Money is a mysterious thing. It is the fuel on which everything runs. At times it is everything, at times its nothing. It is what creates huge dams, roads, railways and entire countries and it is what annihilates an entire civilization. Money is magical and it is what everyone desires and it is what is the answer to everything - this is the view most people hold. At-least most people hold the view that money is the solution to most of our economic problems, poverty being the main one.
Kya bolti hai kya cheez hai paisa?
All the luster and magic is gone once you look at money from an economic view point - as a simple financial instrument. My father being in the Reserve Bank of India (RBI) talks to me a lot about money, the intricate ways it work and having taken a few courses in Financial Management and Economics I don't find the basics to be too complicated. In fact an understanding of demand and supply is all one needs to understand money. I thought I would share these ideas at this time mainly because of sudden news of 1.5 trillion dollars (40% of GDP) of black money laying in swiss heavens and how bringing it back can solve many problems including poverty. The times when my father used to work in the vaults with billions of rupees of money in them our house contractor in his naive mind couldn't help but ask - "Can't you just open the vault and distribute the money? It would solve so much of our problems...".
To understand how money works lets think of a hypothetical situation. You along with 10 000 more people are stuck in an Island, the same island that was shown on LOST. So as you have guessed no one is coming for your rescue. You being so smart and handsome are selected by the fellow survivors as the king. You came up with the idea of using currency rather than primitive barter system. You also happen to have a press that only you can operate to print money that is impossible to forge. So first question is how much money should you print and how will you decide who will get how much? May be you can start off with gold which happen to be with most of the people there and fix 100$ (assuming you named your money $) as worth 1gm of gold. You being the government also started large projects of building bridges, shelters, fishing boats and stuff. So now people have two ways of getting money - deposit the gold they have and work on the government projects. So with the economy established people go about their daily lives - earning and spending money. As time progresses you realize something - every time money changes hand some value is generated but the money itself is not destroyed. That is say if I give 100$ to you, you deliver value worth 100$ to me; now you give the same 100$ to someone else and you still get value worth 100$. So if the same 100$ changed hand 10 times it has created value of 1000$ yet the physical money is still 100$ only. As time progresses with people working hard earning a lot and spending a lot there is a sudden demand for more and more money. You come up with Banks - which can borrow and lend more physical money to the inhabitants. People start taking money from the banks but that money is again deposited back into the same banks. This is an interesting situation. Suppose a guy deposits 1000$ in the bank, the bank then lends the same 1000$ to someone to buy a house who then writes a check to the builder who has an account in the same bank! The bank created 3000$ with just 1000$ of real money. You realized that this situation can go out of control if the bank indiscriminately starts lending money or if for some reason all costumers of the bank lose faith and ask for their money on the same day. So you devised cash reserve ratio (CRR) - a percentage of the deposits that must be kept with you. If you fix it at 20% then the bank can lend only 80$ for 100$ deposit and 64$ if the 80$ is again deposited back in the bank and so on... You realized varying the CRR can have significant impact on how much money floats in the economy. So from now on your single most important task was to see what is the true demand of money based on true value generated in the system and maintain a supply of money that is as close to it. Every time the amount of money in circulation is larger than the true value generated in the system - your money loses its value causing inflation. A situation you realized is good if kept in control because it excited people to do more work and generate more value (if they just hold on to the money it will lose its value and they would be at loss). While the other situation where amount of money is less than the true value in the system - your money gains value causing depression. A situation that is very risky - because suddenly it makes people think that the same amount of money can get them more value if they just hold on to it (or other way of seeing this is the products are getting cheaper and cheaper with time). As people stop spending, the amount of money in circulation plummets even more (no increase in money because of change of hands, and no one is interested to take loans - everyone wants to deposit) causing even more depression. A situation that could be catastrophic. You realized how important it is to maintain the amount of money in circulation to reflect the true value of the system by controlling CRR and other methods like Government bonds. You can't just distribute money as you wish just because you can print as much as you want!! You realized the grand truth that MONEY is JUST A (NOMINAL) UNIT to QUANTIFY GENERATED (REAL) VALUE
This brings me to a more rigorous analysis of Money using the equation of exchange and quantity theory of money proposed by Keynes et al.
is the total nominal amount of money in circulation on average in an economy
is the velocity of money, that is the average frequency with which a unit of money changes hand.
is the price level or the "worth" of a unit of money
is an index of real expenditures or "real value" generated in the system.
Note that no assumptions are made in forming the equation. Although how one interprets the equation and what assumptions are made on the quantities involved results in various models of money. What is much more interesting compared to this original equation is the derivative of relative terms with time.
is the inflation rate
is the rate at which money is injected into the system
is the rate change of velocity of money
is the rate at which real value is increasing.
This equation in a very elegant way explains money. Now lets analyze what will happen if we bring the money laying in swiss banks which account for a large percentage of GDP back to India. So now -
will increase dramatically
The increased money will cause large spendings there by increasing velocity by a comparable amount
The rate at which real value is increasing still remains constant compared to others because the money injected was artificial and did not represent any real value.
and the result is -
is the inflation rate goes through the roof. In short term it will cause so much depreciation of value of money that the now increased (nominal) money will still represent the same (real) value. In long term the increased inflation which certainly is way higher than safe values will cause considerable damage to the economy.
The money laying there is useless because it does not represent any real value. It is as good as stationary (a term used by RBI for money printed but not in circulation). Which brings me to the final conclusion of this rather long article.
Poverty is NOT lack of money. It is the inability to generate any real value either because 1. the (poor) guy is worthless 2. The government and other private organizations are failing to provide opportunities 3. a combination of both.
Unless and until government realizes this simple concept our country will be plagued with poverty and under-development. The government still choses the destructive path of giving free food to the poor rather than giving job to them and in the process make them more worthless (if they are not already). I hope all those reading this article make it big in the task of real value generation. Give jobs to thousands of people and take India to new heights.
Disclaimer: I'm not an economic major (or minor) so the opinions expressed here are best to my knowledge and may not be correct in every aspect. I would encourage those with better understanding of economics to shed light on the matter.
Print This Post