Economics Question
My question is a simple one (i think).
How does inflation work?
Imagine a building (the world) with 5 floors (trading countries) and each floor has 1 million of its own currency, which it trades between the other floors, each floor has its own workers, houses, banks and produce, some of which is created (to replicate mining or crops).
How does this building ever have more than 5 million in currency in it?
Its obvious that a better run floor could exceed 1 million, but only at the expense of a poorer performing floor. Is this what is happening in the real world, or are some offical body(s) injecting money into the economy, if so, how?? Surely this would be an advantage to someone and a disadvantage to someone else? and who decides who benefits?
Or I am totally way off.
The money supply can be increased. Generally this is referred to as printing money, and that happens as in Zimbabwe. In major economies it happens but I don't think the money has to literally be printed [not sure].
Quote: WizardofEnglandImagine a building (the world) with 5 floors (trading countries) and each floor has 1 million of its own currency, which it trades between the other floors, each floor has its own workers, houses, banks and produce, some of which is created (to replicate mining or crops).
How does this building ever have more than 5 million in currency in it?
Let's call the five floors Austrians, Brits, Croatians, Danes and Jews.
1,000 Austrians bring 1,000 each to the Jew with promise to be paid 2,000 (their million plus his). 1,000 Brits take 1,000 each from the Jew with promise to pay 2,500 each. Croatians and Danes also want to do the same.
But they only need that 1,000 to pay Austrians and Brits. So, instead of giving them money, the Jew settles their debts. Now the Austrians are owed 3,000,000, the Brits owe the Jew 1,500,000, and the Croatians and the Danes owe the Jew 5,000,000.
There is now a total of 8,000,000 in wealth, 5 million in circulating currency and 3 million in Austrians' accounts, and a total public debt of 6,500,000.
After a second iterations there is 11,000,000 in wealth and a total public debt of 13,000,000.
First off inflation is determined by the CPI(consumer price index) which tracks the cost of everything from housing to the price of whiskey....And then even breaks it down into what the average household spends their money on...So what makes the prices on the CPI move? Basically in the simplest terms...the demand vs supply of the products and the currency the products are being bought and produced with....you will have many reasons the prices might go up just simply based on demand....The demand of one product might also cause another to go up(aka push cost inflation) And example would be the price of fuel goes up because of global demand. this would also cause the cost of transportation of getting goods to market to increase, and many products such as food would increase. You can track with a Phillips curve how low unemployment will cause inflation. As the demand for labor increases with low unemployment, wages increase. meaning the prices of goods and services will also increase...this would also be an example of push cost inflation.....This is kinda the easy part to inflation I think pretty much everyone understands...basic supply and demand stuff....
The more complicated part it how the CPI is affected by the value of our currency(the dollar) compared to other currencies....Currency is really like any other product. Its value is determined by supply and demand. If our currency is in high demand or is in short supply you will see deflation....and vice verse...really what makes a currency move is trade...and trading deficits and surpluses....The easiest way to explain it would be to make a simple example...Lets say there are only 2 countries in the world...USA and China....and the two currencies are the Dollar and the Yuan......Lets say company "A" in China makes playing cards. And they need to sell their playing cards for 10 yuan to make the profit they want. And lets say company "B" in the USA makes dice. And they need to sell each set of dice for 1 dollar to make the profit they would like. And to make things simple lets say the current exchange ratio is 10 yuan = 1 dollar.
In the first month Company "A" exports 1000 decks of playing cards to the USA. and company "B" exports 1000 sets of dice to China. Because of the current exchange ratio...company "A" sells their playing cards in the USA for 1 dollar each and company "B" sells their dice sets in china for 10 yuan each. at the end of the month company "A" has 1000 US dollars..... but this does company "A" no good. they cant take those dollars back to china and do anything with them. They cant pay taxes in china or rent or their employee with them. And Company "B" has 10,000 yuan they cant do anything with for the same reasons. So they need to exchange currency(done on a exchange market of course)....and becasue I made the math simple it all works out.....Company "A" trades its 1000 dollars to company "B" for their 10,000 yuan and everyone is happy and the exchange ratio is still 10/1 and everyone made the money they expected and the companies made profits.
