So You Want to Know About Economics

by Roopa Pai

  At first, A and B benefited from the extra money they received and were able to buy a box of mangoes for ₹50. They would not have been able to do so if they didn’t have the extra money. But in the end, everyone lost out. Yes, even Alphonso, despite making all that extra money (he made ₹340, instead of the ₹250 he would have made had he sold his mangoes at ₹50 a box).

  How? Because, when Alphonso goes out to buy bananas the next day, he will find that the price of bananas has gone up too (because A, B, C and D have decided to spend their leftover money on bananas, and the sudden demand for bananas has pushed the price of bananas up). If you extend this example to many more people suddenly coming into money and a LOT more money in the ‘money pool’, you can see how the prices of many other goods will also go up, in a domino effect, sending prices up as a whole. That’s why it’s sort of silly for governments to simply print money and give it to people. It not only doesn’t help the poor, it is bad for everyone.

  This kind of increase in the general level of prices of things is called inflation. There are many reasons that inflation occurs, but one of the reasons is ‘more money in the system’ (see page 92 for more details). Inflation is generally considered a bad thing because it decreases the value of the money you have.

  Despite knowing how this works, governments do print more money every year. One reason is of course to replace the torn and old notes in the system, but the second is to ‘keep the economy running’. Governments believe it is necessary to print more money every year. Why?

  Year 2: The government prints no money at all

  Let’s consider a slight variation on our previous example. Alphonso, happy with the response to his mangoes, and having more money to spend because of the killing he made in Year 1, decides to buy another mango farm from Farmer Langra. Langra goes off to spend the money from the farm sale on bananas, sugar and clothes. The producers of bananas, sugar and clothes are happy. Many people in the village have got prosperous because of the extra ₹500 the government decided to print in Year 1.

  In Year 2, Alphonso has fifteen boxes of mangoes to sell, the ten extra ones coming from his new farm. He does not know that the government does not plan on printing any money this year. What happens next?

  Day 1: 1 box—₹60

  Without any extra money coming into the system, no one can afford to buy mangoes at Alphonso’s price.

  Day 2: 1 box—₹30

  Sadly, Alphonso slashes the price by half before the fruit can go bad, and manages to sell all his fifteen boxes.

  Poor Alphonso! He was hoping to recover the money he spent on his new mango farm, but ended up earning only ₹90 more than last year despite selling three times the number of mangoes (fifteen boxes instead of five). Simply because no one in the village (including A, B, C, D and E) had the extra ₹60 to spend on mangoes this year (because no one gave them the extra ₹100 each, since the government didn’t print any extra money).

  Worried about the future, Alphonso decides not to take any more risks. Instead of buying another farm like he had planned to do, he locks up his money safely in a bank, thus taking his money out of the village’s ‘money pool’. That affects all the other ‘producers’—the other mango farmers with farms to sell, the producers of bananas, clothes, sugar—everyone. Worried, they begin locking their money away too. The economy of the village stagnates. Nothing new is being produced and what is being produced is not being bought. Everyone is pessimistic and unhappy.

  But suppose the government had decided to print more money this year? Suppose they had decided to print ₹600 worth of money and give ten people (instead of five) ₹60 each (instead of ₹100)? This is what would have happened.

  Year 2: The government prints some extra money, a little more than last year

  Day 1: 1 box—₹60

  Alphonso sells ten out of fifteen boxes of mangoes, making ₹600.

  Day 2: Alphonso and Raspuri have their Big Idea

  To make good use of the remaining five boxes of mangoes, Alphonso and his wife Raspuri decide to make mango juice and sell it.

  Day 3: The mango juice stall is up

  Everyone loves Raspuri’s mango juice! Excited, the couple considers setting up a more permanent juice shop.

  Two months later

  Raspuri rents a place in a good location and pays rent to the owner. She employs two of the ten people in the village to help her. She pays them a salary, which they may use the next year on buying mangoes from Alphonso.

  Sure, all this activity will also push up prices of things a little bit and thus cause inflation, since everyone has more money. But because there are also more goods in the market—mangoes, mango juice, shops for rent—inflation doesn’t matter so much. In fact, a little inflation is a good thing; it keeps the economy running.

  A good economy helps producers like our farmer feel confident about the future. It encourages them to take risks by spending money to produce more goods, because they feel they can earn it back, maybe even make a profit. As for the customer, she now has more choices about where to spend her money. Everyone benefits! In a bad economy, people don’t want to take risks, and the economy slows down and stagnates. Everyone loses.

  Of course, governments don’t go around handing freshly-minted money out to people like lollipops. They make more money available to people in other ways. They may make sure that banks have more money, so that there will be enough to lend to people who want to borrow money to start fruit-processing plants or papad-making units or software companies or car factories or hospitals or schools, or to buy homes or land to grow organic vegetables. All this borrowing and building will create products—juice, jam, pulp, papads, cars, organic vegetables—and services such as medical care, education, and software programs. It will also create employment as people have to be hired to build the factories and teach at the schools and code the software. These people will earn salaries, which they will spend on the new products. Hurray.

