Friday, February 17, 2012

Does Printing Money Really Causing the Inflation?

Almost everyone knows that inflation is defined as “Too much money chase too few goods”, butnot many people know what causes inflation. The majority of people believe that the process of printing money by the issuing authority such as the Federal Reserve is the culprit that causes inflation;however, it is not right. In this article, I will use a theory that has been thoroughly ignored among mainstream economists to explain why it is wrong and what is the true cause of inflation. This is known as “The Real Bill Doctrine” or  “Backing Theory”.

In ages, the majority of macroeconomists have always emphasizes the positive relationship of “inflation” and “money supply” (the total amount of money available in the market at specific time). They believe an increase in money supply will proportionally increase the price level, which will lead to inflation. These economists are referred as “Quantity Theorists.”Their belief comes from the “Equation of Exchange”, which is MV=PY. “M is the quantity of money, P is the price level, and Y is aggregate output. V is velocity, which serves as the link between money and output. Velocity is the number of times in a year that a dollar is used to purchased goods and services.” (CH21, TheDemand for Money) As a result, this equation tells people that an increase in M will lead an increase in P.

Indeed, if we assume that all the Federal Reserve does is print money and sprinkle them by helicopters from the sky, then no doubt it will cause inflation regardless of any theory.  However, that’s not the case in the real world because whenever the Federal Reserve issues new paper money, they can’tjust throw them into the market, but instead they have to use that money to purchase different assets that are equivalent to the value of the money they issued. The asset can be anything such as foreign government bonds, bank bonds, land, etc. This process of using issued money to purchase equivalent value of assets is called the “Backing Theory”.

The Microeconomics professor Michael Sproul, who is currently teaching in the University of Southern California, named the “Backing Theory”. This theory can be traced back to the “Real Bill Doctrine”, which can be found in the writing of John Law (1705), Simon Clement (1710), Adam Smith (1716), and many others. Unlike the Quantity Theory, the Backing Theory states that an increase or decrease in the money supply will normally have no effect on the price level as long as the money issuer has sufficient assets to cover redemption. To reconcile the Backing Theory with the equation of MV=PY, the Backing Theory says an increase M (money) will increase Y rather than P because Y is not the aggregate output of goods, but the quantity of goods bought with M. 

The following is an example that I created to explain the cause of inflation in Backing Theory perspective.
Text Box: Assume 1 oz. silver = $1 and they are convertible to each other                                                                    The Federal Reserve gets 50 ounces of silver from the Tommy Trojan for deposit. Bank prints $50 paper dollars for Tommy as an exchange of silver.     ASSET           LIABILITIES

1) 50 ounces      $50 paper bills
    of silver     

Text Box: The Federal Reserve prints another $100 in paper bills and lends them to Jeremy Lin as an exchange of 100 oz. IOU. The backing asset has increased in step with the issue of paper money, so each $1 is worth one ounce of silver, and it is convertible at any time. As you can see, there is no inflation in the market due to print money if issuer obtain adequate backing asset.

2)100 ounce      $100 paper bills
IOU of Silver     lent to Jeremy Lin

Text Box: Suppose Federal Reserve prints another $100 paper bills and spent them wastefully in 901 bar. Notice this time Federal Reserve did not receive any adequate asset to back the paper money issued. As a result, the total asset at this point is 150 oz. of silver. The total liability of Federal Reserve is $250 paper bills. After a simple calculation, we get $250/150 oz. = $1.67 per oz.

3)0                 $100 paper bills
                        spent wastefully

In the calculation of line 3, we noticed that there is inflation in the market because each ounce of silver is now worth $1.67 paper dollar. Ifthe Federal Reserve still maintains the convertibility of 1 oz. = $1.00, then people will run to the bank and convert their money back into silvers. Unfortunately, there is only 150 ounces of silver to withdraw, so the last person who’s holding $100 paper will get nothing, and result in bankruptcy. If bank wants to avoid bankruptcy, the only way is to “suspend convertibility”, which means people cannot bring their paper bills to the bank teller to ask for an exchange anymore. The consequence of “suspend convertibility” is that the market will always maintain the inflation, $1.67/oz.

This example can apply to the real world too. Today, our Federal Reserve prints money in exchange of equal value bonds from the local banks, bonds from corporations (bailout), bonds from other countries, and other types of assets. We have inflation is not because of the action of “printing paper”, but because the depreciation of the asset that is backing the money. The depreciation can result from devaluation of foreign government bonds (if the foreign country is having a recession, their bond value will fall), default of banks and corporations etc.The U.S dollar we are using todayis called “fiat money”, which defined as “inconvertible currency”. This type of currency allows Federal Reserve to print money without worrying bankruptcy, but results in inflation.

After all, it is obvious that Backing Theory’s explanation towards the cause of inflation seems much more convincing than the Quantity Theory.

Exhaustible Recourses Will Never Run Out!

For centuries, people have been worried that exhaustible resources,such as oil, will eventually run out. By researching on internet, you can easily find something like this, “BP's Statistical Review of World Energy, published yesterday, appears to show that the world still has enough "proven" oil reserves to provide 40 years of consumption at current rates. The assessment, based on officially reported figures, has once again pushed back the estimate of when the world will run dry” (Daniel Howden, 2007). I believe you can always heard predictions like this from scientists about how“we will run out of oil” in the daily news or online articles, even though they have been proven wrong again and again. As a matter of fact, any economist will tell you that we will never run out of oil.