Now let say the next month "A" exports 2000 decks of playing cards to the USA and sells them for 1 dollar. and "B" does the same as last month and exports only 1000 sets of dice and sells them of 10 yuan.....Now what happens?....."A" has 2000 USA dollars and "B" only has 10,000 Yuan.....when they go to exchange the ratio is no longer 10/1 it's 5/1.....so company "A" lost money, they couldn't cover costs selling for 1 dollar in the USA market becasue the US dollar lost half it value(or you could say the Chinese yuan doubled in value). So now company "A" will have to sell their playing cards in the USA for 2 dollars a deck instead of 1...and this affects the CPI.
Of course China doesn't want to have the ratio drop from 10/1 to 5/1 becasue then a USA company might be able to make the playing cards for cheaper...SO they peg their currency to keep the ratio 10/1..But that's a WHOLE other story LOL and this becomes MUCH more complex when you add in millions of more companies trading and hundreds of more currencies...
And lastly and the least thing to affect inflation or deflation is monetary policy.....Even though guys like Ron Paul would love for you to think the Federal reserve and it's "printing of money" really has that big an effect. But it doesn't. Sure it adds to supply which will surely decrease the value of the dollar. But its done in such small quality and at such a slow rate....it really has almost no affect what so ever. And is done in some cases to fight deflation. Which is kryptonite to any economy. You have to remember there are literally Trillions of dollars being exchanged per hour on exchange markets around the world....M0(the total amount of currency in circulation) is only 1.1 trillion...So if the Fed increase M0 by 10 billion one month to fight deflation or lower interest rates. that is only a drop in the bucket, even after it passes through fractional reserve banking and is expanded becasue of the multiplier effect...
I hope that helped by probably not, I'm tired and sure it makes little sense LOL
Quote: WizardofEnglandImagine a building (the world) with 5 floors (trading countries) and each floor has 1 million of its own currency, which it trades between the other floors, each floor has its own workers, houses, banks and produce, some of which is created (to replicate mining or crops).
How does this building ever have more than 5 million in currency in it?
The amount of fiat currency in the world is expanding at an exponential rate. The US Dollar, Japanese Yen, and the Euro each have more than a trillion dollars in currency printed.
From 1928 until 1969 when the $500 and $1000 bills were retired, the Treasury printed
231,708,000 $100 banknotes and about half of them were still in circulation
From 1969 until 1995 another 4,640,640,000 were printed. The large head banknotes were introduced, and over a period of several years all but a handful of the small headed notes were destroyed.
From 1996 until the end of 2010 another 12,940,800,000 large headed $100 banknotes were printed, with an estimated 7,000,000,000 still in circulation at the end of FY2010. So that is $700 billion in $100 banknotes alone, with over $300 billion in smaller banknotes also in circulation.
The Japanese now have well over 7 billion ten thousand yen notes in circulation, and they are worth over $100 apiece.
The Euro surpassed the dollar in circulation value about five years ago.
I will take 1 very minor difference of your wording "inflation is determined by the CPI" and assert that 'inflation is measured by CPI.
Then we could get into the tug of war between Monetary and Fiscal policy...de facto printing of money by Reserve Banks (incidentally Ron Paul loses my vote with his crusade against the Fed), etc
Quote: slythervert that was fantastic! I was an econ major in college so reading such a fantastic description brings a tear to my eye! :)
I will take 1 very minor difference of your wording "inflation is determined by the CPI" and assert that 'inflation is measured by CPI.
Then we could get into the tug of war between Monetary and Fiscal policy...de facto printing of money by Reserve Banks (incidentally Ron Paul loses my vote with his crusade against the Fed), etc
ya your right measured would be a much better way of saying it...I think I might have been thinking "determined" only becasue the bureau of labor and statics assigns weights to the products it tracks....so giving some things a higher weight than other...in some cases they are "determining" inflation....a great example of this is shelter group of the CPI and how they weight houses bought vs people who pay rent...but ya for sure you're right I think "measured" would have been a much better word to use....
Quote: vert1276And lastly and the least thing to affect inflation or deflation is monetary policy.....Even though guys like Ron Paul would love for you to think the Federal reserve and it's "printing of money" really has that big an effect. But it doesn't. Sure it adds to supply which will surely decrease the value of the dollar. But its done in such small quality and at such a slow rate....it really has almost no affect what so ever. And is done in some cases to fight deflation. Which is kryptonite to any economy. You have to remember there are literally Trillions of dollars being exchanged per hour on exchange markets around the world....M0(the total amount of currency in circulation) is only 1.1 trillion...So if the Fed increase M0 by 10 billion one month to fight deflation or lower interest rates. that is only a drop in the bucket, even after it passes through fractional reserve banking and is expanded becasue of the multiplier effect...