  But all this frenetic economic activity does push up the prices of things, which is why everything costs more today than it did when your parents were your age, and even more than they did when your grandparents were your age. But in many ways, that’s not something to whine about.

  LEARN THE LINGO

  Inflation

  The meaning of the word ‘inflation’, in Economics, is ‘a general overall increase in the prices of things’ in a country. Most people say that ‘inflation is caused because governments print more money’, but some economists say that it is actually the other way around, i.e., ‘governments print more money because there is inflation’. Either way, for our purposes, it is enough to know that inflation and ‘more money in the money pool’ go hand in hand, whichever comes first.

  Now, what are some of the factors (besides governments putting more money in the money pool) that cause inflation?

  ▶I’m the bossman: this is going to cost you. If a producer has no competition, he has market power. People who want what he is selling have no choice but to buy it from him. Therefore, this guy can merrily jack up his prices, causing inflation. That’s what Alphonso, in our example, did in Year 1. Economists would call our farmer a monopolist, and his business a monopoly.

  ▶Everyone wants it, and is willing to pay the price. If there is a sudden increase in demand for something which is in short supply, prices go up, causing inflation (demand-pull inflation). In our example, people in the village who suddenly found themselves flush with money all wanted mangoes since it was the season. This was unexpected, and the supply available could not keep up with the demand, causing prices to zoom. (This is also what happens to the price of tickets to an important IPL match, although that is not entirely unexpected.)

  ▶Dude, it cost me to make this thing. If it costs more to produce something this year than it did last year, then obviously the producer has to make up the extra money he spent. So the price of the product goes up (cost-push inflation).

  However, inflation is never equally bad for
everyone. So who benefits, at least for a while? And who loses?

  ▶The producers whose products are selling at high prices win, their customers lose.

  ▶People who have borrowed money from other people win—because of inflation, the money they return has gone down in value, so they are actually returning less than they borrowed. The lenders lose.

  ▶Inflation can really hurt producers in a country that has high inflation when they trade with other countries. Let’s say Alphonso has become such a big mango merchant that he has signed a contract with a Chinese company to supply 100 boxes of mangoes to them every season, at ₹100 a box. He stands to gain ₹10,000 from this trade. If India has really high inflation one year (which makes the value of Indian money go down), that ₹10,000 is simply not worth as much to Alphonso as it would have been if there had been low inflation. (Low inflation would not have affected him much, because everyone expects that there will be some inflation, and charges a little higher for their goods for that reason.)

  And so, the moral of the story is that, with inflation, just like with everything else in life, the Goldilocks Principle works best. Not too much, not too little, but just right.

  What does India buy when she goes shopping?

  Everyone agrees that too much inflation is a bad thing. That’s why countries are paranoid about inflation numbers, and are constantly measuring and tracking them. But how do you measure inflation?

  One popular method (which India also uses) is to track a number called the CPI (Consumer Price Index)*. How is it calculated?

  ▶First, statisticians study a load of data and work out what the Indian customer mainly spends her money on. Obviously, there will be some differences in what different people spend on, depending on their age, their preferences, where they live (city or village, warm place or cold place, mountains or plains), and how much money they have. Broadly, though, experts have figured out that the things most people spend on are: food and drink, clothing and footwear, housing, electricity, petrol, education, communication (phone, radio, television), personal hygiene (soap, shampoo, toothpaste, detergent), travel, medical care and recreation.

  ▶All these are thrown into what is called the Indian customer’s basket of goods and services (things like food and footwear are goods, things like electricity and education are services).

  ▶Statisticians now try and work out how much Indian families spend—on average—for each of these goods and services, as a percent of their total expenses. Do they spend more money on food or on rent? Do they spend more on clothing or on education? Based on the results, they figure out what is more important and what is less important to the customer.

  ▶Each of the different categories is now listed in order of importance, and a number called a weighted average is calculated for each. We don’t need to go into the details of how this is calculated; all you need to know is that a higher weighted average means that that item has a higher importance for the customer than something with a lower weighted average. The figure shows the weighted averages for the Indian basket of goods. (The ‘Miscellaneous’ category includes travel, medicare, education, communication, personal hygiene, etc).

  THE INDIAN SPENDING CHAPATI, AND HOW IT SLICES UP

  ▶Every month, the price of the overall basket is calculated. This is the CPI for that month. Has the price gone up or down compared to the previous month? If it has gone up (which means inflation has happened), by how much has it gone up? The difference in the CPI is used to calculate the monthly rate of inflation. At the end of the year, the monthly rate of inflation for the previous twelve months is put together and the annual rate of inflation is calculated. PHEW!

  Over the last ten years, India’s highest annual rate of inflation—15 per cent—happened in 2009 (that means, in 2009, the prices of things in our basket went up by 15 per cent. In other words, the purchasing power of our money went down by 15 per cent, which is not such a great thing). The lowest was in 2007—5.5 per cent. This, many economists feel, is an acceptable number. It’s just a little over a recommended rate of inflation (4 per cent) for a growing economy, where everyone is borrowing like mad (i.e., putting more money in the money pool) to build things and grow things and make things and mine things from inside the earth, so that more people can be employed and more resources can be used well. In January 2016, we achieved the target of below 6 per cent inflation again—hurray!

