As the intent here is to illustrate principles and specific points, simple analogies will be used, studied in extremes. Simple illustrations with locked in variables will be employed. If these views are correct, then more complex models with more variables will provide the same results, given that one has sufficient time and the patience to work through the details.
Here will be presented an illustration in two forms. The first will illustrate what the purpose of inflation is NOT and the second will illustrate what the purpose of inflation is.
Here is a set of facts to work with for this exercise:
- Imagine a country
- With exactly five (5) guys
- Imagine that they each have ten gold coins valued at ten dollars each
- Imagine that they like using receipt money, so their coins are in a vault
- $100 each * 5 guys = $500 Total Money Supply
- Imagine that corn is priced at $1 per bushel
Illustrating what the purpose of inflation is NOT...
In this imaginary world, the five guys have an economic summit on January 1st each year. In year one, they meet and then go about their business. In this simple low velocity economy, each man uses his one hundred dollars in receipt money to purchase 100 bushels of corn.
In year two they meet and decide to “lubricate” their economy so they can be like the neighboring countries. They print an extra one hundred dollars each in receipts, thereby giving each man two hundred dollars.
$200 each * 5 guys = $1000 Total Money Supply
Has the wealth of their nation increased?
The answer is no. The paper is costless and therefore valueless in its own right. The paper references the same gold coins and therefore each receipt is now worth half as much. They still only have $500 in gold in the vault.
Has the value of the corn changed?
The answer is no. The corn has the same nutritional value and other value attributes as it did before someone pressed the “print button.”
Has the price of the corn changed?
The answer is yes. Since the receipts are half as valuable and the corn retains its same value, one now needs to spend two dollars (in terms of inflated receipt money) for each bushel of corn.
How many bushels of corn can each of the five guys purchase with their $200 of old and new receipt money? Corn is $2 a bushel now so they are able to purchase exactly what they could before; 100 bushels of corn. Nothing changed.
Therefore, one can see that inflation serves no purpose if everyone gets the new money on the same day. So what is the purpose of inflation?
Illustrating what the purpose of inflation is...
Let’s begin again with the five guys as at the very beginning. This time on January 2nd in year one, one of the five guys decides to become a beloved central banker. He decides to print an extra $500 in receipt money, place it in the bank and then borrow it.
Has the wealth of their nation increased?
The answer is no. The paper is costless and therefore valueless in its own right. The paper references the same gold coins and therefore each receipt is now worth half as much. They still only have $500 in gold in the vault. Yet in this case, the paper in the other four guy’s pockets lost half of its value; the banker enjoyed an increase in purchasing power at least equal to their loss.
Has the value of the corn changed?
The answer is no. The corn has the same nutritional value and other value attributes as it did before someone pressed the “print button.”
Has the price of the corn changed?
The answer is yes, but not yet. Since the receipts are half as valuable and the corn retains its same value, one now needs to spend two dollars (in terms of inflated receipt money) for each bushel of corn. However, the other four guys do not know about the new money so they continue to trade at the price of $1 per bushel.
Consider how this plays out. The banker has $600 dollars to spend. To keep the math simple, one can assume that the price changes do not occur until the January 1st summit a year from now. The four guys are going to be quiet, but happy, because each thinks that he is making really big money this year as his account swells from $100 to $200, since the banker is purchasing more corn than normal. For the purpose of illustration, it is specified that each of the four guys winds up with $200 dollars and one hundred bushels of corn. The banker, on the other hand comes away with 600 bushels of corn.
At the summit it quickly becomes clear that the banker has inflated the money supply, which halved the value of the dollars already in existence. The farmers should have been selling corn for $2 a bushel and clearly in the upcoming year they will only be able to buy 100 bushels of corn with their $200 dollars.
Since everyone ended up with the same amount of dollars relative to one another, one might conclude there is not really any harm done, but that conclusion would be wrong. Remember that the banker now has 600 bushels of corn when he should only have 100 bushels.
So now one can see the purpose of inflation.
When inflating with costless money, the purpose of inflation is to use NEW MONEY to purchase REAL ASSETS at OLD PRICES, thereby causing a wealth transfer from the people who get the new money last, toward the people who get the new money first. - Shane Coley
Observe the illustration closely. Whose money was the banker giving to each of the other four guys when he made his purchases of corn? The banker was actually giving the other four guys their own money back again and taking the fruits of their labor at the same time. What does this mean for those who are members of a society which operates under an inflationary monetary system?
Perhaps these illustrations help explain this popular quote attributed to a past Chairman of the Bank of England from a talk at the University of Texas in 1927:
Banking was conceived in iniquity and was born in sin. The bankers own the earth. Take it away from them, but leave them the power to create money, and with the flick of the pen they will create enough deposits to buy it back again. However, take it away from them, and all the great fortunes like mine will disappear and they ought to disappear, for this would be a happier and better world to live in. But, if you wish to remain the slaves of bankers and pay the cost of your own slavery, let them continue to create money.
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