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What is Inflation and How it works? | Supply of Money and Reserve Ratio

Inflation is like a termite that eats away at your money. As harmful as that sounds, we have to learn to live with it. The reason behind this is that the entire economic system is inflationary. i.e., prices consistently rise over time. I will be explaining why that is the case and also talk about money supply in the economy and how it works.

I still vividly remember the time when I was a small child, and my mom used to send me to the store to buy stuff and how I used to skim money to purchase chocolates. You could buy four orange balls for the price of 1 rs. Those were the good days when things were a lot cheaper. But things change and as we see in the real world prices of things increases every year. Why is that? The reason is inflation. Inflation in an of itself is not a bad thing, but it usually turns bad due to weak governmental policies and economic mismanagement.

In this article I want to discuss the following topics :

What is inflation?

As I described earlier, inflation is like a termite that eats away at your money. Inflation is the reason why our parents keep telling us that “during their time weddings only cost 5 Rs”. But inflation in an of itself is not a bad thing. Inflation would not be a problem if everything in the world inflated at the same rate. i.e., If the price of houses rises, then who gives a fuck if your wages can increase to offset the rise in price proportionally. But of course, things in the real world are not so simple, and different things inflate at different rates.

Inflation is measured by tracking the price of a set amount of commonly purchased goods like milk, bread, rice e.t.c which form a market basket. Hence the inflation rate is the price change in the price of that basket over time.

Types of Inflation

Before I go on to answer the different types of inflation that exist in the world, first, you have to answer a simple question. What does it mean to be rich? A simple answer is, of course, having a lot of money. Then what if I gave you a million dollars and left you on an island where you cant buy anything. Of course, in that case, the million dollars you hold is practically useless. Hence, you being rich is not dependent on the amount of money you have but your purchasing power. i.e., the amount of stuff you can buy with the money you have.

Demand Pull Inflation

Now let me put you back in human society with that million dollars. Now you can buy stuff with that money, but so can everyone else. Demand-pull inflation occurs when the supply of goods is lower compared to the demand for those goods. If everyone else in the market has a million dollars, then the stuff which is in high demand will have a high price. Prices increase because the same amount of money is chasing after the same supply of a product. Hence you and everyone else will bid on the same product and increase its price.

A prime example of demand-pull inflation is the rise in the price of houses and also the reason behind the Tulip-bubble.

Cost Push inflation

Cost-push inflation is the result of companies pushing the rise in the price of making a product (rise in the price of raw materials and wages) onto their customers. If companies don’t do this, they will simply cease to exist. As long as the rise in price is not too extreme, companies can get away with it. This is because there is an expectation that people’s income rises over time, which means that people can afford to spend an extra 5 Rs to buy that packet of Lays.

Cost-push inflation is the main reason why the price of stuff keeps rising every year. Money might be infinite but the amount of resources that money can buy is limited. The result is a continuous rise in prices over many years. Of course, new technology has been solving the problem of cost-push inflation by optimizing production output but that is another vast topic for another day.

How do governments control the supply of money in the economy

We cannot possibly talk about inflation without talking about the supply of money. This is because an increase in the supply of money is one of the main reasons why inflation happens in the first place.

Whether you believe it or not, inflation is most commonly related to growth? How the fuck is me having to pay more money in the future to buy stuff is related to growth, right? Well, for an individual, this might seem like a bad thing, but for the economy, as a whole controlled inflation is actually a good thing. Emphasis on control.

When people have more money, spending increases, resulting in higher demand for goods and services in the economy. This leads to a need for an increase in productivity, which ultimately creates more jobs, and the economy as a whole can grow. Then why not keep increasing the supply of money, right? I will answer this question a bit later, but first, let us understand how governments increase or decrease the supply of money to control inflation.

Governments usually help to control the supply of money in two ways:

  • By Increasing or decreasing spending
  • By Increasing or decreasing taxes

Governments can increase spending by either taking on loans or printing more money (based on specific economic principles). The government increases spending by investing in social projects such as building roads, bridges, schools, nuclear powerplants, e.t.c. Government spending, in turn, helps to increase employment and the supply money in the economy by giving it directly(social security) or indirectly(employment opportunities) to the general public.

