Download FED AND FIAT CURRENCY

INFLATION. STAGFLATION.DEFLATION. FED AND FIAT Currency
Last year you were able to buy a dress for $100. You haven’t checked the prices this
year. What could be the 3 possibilities, 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 year
1 – Is called zero inflation
2 – is called inflation
and
3: negative inflation or deflation.
Another way to say prices have gone up
{Inflation}
is -> the VALUE OF MONEY HAS GONE
DOWN. In that, the same $100 now
is able to buy less than it used to
– before.
The adjoining graphic depicts the erosion
in the value of money {value going down means erosion in
value} since 1776 in the USA. From the graph, one can
see:
having $1 in 1776 meant a hell lot
more. In today’s terms, to match the buying
power of $1 in 1776 you would need to come
up with $1/0.04 = $25.
Natural
How
question
come
is: why is that so:
the same dollar is less-dollar
today? And the answer is -> Inflation
–
prices
moved up.
BUT
why?
-> Dollar
like
many
other
currencies is a FIAT
currency
–
in
that
it’s
a
representative
currency. Its VALUE is
not fixed to something tangible – it changes, it represents what it can BUY. This
depicted the story of inflation and what 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
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 allow 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
of
money
the
multiplier, m,
is
the
inverse
reserve requirement, RR:
Just what the hell is RR – the reserve requirement: Lets understand what moneymultiplier 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 - $Y lying in YOUR savings account? see
below
Let’s see what are the possible answers for the point [3] above: but before
that let’s see what a bank does:
A bank is a business. A business that exists to make money. Making money means
– making profits.
Most businesses make money by selling their products for more than it costs
them. {Revenue – Costs = Profit}. A bank does not have any *products* to sell.
So, how would they make money? below is how
A bank takes money from YOU ($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
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 for that 3% return, i need $100 for emergency – give me
my money back”. Now, if this happens – the bank is OBLIGATED 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 RR
If 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 or contract in amount warranted
by economic conditions -> Control RR up/down and see what happens
Recap:
lets
see
the
through an equation:
intuition
quantified
–> 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 => reduction in inflation
Few
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 that the central bank would do something that would
tantamount to a contraction in the economy. This, now deserves an exclamation
mark. When would the central bank want to limit the money multiplier? below
are the situations 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
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 P2
S: is for supply, D – for demand, AS => aggregate supply. AD: aggregate demand
Aggregate: means -> sum of all..