Economics Part III

Right, here we go, part III. I have to admit I was feeling quite hungry during most of this session, so my notes have large gaps which my economics knowledge isn’t capable of filling. Nevertheless here’s what I picked up between kitkat cravings…

The theme is inflation. Tony Blair made the Bank of England independent and told it to control inflation at 2%. Their tool was control of interest rates. They were allowed 1% either side, any more variation than that and they had to write an apologetic letter. It has actually worked quite well, with inflation staying pretty close to 2% most of the time, although in December it jumped from 1.9% to 2.9%, and some predict it might go as high as 3.5%. Nonetheless, this is nothing compared to the 25% we saw at times in the 1970s (or Zimbabwe’s ridiculous recent performance).

Inflation is a sustained increase in overall price levels, accompanied by a fall in the value of money. Ie things cost more at the same time as every pound is worth less. If it’s anticipated it can be a very useful tool of economic policy, for some reasons that sadly I never caught. The only two I did write down were that: higher inflation reduces the value of national debt, which is good; and business quite likes it because it weakens the pound, which makes importing raw materials easier and reduces the competition from cheap imports. A downside is that it makes savings worth increasingly less – it has been described as a tax on savings (using tax in the sense of something onerous, rather than a contribution to society, a bugbear of mine that I might write about another time).

The problems come with unplanned inflation, that can race out of control and screw everything up (like the UK in the 1970s or Zimbabwe very recently.) It hugely increases the risk of investing, and also changes consumer behaviour dramatically – panic buying, increased demand initially, followed by a massive fall in consumption. Not good.

Then we moved on to the causes of inflation. You can either have a shock on the supply side (so something goes wrong with production – perhaps the raw materials get too expensive), or a demand shock (where something goes wrong with consumers, who stop buying somethings all of a sudden). And then either way, government reacts to shocks by increasing the supply of money, which leads to inflation. Now, apparently this makes sense if you look at Fisher’s Law, which I didn’t quite follow, but apparently says this:

Supply = Demand
M * V = P * T

Where M = amount of money that can be in circulation
V = velocity of money (whatever that means)
P = Price of each transaction
T = National income

Therefore when government raises M, and V and T stay the same, P has to rise, which is inflation. I understand that, but I don’t really understand why MV = PT. Any helpers?

Anyway, moving on. How to control inflation is the next tricky question. The main tool is interest rates, which can be manipulated to change the ratio between consumption and saving (higher interest rates leads to higher saving, presumably?)

However, government doesn’t want interest rates to go up very much at the moment, because that will make paying back the debts much harder. So what’s the alternative? That, sadly, is where I stopped paying attention, right up until the end. So, any ideas on that much appreciated.

It hasn’t been my strongest contribution this week I’m afraid, but I promise I’ll try and do better next time. I’m going to take my graph-based introduction to economics on holiday, and report back. Oh yes I am.

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4 thoughts on “Economics Part III

  1. Hey Will,

    Yeah – that equation equates to Sam Knafo’s ideas about the problem of maintaining monetary tension as the goal of all monetary policy.

    To give you an example of the velocity of money increasing, we can look at the huge amount of transactions made in the City prior to the recent crash. With each transaction generating a profit, it directly corresponds to increassing the national income. The equation makes sense.

    The mystery during the 90s and naughties was why given such a successful economic boom with increased economic activity, and monetary velocity, inflation did not rise. If you read Konings, he resolves the question by saying that infaltino was essentially avoided because the financial sector was so attractive to investors, this is where they placed their money rather than into the real economy. therefore huge amounts of wealth were created on paper without the negative effects of inflation on the real economy.

    Interest rates are the primary tool used to control inflation. Certainly because higher rates encourage savings. But also, in a society defined by homeownership, raising interest rates has a dramatic and virtually immediate impact on the amount of liquidity available to a household to spend on consuemr goods. However, in the era of freely available debt, this had very little impact on consumer spending, and we can see that households took on increasing amounts of debt during the recent economic boom. So what indeed did hold back inflation – here again Konings’ argument is applicable.

    Really, you need Sahil to get up off his butt and start giving good explanations for this kinda stuff.

    Cool

  2. Willz is all over this, and I’ll add to that soon. For now, I’ll have a go at mending any equation confusure.

    M = amount of money circulating
    V = velocity – the number of times money changes hands for one transaction. So, I buy a hat, but the cash has to go from someone else to the bank to me, so it has a velocity of three.

    P = price of transactions
    T = number of transactions.

    P*T = national income, which makes sense. (I blame the sleepy notes for this confusion)

    Does that clear it? If not Biz-ed and this explanation got me through most of my degree, they make it clear there.

    Inflation is actually a lot more significant than that sodding equation suggests.
    The worldwide inflationary spike in the 1970s and early 1980s coincided with the emergence of ‘finance’ as the driver for growth in the US and UK (and beyond – Ireland, for example). Pretty sketchy thoughts at the moment but inflation – ie too much money chasing a certain asset – is in effect, speculation.

