Posts tagged ‘supply creates demand’

Inflation: Back to the basics

Above mentioned news peice published in zee news – business with the Title “Tight money policy will choke higher growth, warns Sen” is another classic example of gross misunderstanding of basic economic principals. The artical quoted Mr Sen from RBI that “any firm monetary action to cool down runaway inflation saying such a measure will cripple demand and choke higher growth”.

Not a surprise! as a wide range of policy makers believes that inflation is a function of growth and caused by increased demand in the economy and the supply is not able to fullfill that demand. This is the wrong diagnosis. The question is what creates demand? Let us refer to Jean’s law, i.e., “supply creates demand”. To understand it better, lets go back to the old days where in everyone used to work and the goods produced by one were exchanged in return of goods produced by someone else. The more one produces, the more demand he could have by exchanging his surplus for other goods as per his wish or need. So he created demand by producing more supply and make a claim to labour. So lets understand that money is a claim to labour.

Lets move ahead: due to surplus production or savings some people moved to the service sector to provide necessary services like building a water-reserve for irrigation. These people in the service sector were not adding any produce to the society and were consuming. However owing to surplus production or underconsumption (if its a war or any other necessary service) producers of the society were willingly able to feed the service sector in return of the necessary service they were providing. More surplus production means now you have more produces to afford research and development, capital investment or increased consumption. This is a wealthy society which is a function of labour, hard work and production which enabled more consumption in the form of SERVICE.

Money like gold then were adopted as medium of exchange with the benefits that it is easy to store, value and exchange. Not to forget that gold itself was a product of hard labour with numerous advantages. However money like paper currency is just a symbol of wealth but no wealth in itself. After the collapse of brettenwood system it is no more linked with gold and the value of paper currency is just its purchasing power.

What we forgot in due course of time that it is the production and specially of essential commodities which is the engine of the society and which enables CONSUMPTION THROUGH SERVICES. We not only started exploiting our labourers, farmers and manufacturers by making improper regulations but by also making claim to their labour in return of phoney jobs like, as someone said “cleaning the rock at the beachside”. We supported the unproductive service sector by bailouts which is printing more paper thereby creating artificial money to generate demand. This increased demand by unproductive people due to increased supply of paper currency on the limited essential goods available in the economy resulted in reduced purchasing power of the paper currency in circulation.

Increase of supply of paper currency is inflation and reduced purchasing power or price rise is its effect. It is possible to hide the effects of inflation by adopting fake means to misinform people like calculating inflation as US do, such as CTPIPCE (chain type price index for personal consumption expenditure). It is also possible to suppress the effects of inflation by borrowing and flooding the markets with imported goods which will push the prices of commodities down until it blasts and result into a hyperinflation after a debt default which is a major threat to most countries in the world today. Extraordinary measures are required by these borrowers with large fiscal deficit and external and internal debt to not only repay the debts but increase the production so much that it outdo the supply of currency so as the common man do not suffer from the inflation. I see this impossible for countries like US and UK and extreamly difficult for countries like India.

And in context to India, as I see another news that 9000 crore has been infused in the banks and further 7000 crores plus are planned so I see little respite from the rise in interest rates which is already too late and too low. Lesson is simple, economies don’t grow by artificially pumping in money and not doing something to increase supply as this will only result in the decrease of purchasing power and rise in the prices of commodities. Efforts must be done to give loans for capital investment at very low interests rates and for consumer debt including housing, cars, credit cards etc at very high interests rates so that we start producing and underconsume thereby saving for necessary service sector that supports the system. However I suspect that any change will be done and the current path will lead to hyperinflationary depression or currency crisis.

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