Decreasing taxes has a similar effect. Only this time you will have more money at your disposal because you don’t have to pay your government overloads and hence you can spend that money to buy that 50-inch screen you have always wanted. Decreasing taxes helps to increase consumer spending and vice-versa.

Consumer spending is important to sustain the economy because one person’s spending is another person’s income. So when incomes rise, so does the standard of living. So why not keep printing money, right? well the reason is an increase in governmental debt (a topic I will discuss in the hyperinflation section)

How the central banks control the supply of money and reserve ratio

Now, let’s understand how central banks control the supply of money. Central banks have the authority to increase or decrease the supply of money in the economy in accordance with the fiscal policy brought on by the central government. Hence central banks are really just a sugar daddy to our government overloads.

The central banks control the supply of money in the following ways

  • By Increasing or decreasing interest rates
  • By Changing reserve ratio of banks
  • And of course, everyone’s favorite, by printing more money.

To understand how changing interest rates and printing more money affects the economy, I would like you to read to my previous article where I explain how the economic machine works in detail, or you can check out this video by Ray Dalio.

In general, if banks increase interest rates, then people are less likely to borrow money. This is because people are more inclined to borrow money in the present only if they know that they have to pay less of it in the future. When people borrow less money, spending decreases, and as we all know that one person’s spending is another person’s income, the economy slows down as a result.

Understanding reserve ratio and how it influences the supply of money

Have you ever wondered what banks do with the money you deposit? Well, they invest it. Banks make their living by investing the money you deposit. But how could they? What if I need my money back? They can pay back your money because, like you, there are millions of other people who deposit money the same way. Banks have to keep a portion of each one of those deposits in their reserves (or vaults) as directed by the central government, which is defined by something called the reserve ratio.

Let’s say the central bank directs its local banks to have a reserve ratio of 4% (which is the Current reserve ratio of Nepal). But what does a reserve ratio of 4% actually mean, right? It’s simply saying that if you go to a bank in Nepal and deposit 100 rs, then the bank has to keep 4% of that (4 Rs) in their vaults as a reserve and has the ability to invest the remaining 96 Rs in whatever the fuck they want. But isn’t that stealing. Well, it depends on how you look at it, but that is how the modern banking system works.

I will tell you another secret. Banks can actually multiply the amount of money you deposit. The 1000 Rs. that you deposited can be converted into 5000 Rs. (at a 20% reserve ratio). In order to understand how this works, you can refer to the image below.

Inflation and reserve ration how it all works
Remember that the actual money deposited is only the first 1000 Rs.

In order to find out the multiplication factor by which the deposited money is multiplied, all you have to do is divide 1 by the reserve ratio (i.e.1/0.2=5). This tells us that the total supply of money in the economy can be increased by decreasing the reserve ratio. With a reserve ratio of 4%, 1 Rs deposited in any bank of Nepal can be converted into 25 Rs (i.e., 1/0.04=25)

Note: Decreasing the reserve ratio does not automatically increase the supply of money in the economy if the banks do not choose to use that extra cash. Banks would most likely try to maintain a substantial reserve in order to circumnavigate an economic crisis. Like of which we are experiencing at this very moment.

What is Hyper-Inflation?

So now its time to answer the ultimate question of, why not keep printing more money? If there is an excess supply of money, you may end up creating a situation where a lot of money is chasing after a limited number of products. The problem, in that case, is the limitation in resources and productivity. i.e. the amount of stuff a country can produce within a time period, say a year. If a country reaches its maximum production capacity, then adding more money into the system cannot incentivize more production. Therefore printing more money, in that case, will only result in inflation and a lot of spending by the consumers. This is because a rapid increase in prices creates anticipation of higher prices in the future.

Anticipation of price increments incentivizes people to spend their money faster. This is because the money they hold right now would quickly lose its purchasing power in the future. And as I said before, it’s not about the amount of money you have but the amount of stuff you can buy with that money. Rapid spending creates more inflation through increasing demand, and if a government keeps printing more money, then it would create unsustainable inflation that will eventually destroy the entire economy.

The only way out this economic clusterfuck, as far as I know, is either by creating a new currency entirely or by using an already stable currency like the dollar (Which is what many countries have done in the past).

