, not unlike debt bonds. If you have 1000 ₹ then the govt owes you 1000 worth of services. The value of those Debt notes is decided by the common man. They decide how much milk or rice they would provide for the note. Of course this depends on the availability of currency notes in circulation. If people looking for rice have more notes than yesterday, then the value of notes will fall, and correspondingly the price of rice will rise. This is basically the Quantity theory of money.

Now the Quantity theory of Money includes a term Velocity. This is where the simple notes in circulation point becomes complex. Velocity is a measure of how many times a note changes hands in a year. The lower the velocity, the less the impact of the quantity of money.

Lets see how inflation affects the velocity. Lets say the rice you buy today will keep for a year. Also storage costs and hassle for storing the rice for the year are small. And the inflation rate is high enough that it makes sense to store the rice for the year. It depends on the storage and hassle costs. Lets say you have deflation that is inflation rate is negative. In this case rice will be cheaper tomorrow, so it makes no sense to store the rice. Nobody will buy it. If the inflation rate is low, then some people for whom the storage and hassle cost is low, will buy it. If the inflation rate is very high lots of people will want to store the rice and get rid of the currency. If more people start to buy the rice (and other things) the more the velocity of the currency.

A high inflation rate causes the velocity to increase which can quickly cause a vicious cycle if a lot of currency is already printed. Eventually this should stop, provided no more currency is printed and/or the Central Bank steps in to absorb the liquidity.

If lots of currency is printed but the inflation rate remains low, people will store the excess currency, and it will not get into the market and cause inflation, ie velocity will drop correspondingly. So as more currency is printed, the more it is absorbed, keeping the inflation rate unchanged. This means that just because currency is printed doesn't mean it will cause inflation. This also means that as soon as inflation increases above a threshold, it will cause the inflation to become runaway, upto a point. That point is decided by the amount of money that has been printed. If more printing is done by the Govt, inflation will keep on increasing.

The reason why printing is done by the govt is because it needs to pay its employees. It needs to buy stuff that are required by the govt. The only way to stop printing would be to downsize to the point where spending equals tax collection. Normally govts get into this condition because they are spending too much in the first place. Getting to the point where they do not need to spend, requires a huge downsizing.

Now we have seen that printing the currency does not increase inflation. Then what causes inflation. The inflation is caused at the ground level. It is caused if there is less of something and the demand for that cannot be offset by something else. This causes people to pay more for the object. This would happen if the lower class people have money. So inflation rises only if poor people get more money than they had been having.

There is another mechanism by which inflation can happen. Lets say a country does not produce enough oil to be used by the govt. The govt needs more, in this case it will use its foreign currency reserve to buy the oil in the international market. Lets say the govt does not have enough foreign reserves, then it must sell its own currency to buy foreign currency to buy the oil. The selling of its own currency will cause the value of the currency to go down. Since the oil is required by the country and affects the prices on the ground there will be inflation. If the country is self sufficient this will not cause any inflation at the ground level. The drop in the value of Currency relative to foreign currencies will only affect the prices of imported items. As long as the imported items are not necessary (like oil), it will not cause inflation. This is why even though Ruble is losing value in the foreign markets, there is no inflation on the ground except imported items. This is why it does not affect the poor and lower middle class people there. Actually the Russian case is interesting as the country is a surplus country, so its not like it needs something. The currency is dropping because the speculators are selling Rubles and buying foreign currencies. The Ruble also needs to drop, so that the input costs to oil production can drop inline with the Oil. If Ruble had not dropped with the oil price drop, it would be in trouble, which would have anyway caused the Ruble devaluation.

We see that the world is afraid of Deflation. Deflation is caused when there is not enough demand for the stuff that is produced. This happens when a country produces a lot of goods for foreign consumption, and does not consume enough. It can also happen in certain industries if they are superseded by new technology. If you think of Electronics Industry it seems to be in a perpetual deflation, per item, but the industry as a whole is growing. When we talk about deflation, we are concerned about the whole country's economic output reducing, because of lack of demand. So that the earning gap due to the lack of demand causes layoffs etc. Normally printing is seen to be the answer to the problem of deflation. It is only helpful sometimes for a short time. The problem with current economy is that the deflation effects have been for a long term. And printing has not helped tide it over.

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