    The dotcom inflationary boom funded the 90s growth spurt, the housing inflation boom the 2000s. Getting people to release liquidity and coordinate it into a single financial asset rather then general price inflation is increasingly key to making money in the modern economy. Bugger producing goods and services, finance is where the real cash is. But how do you organise inflation?

  3. Apparently I need to explain stuff more,

    Inflation became an issue during the inflationary peaks of the oil crisis in the late 70s, mentioned by Will. Prior to this moment, economies had be run along lines typically known as Keynesian. Monetary policy was directed towards stimulating demand through state investment etc. When people say the recent crash witnessed the reintroduction of Keynesian policies, they are pointing towards state strategies such as the £2,000 contributed by the state toward purchasing a new car when you hand in your old car. This is a direct state subsidy to stimulate demand.

    Policies such as this are also pretty controversial since they were largely discredited during the aforementioned inflationary problems of the 70s and early 80s. Inflation had typically been considered a natural consequence of a booming economy, as the high demand for goods enables producers to push up prices with the running effect that workers demand wage increases and therefore the amount of money required to purchase the same product increases. However, when the Western world went into recession, its economies encountered for the first time a phenomena known as ‘stagflation’: stagnating economies AND inflation.

    The causes of this are still being debated over today. What is clear though is that the standard knowledge of inflation being a consequence of economic health had to be rethought. It also became a huge problem because not only were people’s wages being driven down by the high demand for jobs, but they were able to purchase less with each £.

    Enter Hayek. He’s a bit of a tosser to be honest. But also clever. He’d been around for years on the fringes of academia, bleating his niche ideas and had never really received a huge amount of traction. That is until the point when new ideas were erquired by poicy makers. He introduced the idea of supply side economics. That is, that the job of the state was not to actively participate in stimulating demand; instead, the state should implement policy designed specifically to create a stable business environment in which business can invest and grow. Inflation is a highly unstable environmental factor and discouraged investment. He said that the getting inflation under control should be the primary goal of the state and that the rest of the economy would take care of itself as described by Adam Smith’s ‘invisible hand’ model.

    Thatcher and Raegan rather liked this chap and were the two proponents of this new ideology which was termed ‘monetarism’ since controlling inflation meant, in essence, controlling the supply of money, as oppose to the traditional model of managing consumer demand. Hence, inflation was now a key agenda and policies such as making central banks independent were implemented in order to de-politicise the monetary supply process. This also is where the letter of explanation when inflation rises above a certain level comes from.

    The UK government has recently been implementing inflationary policies in order to alleviate the effects of the depression. “quantitative easing” is just that. In effect, printing more money and injecting it into the economy and also reducing interest rates to nearly 0 in order to encourage people to spend and borrow. THe rpoblem with this is that outside investment in the £ reduces in an era of floating exchange rates. basically, the £ becomes a highly unattractive currency to financial investors since it’s value will reduce over time compared to other currencies and therefore they sell £ in exchange for other currencies thereby reducing its comparative value. Two years ago, the £ was worth NIS8 (New Israeli Shekels) now it is worth only NIS6. With a devalued and unattractive currency, the government cannot raise as much money through mechanisms such as issuing bonds and nor can other UK businesses. In addition, foreign investment in the shares of UK businesses will reduce since they expect the value of their investment to reduce comparative to other currencies. Therefore, with currency devaluation you begin to feel a general flight of money away from the country which is bad for all.

    As it happens, the inflationary problem of dealing with this crisis has not been too great so far because every government has cooperated (not wihsing to repeat the catastrophic policy mistakes of teh 30s) and therefore all the Western Currencies have experienced devaluation at the same time due to there implementation of demand-side stimulus packages. Maybe this is why much fo the talk is about the rise of the East since it is here that boom continues and the area remains hihgly attractive to financial investment. Not to worry too much for now because the Eastern economies are tied into the health of the West since they are geared towards exporting their products for consumption by Western consumers and they are therefore as reliant on the Westerndemand-side stimulus packages as the Western economies themselves.

    Waht do you call nine rapping babies?
    No Solid Crew

    So anyway that’s a bit about inflation. It kinda makes me wanna fall on my own sword really. If I had a sword – which I don’t. But euphemistically speaking if you catch my drift. Basically – if you’ve actually managed to trawl through all the junk that preceded this paragraph, I apologise for the inevitable mind-boggling boredom you must have felt and will make it up to you with yet another joke of insurmountable qulaity:

    A young couple on the brink of divorce visit a marriage counsellor. The counsellor asks the wife what is the problem.
    She responds ” My husband suffers from premature ejaculation.”
    The counsellor turns to her husband and inquires “Is that true?”
    The husband replies “Well not exactly, it’s her that suffers not me.”

  4. Fascinating stuff, thank you both. And really well explained, particularly like Willz’ last post. It is slowly coming together, but taking a little while. Just about to write parts 4 and 5, which will no doubt confuse me further…

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