I am not sure that I would equate "monetary policy" with currency policy.
I do understand that currency and coin is the small change of the world financial system, but I think it carries a symbolic weight that far exceeds the actual value of the transactions. It is the symbol and the fuel of the underground world, from drug smuggling to piracy to overlords. For the majority of everyday people it is their primary connection to the financial system.
It's part of the reason Ron Paul does so well politically. Many people are terrified by a world where there houses zoom up and down in value, the moves factories around the planet, where loans are nearly interest free at times to rates that border on usury. It's easier to think about a government printing it's way out of problems. It's a well known concept. Most of us grew up in school learning that hyperinflation caused WWII.
But I am concerned about this debacle in printing the new $100 banknote. In some sense it has been going on since 2007, when they were originally scheduled to begin circulating a new improved note. If there is a successful counterfeiting operation that causes a widespread scare, people around the world will gravitate to the euro and the new Canadian $100 polymer note. The repercussions are likely to be more severe than the immediate impact on the $700-$800 billion in circulating $100 bills.
Quote: pacomartinI am not sure that I would equate "monetary policy" with currency policy.
I do understand that currency and coin is the small change of the world financial system, but I think it carries a symbolic weight that far exceeds the actual value of the transactions. It is the symbol and the fuel of the underground world, from drug smuggling to piracy to overlords. For the majority of everyday people it is their primary connection to the financial system.
It's part of the reason Ron Paul does so well politically. Many people are terrified by a world where there houses zoom up and down in value, the moves factories around the planet, where loans are nearly interest free at times to rates that border on usury. It's easier to think about a government printing it's way out of problems. It's a well known concept. Most of us grew up in school learning that hyperinflation caused WWII.
But I am concerned about this debacle in printing the new $100 banknote. In some sense it has been going on since 2007, when they were originally scheduled to begin circulating a new improved note. If there is a successful counterfeiting operation that causes a widespread scare, people around the world will gravitate to the euro and the new Canadian $100 polymer note. The repercussions are likely to be more severe than the immediate impact on the $700-$800 billion in circulating $100 bills.
Hmm I'm not quite sure what you are trying to get at...Monetary policy is controlling of the money supply....when you say "currency policy" are you referring to the money supply or protection of currency against counterfeiting.....because the later is not controlled by the Fed...but by the US treasury who prints the money and the Secret service...
as to the "government printing its way out of problems". that's not how the federal reserve works.....Just last night I was watching Ron Paul's speech after the New Hampshire primaries.....and Paul's was on one of his normal rants about the Federal reserve....and at one point said "the Federal reserve just prints money to pay for deficits"....The man is not that dumb...and that is a flat out lie! That is not how the Federal reserve works and he knows it...but most people really dont understand the Federal reserve or how it work or why it is even there. So they fear it and people put things out of context to scare people. that's why I cant support people like Ron Paul....
Lets take for example the news story floating around about how the Fed gave out 16 trillion in loans after the financial crisis....People hear this and think A) either that's somehow tax payer money or B) that the Fed "printed" this money to give to banks....and neither is true in any way....and the 16 trillion is a very misleading number...First of all when the Fed loans money to a bank...its really the banks own money the Fed is loaning them...To became a member bank of the Federal reserve the bank must give 6% of its cash holding to the Fed(3% up font 3% in reserves). So the Fed is sitting on this giant pile of money. they loan this out to banks when they are have liquidity problems. This is how the Fed prevents bank runs. This is why the banks join this "club" called the Federal reserve and give them 6% to hold....becasue they know bank runs are bad for everyone. If one bank has a run. People lose confidence in the banks and there will be a chain reaction and they can all go down.
So anyway, back to the 16 trillion. Like I said before there is only 1.1 trillion total currency in circulation(M0) and when you look at M2 which is total currency in circulation plus on demand accounts(checking and savings accounts) is only about 9.7 trillion( the difference is becasue of the multiplier effect set up by fractional reserve banking). Thats EVERYONE'S money added together so how could the Fed loan out 16 trillion? Well its easy. The Discount window at the Fed makes short term loans. Most of the time 24 hour loans. The discount window works just like a pawn shop. You hand over an asset(US treasury bond) they give you a loan. But instead of being 90 days like at a pawn shop they are intended to be 24 hour loans or what they call "overnight loans"...A bank gets one of these loans becasue they are bumping up against their reserve ratio and need CASH to meet customers withdraws...But they are NOT insolvent(this is key).....So anyway, back to the point about the 16 trillion....how did this number be so high? Because they made millions of small "overnight" loans...if a Bank borrows 100 million every week on Thursday to meet there cash needs but then pays back the loan on Friday after deposit are made....and this happens weekly.....did the bank really borrow 5.2 billion or did they just borrow and pay back 100 million 52 times? Now multiply this by thousands of banks and thousands of "overnight" loans and that how you get a number like 16 trillion...
