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 t o 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 question is: why is that so: How come 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.

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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.

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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 allows 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 money multiplier, m, is the inverse of the reserve requirement, RR:

Just what the hell is RR – the reserve requirement: Lets understand what money-multiplier 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

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Let’s see what are the possible answers for the poi nt [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 fo llowing 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).

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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 intuition quantified through an equation:

–> 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 MONETA RY 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..