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January 20, 2016

Why not just print more money?

Wouldn’t We All Be Wealthier If We Printed More Money?

If we print more money, prices will rise such that we’re no better off than we were before. To see why, we’ll suppose this isn’t true, and that prices will not increase much when we drastically increase the money supply. Consider the case of the INDIA. Let’s suppose the INDIA decides to increase the money supply by mailing every man, woman, and child an envelope full of money. What would people do with that money? Some of that money will be saved, some might go toward paying off debt like mortgages and credit cards, but most of it will be spent. I know the first thing I’d do is go down to some mobile showroom and buy a IPhone or Samsung Galaxy.

I’m not going to be the only one who runs out to buy a IPhone. This presents a problem for Mobile Sellers. Do they keep their prices the same and not have enough IPhone to sell to everyone who wants one, or do they raise their prices? The obvious decision would be to raise their prices. If Sellers (along with everyone else) decides to raise their prices right away, we would have massive Inflation, and our money is now devalued. Since we’re trying to argue this won’t happen, we’ll suppose that retailers don’t increase the price of IPhone. For the price of IPhone to hold steady, the supply of IPhone will have to meet this added demand. If there are shortages, certainly the price will rise, as consumers who are denied an IPhone will offer to pay a price well in excess of what Retailer was formerly charging.

For the retail price of the IPhone not to rise, we will need the producer of the IPhone, to increase production to satisfy this increased demand. Certainly this will not be technically possible in some industries, as there are capacity constraints (machinery, factory space) that limit how much production can be increased in a short period of time. We also need APPLE not to charge retailers more per system, as this would cause retailers to increase the price they charged to consumers, as we’re trying to create a scenario where the price of the IPhone won’t rise. By this logic we also need the per-unit costs of producing the IPhone not to rise. This is going to be difficult as the companies that Apple buys parts from are going to have the same pressures and incentives to raise prices that retailers and Apple do. If Apple is going to produce more IPhone’s, they’re going to need more man hours of labor and obtaining these hours cannot add too much (if anything) to their per-unit costs, or else they will be forced to raise the price they charge retailers.

In short prices will go up after a drastic increase in the money supply because:

1. If people have more money, they’ll divert some of that money to spending. Retailers will be forced to raise prices, or run out of product.
2. Retailers who run out of product will try to replenish it. Producers face the same dilemma of retailers that they will either have to raise prices, or face shortages because they do not have the capacity to create extra product and they cannot find labor at rates which are low enough to justify the extra production.
3. The supply of money goes up.
4. The supply of goods goes down.
5. Demand for money goes down.
6. Demand for goods goes up.

We’ve seen why an increase in the supply of money causes prices to rise. If the supply of goods increased enough, factor 1 and 2 could balance each other out and we could avoid inflation. Suppliers would produce more goods if wage rates and the price of their inputs wouldn’t increase. However, we’ve seen they will increase. In fact, it’s likely that they’ll increase to such a level where it will be optimal for the firm to produce the amount they would have if the money supply had not increased.

This gets us to why drastically increasing the money supply on the surface seems like a good idea. When we say we’d like more money, what we’re really saying is we’d like more wealth. The problem is if we all have more money, collectively we’re not going to be any more wealthy. Increasing the amount of money does nothing to increasing the amount of wealth or more plainly the amount of stuff in the world. Since the same number of people are chasing the same amount of stuff, we cannot on average be wealthier than we were before.

How Money is Created and how it works ?

In the past money was backed by precious metals like gold or silver. At that time it was theoretically possible to take your money to the bank and exchange it for an equivalent value in precious metals.

Today this is not the case anymore. The last western country with a gold backed currency was Switzerland. When Switzerland joined the International Monetary Fund in 1992 they were forced to abandon the gold backing of the Swiss franc.

Coming to types of money there are types:-

1. Everlasting Money.
2. Spendable I OWE YOU(IOU’S)

Let me say what is an Ordinary IOU for your brief understanding.

Say there are 2 friends A and B, B In Need of Money asks Rs.100 to A, A for the sake of evidence asked a letter of IOU. B Wrote IOU in a piece of paper and given to A for which A gave him 100 rupee note.

Now what’s the position of A with IOU paper, tomorrow can he buy any stuff outside with the piece of paper given by B, it’s quite Impossible.

What will happen to the piece of paper if B repays it, B takes the Piece of Paper and destroys it.

Can we say the piece of paper in above example is spendable IOU, no it is not ,say this paper is attested by some bank and discloses that it can be treated as Medium Of Exchange(Eg: Negotiable Instrument) , then this would convert non spendable IOU into spendable IOU.