Quote: vert1276Hmm I'm not quite sure what you are trying to get at...Monetary policy is controlling of the money supply....when you say "currency policy" are you referring to the money supply or protection of currency against counterfeiting.....because the later is not controlled by the Fed...but by the US treasury who prints the money and the Secret service..
I thought that monetary policy was any policy decisions concerned with money up to M2 (over $9 trillion dollars), not just M0 ($1.1 trillion). All I was saying was that you began your discussion on monetary policy, but all of your comments were concerned with M0.
Quote: pacomartinI thought that monetary policy was any policy decisions concerned with money up to M2 (over $9 trillion dollars), not just M0 ($1.1 trillion). All I was saying was that you began your discussion on monetary policy, but all of your comments were concerned with M0.
yes but M2 is dictated by M0 and the reserve ratio.....If the Fed changed M0 to 3 trillion and the reserve ratio to 50% then M2 would eventually end up at around 6 trillion.....M2 increase or decrease really based on how closely banks can come to their reserve ratio. Of course only 2800 or the 9000 US banks are member banks of the Federal reserve....the rest are state banks and regulated by state banking laws...and some not not required to have a reserve ratio at all.....
Government and banking policy can create money. Here is a simple example of how.
I deposit $100 into my savings account at Bank of Alan.
The government says Bank of Alan must keep on hand 20% of all deposits as its "reserve." That allows the bank to lend out 80% of my deposit as a loan.
My friend Bill needs to borrow $80, and he gets the loan from the bank.
I still have my $100 on deposit, and Bill now has $80 from a loan from the bank where I made the deposit. There is now $180.
Inflation simply means an increase in prices, but there are many different causes of inflation such as an increase in the money supply. One way to curb the money supply is to increase the reserves that banks must hold. In my example, instead of banks holding 20% they might be required to hold 80%.
So let's get back to the five companies on five floors each with $1,000,000. If floors A, B, C, and D, each deposited their $1-million with floor E, the total money supply would be:
Floor A $1-m on deposit with floor E
Floor B $1-m on deposit with floor E
Floor C $1-m on deposit with floor E
Floor D $1-m on deposit with floor E
Floor E $1-m of its own money plaus $4-mill from floors A, B, C and D = $5-m
Now add up all the floors: A + B + C + D + E = $9-million is the new money supply from the original $5-million
without the ability to lend there would be no growth.
the problem is not that the banks lend. the problem is that the loans are not repaid-- which could be the borrower's fault or the bank's fault.
Quote: AlanMendelsonThere are a couple of different questions here. The original question is really not one of inflation but one of "money creation."
Government and banking policy can create money. Here is a simple example of how.
I deposit $100 into my savings account at Bank of Alan.
The government says Bank of Alan must keep on hand 20% of all deposits as its "reserve." That allows the bank to lend out 80% of my deposit as a loan.
My friend Bill needs to borrow $80, and he gets the loan from the bank.
I still have my $100 on deposit, and Bill now has $80 from a loan from the bank where I made the deposit. There is now $180.
Inflation simply means an increase in prices, but there are many different causes of inflation such as an increase in the money supply. One way to curb the money supply is to increase the reserves that banks must hold. In my example, instead of banks holding 20% they might be required to hold 80%.
So let's get back to the five companies on five floors each with $1,000,000. If floors A, B, C, and D, each deposited their $1-million with floor E, the total money supply would be:
Floor A $1-m on deposit with floor E
Floor B $1-m on deposit with floor E
Floor C $1-m on deposit with floor E
Floor D $1-m on deposit with floor E
Floor E $1-m of its own money plaus $4-mill from floors A, B, C and D = $5-m
Now add up all the floors: A + B + C + D + E = $9-million is the new money supply from the original $5-million
ya well the OP question was not how fractional reserve banking works....But what causes inflation. But fractional reserve banking in and of itself doesn't create inflation. If utility is created with the "money" created through the multiplier effect. Then no inflation should take place at all. In fact it can cause deflation. It really just depends how much utility is created.