To fully understand what hyperinflation can do to a country, let us look at Venezuela and what happened there. Corruption, along with economic mismanagement and an authoritarian government, has led to hyperinflation so bad that the government refuses to even share any official data. So Bloomberg created “The Cafe Con Leche Index” that measures the price of a cup of coffee in eastern Caracas. In March of 2018, that cup of coffee cost 1.2 bolivars, and in May of 2020, that same cup of coffee costs 1,80,000 bolivars. Paper money in Venezuela is practically worthless, and things have gotten so bad that almost a third of the population has left the country. 

venezuala-hyper-inflation
Image to show the worthlessness of Vezenulan currency

To make sure that inflation is not allowed to run rampant, the central governments and the central banks have to keep a very close eye on the amount of money flowing in the economy and the rate of inflation.

How to adjust your financial freedom number to account for inflation

In the last article, I talked about how you can find out the amount of money you would need in order to be financially free. But I hadn’t adjusted that number for inflation. Let’s look at an example and try to understand how you can adjust your financial freedom number to account for inflation.

Let’s say you don’t want to take any risk with investing your money and want to attain your financial freedom by savings alone. Let us assume that your financial freedom number is 50 Lakhs.

If inflation did not exist, then it would be a simple algebra problem. If you started to save at 20 and wanted to retire at 60, then you would need to save (50 lakh/(40 years*12 months)) 10,416.67 Rs every month in order to attain your financial freedom.

But because inflation exists, that number will be a lot higher. Let us assume that inflation for the next 40 years gets maintained at a conservative annual rate of 4%. Then to maintain the same purchasing power of 50 Lakhs, 40 years later you would need a total of (10,416.673512*4) 1 Core 75 lakh rs. So to attain your financial freedom, you would need to save around 36,458.3 Rs every month. I know, this number seems daunting and almost impossible if you do not already have a good job or a substantial source of income.

Above is the reason why many will never be able to escape the middle-income threshold. If that is the case, then is attaining financial freedom impossible? Well, no, because there is a way to achieve financial freedom and that is by investing. To understand this, lets us look at how inflation affects wages and the securities market (stocks and debentures).

Note: Reaching financial freedom through savings alone is difficult because inflation slowly eats away at your savings over time.

Effect of inflation on wages, and investments (Securities)

One Sunday morning you go to your office and all of a sudden you get a raise of 5% in your salary. You are so happy you go home and want to break a bottle of champagne to celebrate. Before you do all that, understand what would happen if the inflation rate that year is at 7%. A raise of only 5% means that you actually ended up losing 2% of your purchasing power that year regardless of the increase in your salary.

So instead of breaking that bottle of champagne, you should rather break a bottle of cheap beer on your bosses’ head for cheating you and be sure not to blame it on me. Hence, an increase in the rate of inflation directly cuts your wage.

A similar thing happens with debentures. Since debentures provide a fixed amount of return every year, the profit you make will be directly affected by inflation in way that is identical to wages.

However, the stock market is affected less by inflation. This is because a rise in inflation ( increase in the supply of money) usually but not always (during the economic crisis) stimulates the economy. Also, due to cost-push inflation, whatever rise in the cost of making a product by a company is pushed directly onto the consumer, which protects most companies from the most adverse effects of inflation. Hence investing in the stock market (stocks or mutual funds) is probably the best way to reach your financial goals instead of letting all your savings stay in a vault somewhere.

I would personally recommend that if you are young (20-30), you can invest 80 percent of your investment cash in stocks or mutual funds and the remaining 20% in debentures and fixed deposits. You can also invest in a good company as a promoter if you feel like you can make a better return. The moral of the story is to invest than to let termites eat away at your savings.

Note: Dont invest the money that you would need in the immediate future. That is simply a recepie for disaster.

Summary

  • Inflation is not a bad thing in and of itself
  • Consumer spending a lot of money is good for the economy as a whole and bad for the individual
  • Prices of all things in the economy do not inflate uniformly at the same time
  • Increase in demand faster than the supply causes demand-pull inflation
  • A rise in the cost of making a product in high demand causes cost-push inflation
  • Banks keep a close eye on the money supply to control inflation
  • Reserve ratio helps to identify how much imaginary money is out there in the economy
  • Hyperinflation can cause many problems
  • Your financial freedom number, when adjusted for inflation, looks very daunting.
  • The only way to protect yourself from inflation is by investing.

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