Let us see another example with Interest.

For simplification sake let us consider there is only one bank in the system.

X has made an offer to sell his car for Rs.1000, y in need of a car goes to Z bank and borrows 1000 @10% Interest, now x made a sale and deposited 1000 in the same bank which in turn bank pays 5% interest, thus banks created money out of nothing.

This is how money works. Let me share one link with you so that it would be clear for you that money is created when banks extend their loans. sbi

In the above link it is clearly said that , As SBI raised the loans to Oil Companies they borrowed funds from RBI by paying Repo rate @ 7.75%.

TO get into little complex Interest in a Debt based Monetary System.

Interest in a debt-based monetary system

As you just learned, the creation of new money in a debt-based monetary system always requires that somebody takes on new debt. But any debt does not only have to be paid back in the future it also requires a payment of interest on top of the initial loan. Since the interest has to be paid also in form of money, this situation creates an insolvable problem : When money is created by someone taking on debt, only the exact amount of money equaling the loan is created. When the loan is paid back additional money is needed in order to pay the interest. Certainly there is other money in circulation than just the money of this loan and the person owing the loan could work in order to earn money and thus pay back his loan and the interest. But if you take a look at the entire system including all money in circulation, then ALL money in circulation is in existence because somewhere somebody took on a loan and this loan needs to be paid back WITH interest. So it should be clear that there is ALWAYS a lack of money in the system equal to the interest required for all issued loans. Due to the overlapping of the various credit periods, this problem is not directly visible but if all loans in the world had to paid back on one particular day, it would become obvious that only the loans themselves could be paid but there would be no money left to pay the interest.

Thus in a debt-based monetary system the amount of money in circulation is forced to grow indefinitely due to the interest mechanism. The additional money required in order to pay the interest has to be created by issuing new loans to somebody. If private individuals and companies decide not to take on new debt (or they simply can't) then there is only one credit receiver of last resort : The government. Thus the government has to constantly increase the amount of national debt in order to inject new money intothe system. At this point it should be clear that any political rhetoric about "putting a cap on new government debt" is pointless. The government has to go increasingly into debt and paying back the national debt is IMPOSSIBLE. There is not enough money in circulation to pay back the entire national debt plus interest and any repayment of government debt without instantly creating new debt withdraws money from the system. The amount of money in circulation has to grow constantly. That is the reason why almost every time a government bond is due the money required to pay back this loan is simply created by issuing a new government bond and using the money from the new bond to pay for the old bond that is due. After all a debt-based monetary system is a Ponzi scheme legalized by the government and it will come to an end just as any other Ponzi scheme eventually came to an end .

National bankruptcy and monetary reform

The term national bankruptcy describes the situation when the government of a country can’t meet its payment obligations - in other words they run out of money. This can only happen if the government neither can raise money by taxes or by issuing new government bonds. Issuing government bonds becomes increasingly difficult if potential buyers loose faith in the ability of the government to pay back their debt. In this case only the central bank can help out by making use of their monopoly to create money out of thin air in return for receiving government bonds. This process of turning government bonds into new money is also called "monetisation" of government bonds.

Since monetisation of government bonds causes an increase of the amount of money in circulation, the money which was in circulation before this monetisation looses part of its value - especially if large amounts of government bonds are monetised. This loss in purchasing power is also referred to as inflation. Within a debt-based monetary system there is no limit to the amount of money the central bank can create. Thus this process usually causes hyperinflation, which implies that money rapidly looses its purchasing power.

The term hyperinflation is generally used if the rate of inflation exceeds 50% per month or - due to the effect of compound interest - 13000% per year.

Hyperinflation causes a flight into real assets e.g. precious metals, which do not loose a large amount of their value during hyperinflation.

This is a list of countries which experienced hyperinflation in the recent past. Usually this is not a topic covered by the mass media because it is too explosive : Austria, Hungary and Poland (1921-1924),

Greece (1943/44), People's Republic of China (1949/50), Bolivia (1985), Nicaragua and Yugoslavia (1988), Brazil and Argentina (1989/90), Russia (1992), Georgia (1992-1994), Angola (1994-1997) and Zimbabwe (2006-2009).

Hyperinflations usually end with a monetary reform. During a monetary reform the old currency becomes practically worthless and is replaced by a new currency. In this process different conversion rates apply for cash, deposits and debt. A national bankruptcy is the main cause for a monetary reform. Government bonds are usually devalued more heavily than all other forms of debt. The government, corporations and sections of the population are treated unequally in this process.

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