  Developed countries, where most of the development has already happened, have a very low rate of inflation, just a little over 1 per cent.

  P.S. How do we get the data about what things cost across the country? Well, there are people who actually go around and collect this information, from some 310 towns and 1181 villages! In fact, this is one of the jobs that village postmen and women do, apart from delivering mail.

  Bet you didn’t know that!

  The tale of the hundred trillion dollar note

  Sometimes, after a country has been through war or some other disaster, when it is not possible for the government to tax people and collect revenues, it prints lots and lots of new currency to pay off all its debts and to fill its banks, so that the banks can then lend money to whoever wants it. However, since there are no new goods being produced to balance all the new money entering the system, the value of the money falls rapidly, leading to inflation. When inflation increases very rapidly, at a rate greater than 50 per cent a month, the country has what is called hyperinflation, which is a nightmare.

  Zimbabwe experienced the hyper-est form of hyperinflation in November 2008, when the rate of inflation was—hold your breath—7.96 BILLION per cent! That means a loaf of bread which cost, say, 1 Zimbabwean dollar (ZWD) in the year 2000, cost 7.96 billion ZWD in November 2008! Over the years, the government had printed currency notes of larger and larger denominations, so that people could at least carry enough money in their pockets to buy their groceries*. On 16 January 2009, the Reserve Bank of Zimbabwe issued the largest denomination ZWD ever—the 100 trillion dollar note! What could it buy? Not even the tiniest bar of chocolate!

  In June 2015, Zimbabwe started ‘phasing out’—or doing away with—its official currency. The government asked people to bring all their ZWDs—in wheelbarrows or trucks or whatever—to the banks and exchange them for US Dollars (USD). How many ZWDs would people have to give in to get 1 USD in return? Just 250 trillion.

  If you ever come across one of those 100 trillion dollar notes though, hang on to it. It is now a collector’s item, and is selling at around 200 USD on eBay.

  BIG QUESTION 4

  How come one Indian rupee is only worth about 1.4 US cents? Who’s the guy who decides this stuff? And can I write him a strongly-worded letter?

  Hmmm. Your indignation is admirable, but unfortunately, India’s poor dollar exchange rate (the need to pay out more and more rupees in return for fewer and fewer dollars) is not decided by any one guy that you can write a letter of complaint to. Instead, like karma, it is a result of our own past and present actions. The good thing is, there is nothing permanent about this—the exchange rate is fluid, it changes every day, and, if we do things right, the exchange rate can get better.

  One thing you must know before we go any further is that the exchange rate is not some absolute number. That means, if we say that the exchange rate is 68 rupees to the USD, it doesn’t mean that it is also 68 rupees to the pound or 68 rupees to the yen. Exchange rate is relative; you can only have an exchange rate between any two currencies, and it changes according to which two currencies you are comparing.

  Also, a country’s dollar exchange rate (its exchange rate against the USD) is a very important number because it indicates how ‘healthy’ a country is economically. More countries will trade with countries that are in good economic health, and that will help that country’s economy get even healthier.

  The country with the stronger currency and better exchange rate (let’s call it Desh) is usually at an advantage, because it spends less of its money to buy things from
the other country (Videsh). Poor Videsh, on the other hand, loses out—it has to spend more of its money to buy things from Desh. That’s why governments fret so much about the exchange rate.

  So what affects this mysterious, quicksilver, ever-changing dollar exchange rate? Many things, and even smart economists with tons of experience often find it difficult to explain them all in a way that everyone can understand. Let’s just look at some of the important (plus easy to understand) factors here, using India and the US as examples, although these would work with any two countries.

  When does the rupee get ‘weaker’ against the dollar (i.e., when does India’s dollar exchange rate get worse)?

  ▶When India has more inflation than the US. Inflation, as we figured out in a previous section, basically ends up reducing the value of your money—it can buy less than it used to. So higher inflation is bad for your exchange rate.

  ▶When India spends more money buying things from the US than selling things to it. Let’s say India spends ₹1000 on buying American goods and earns only ₹900 by selling Indian goods to America. India will now have a trade deficit of ₹1000–₹900 = ₹100. A high trade deficit brings down the value of the rupee against the dollar.

  ▶When India becomes a country in debt. Let’s say India has a high trade deficit, and therefore has less money to spend. So it borrows money from other countries. As its debt gets higher, other countries become reluctant to lend money to India, for obvious reasons. (If you knew that your friend had borrowed ₹50 each from your classmates A, B and C over the past year and has not yet returned their money, you will think twice before lending him another ₹50 yourself.) Now that it has become difficult to borrow money from other countries, India may decide to simply print more money to cover its deficit, and we know that printing excess money without the goods to back it leads to inflation. The more the inflation, the worse your exchange rate. It’s a vicious, vicious cycle.