In Economics, there is a term called the “Invisible Hand”. It simply metaphorizes the supply and demand that guides free market through competition for scarce resources. In other words, as oil becomes more scarce, the quantity of supply decreases and the price increases. This result will affect both demand and supply. On the demand side, people start to purchase less oil due to increase in price. They might also start to look for substitutes that are more affordable compared to gasoline. On the supply side, price increases on inelastic goods will increase revenue, which leads to extensive drilling. More drilling will lead to a more scarce supply of oil, and the scarcity of this supply will drive prices higher and higher. The price will keep rising until it reaches a point where gasoline becomes a niche good purchased by very few consumers. However, this does not necessarily means that people will drive less. It means that people should have already discovered or invented other alternatives to substitute gasoline such as natural gas, or hybrid cars.

Once we understand that the “invisible hand” automatically conserves exhaustible resource for us, it is clear that various conservation energy programs imposed by government is superfluous.

The following graph is a cost and benefit analysis of energy conserve program. This graph will show you the gain and loss of the community.

(P=Price, Q= Quantity)

The vertical line S is the supply curve for the oil. Since the amount of the oil is fixed, let us assume it will always be 100. The D1 represents the community’s demand for oil in next year, which is 40 units in this case. The D0 represents the demand for oil in this year, which is 60 units. Now let us just focus on the area A, B, and C, which will tells you the cost and benefit of our society. By imposing on the energy conservation program, the community of next year will gain from 40-45 units, that is the benefit represented by the area of A.At the same time, this year community needs to conserve oil from 60-55 units, which will lose the area of B+C. Needless to say, B+C is bigger than A, which means the loss of this year is bigger than the gain of next year. Therefore, the total community is worse off than without impose conservation program.

From this example, now you can see that any government’s attempt to save resources will actually waste more than it conserves. You can treat this as an example of opportunity cost. This years’ community loss is an opportunity cost to conserve resource for next year. To understand this, imagine when you try to recycle plastic bottles. You spend times to gather all of the bottles to a space, and drive to Recycling Station in exchange for few dollars. Have you thought about the cost of your time, plus the cost of your space, plus the cost of your gasoline has already exceeded the benefit of recycling? I am not trying to say that the entire recycling program is futile, but trying letting people be aware of the fact that recycling are not as effective as we thought when we take opportunity cost into account.

Economics Let You See the Hidden Cost of Your Daily Life

Economics has been defined in many ways. Some people believe Economics is all about money; some people believe Economics is all about wealth of nations; I believe Economics is all about making rational choices. Life is full of choices because our resources are limited (time, money, etc.). But our needs and desires are unlimited. So, how can we fulfill as much desires and needs as possible with limited resources? We have to prioritize the needs and wants, to allocate the resources and use them in the most efficient way.

Opportunity Cost
An opportunity cost is the cost of spending your time, money, and energy on one thing, instead of another thing. Every time when you make a choice, you are facing a direct cost and indirect cost. The direct cost represents the cost you choose to pay. For example, when you take money out of your wallet to pay for food, goods, and services; this is direct cost. An indirect cost example would be when you take money out to pay for foods, goods, and services; you automatically sacrificed the other possibilities to spend this money.  This indirect cost is referred as Opportunity Cost.

Opportunity cost triggers when you choose one option over another. It is an action of brainstorm the benefit and cost for each option, includes all direct and hidden cost, use your logic to determine which option will maximize your utility (the greatest value you can derive from making the decision). Although people try to make the best decision they can in every situation they encounter, it is very easy to disregard the opportunity cost.
Everyday there’s a lot of people think they just made a smart decision but actually not because they forgot to take opportunity cost into account. For example, I noticed many students try to save their notebook paper by write tiny word and try to fill out the entire page before flip to the next. However, the hidden cost of doing that is it hurts your eyes while reading and lowers the efficiency while organizing and studying, and the long-term cost is their vision will degrade faster than they usually would.

Another example would be one of my friend lives thirty minutes away from school (with traffic one hour), and he told me he wants to commute to school instead of rent an apartment nearby for save money purpose. All he considered was the gasoline cost for a month is cheaper than the rent cost but ignored the hidden cost that he will spend about two hours per day for driving plus the percentage risk of getting a car accident. These examples are just telling us that opportunity cost exists in every decision of our life.
As you can see, opportunity costs play a big role in personal finances. Every choice that you make in life has an opportunity cost attached to it, even if it is not easily seen. An opportunity cost doesn’t only include monetary costs, but it includes all real costs of making one choice over another, including the psychic profit of lost time, energy, and pleasure.

Sunk Cost
Like the opportunity cost, there is a “sunk cost” is another indirect or hidden cost. It is also exists in our daily life and affecting our decision-making. It is a “cost that has already been incurred and thus cannot be recovered.” A “rational actor,” as economists say, will completely ignore the sunk cost. When you take the sunk cost into account while making a decision, it is considered to be irrational. For instance, assume you purchased 100 shares of stock that worth $500, but after a month they falls to $50. The $450 you lost is a sunk cost and it is already irrelevant to you now. If you choose to hold that stock because you think you bought it for $500, you are making an irrational decision. From a completely rational perspective, you should abandon the original cost and only consider the prospect of the stock. If you believe the stock will keep falling, you should sell the stock to prevent future lost.

This also applies when you try to sell something you just bought or bought before. Many people said “I’m not going to sell it at this price, I paid ten times more than that.” No matter how much you spent originally, it is independent.When you are making the decision of sell or not sell, you should only compare the remaining value of the object with the price that buyer offers, not how much you paid for.After you start pay attention to the sunk cost, you will be able to make the best decision for each situation.

Since we are making choices all the time, the awareness of opportunity cost and sunk cost becomes significantly important in our daily life. Although it is very difficult to always consider these hidden costs into account, I would still encourage you to think about what else you could do with your money and time; think about these foregone opportunities when the next time you decide to spend those precious dollars, or spend your time doing something that does not maximize your life expectation. Last but not least, no matter how wealthy we get, resources are always limited, and therefore we should consider rationally in all the decision we make.