The Science of Everything Podcast - Episode 65: Money, Inflation, and Interest Rates

Episode Date: August 30, 2014

An introduction to the concept of money, including its uses, purpose, and a brief account of its history. I discuss the notion of money as a medium of exchange, a unit of account, and a store of value, and some of the properties that make particular goods useful as money. I also discuss various measures of the money supply, and briefly outline the difference between the monetary base and money created through the fractional reserve system. I discuss inflation, including its definition, causes, and effects on the economy, before concluding with a brief look at interest rates and exchange rates.

You're listening to The Science of Everything Podcast, episode 65, money, inflation, and interest rates. I'm your host, James Fodor. So in this episode, we're going to have a fairly introductory look at some of the concepts of money, inflation, causes and effects of inflation, and we'll also look at interest rates and exchange rates. This is intended to be a sort of an introductory, take at some of these matters, preparatory to future episodes where I hope to look at, say, monetary policy and central banks in more detail, as well as other things such as the business cycle and unemployment and things like that. So in order to understand any of those things, we'll need some background in money and

inflation and exchange rates. So that's what I hope to put forward in this podcast. There are no specific prerequisites for this episode. However, if you've listened to some of my previous episodes on economics, for example, episode 12 on the price system, and episode 16 profits and competition, that might be of some use to you. All right, so let's make a start. The first thing I want to talk about is just money as an abstract concept and explain a bit about the history of money and the uses and purposes of money. So the first question that we want to ask here is, what is money? When people think about money, they generally think about notes and coins and things like that. You know, the money is a $20 bill or something like that. But that's actually not what money is. That's just an example of money.

Because money can actually be many different sorts of things, and it has been over the course of history. So if we look at the concept of money at a bit more of an abstract level, we could define money as something like an item or record of some sort that is generally accepted as payment for goods and services in a particular area. So what is money depends on the conventions of a particular area or economy or people at a particular point in time. All sorts of things have been considered money at different points in time and at different places. And I'll list some of those a bit later on.

So money is essentially an abstract concept. It depends not on anything intrinsic about the good. It doesn't have to be a coin or a piece of paper. It doesn't have to have numbers on it. It doesn't have to have anything like that. It just has to be generally accepted as payment in a particular area. Why do we have money? What's the point of it?

Again, that might not be a question you've thought of before, but there are actually very particular reasons why we have money. It serves a very important function. In fact, there are three main functions that money serves. They are generally outlined as a medium of exchange, a unit of account and store of value. So I'll talk about each of those in turn. Money acts as a medium of exchange.

This means that it helps to facilitate exchange between two people. If you don't have money and you are instead reduced to what we call barter, which is where you trade one good directly for another, then it is necessary for a trade to take place for there to be what we call a double coincidence of wants. That is, you have what I want, and also I have something that you want. So we have to have both ways. An example would be if I wanted a haircut, I'd have to find a hairdresser who wants something that I have.

Maybe I make shoes, and so I would need to find a hairdresser who wants the shoe that I have that I can make for him. And as you can imagine, that would be quite difficult, particularly as an economy, gets more complicated. I mean, how would you have lawyers or doctors or other people like that, particularly people who had very specialized skills? How would you find someone who wanted to trade all of the things you wanted for that particular specialized skill? it would be very difficult and time-consuming and essentially impossible to have any sort of reasonably complex economy. So instead, we have money, which acts as a medium to facilitate exchange between these two people. So now, neither party needs to find someone else who wants something that they have and has something that they want. Instead, they just trade in money. So I don't

need to find a hairdresser who wants the shoes that I make. All I have to do is find a hairdresser who will accept money, and any of them will accept money, because it's used as a medium of exchange. and then I can go and, sorry, then the hairdresser can go and buy whatever he wants with the money that I give him. And similarly, I can sell shoes to whomever I like and people buy those from me, and that's where I get the money from him that I pay the hairdresser. So this concept of a medium of exchange is probably one of the most important functions of money, because it allows a much more complicated economy to take place so that we don't have to always find someone who has exactly what we want. It's just immensely more convenient. So that's the first purpose of money, a medium of exchange.

The second main purpose of money is acting as a unit of account. A unit of account is some measure, a unit of measure, a unit of value, which is used to compare the cost or value of different goods and services and assets and liabilities. All of these different types of assets or liabilities or payments or whatever are reduced to the same unit of account and then are able to be compared with one of the other. This is also exceptionally important because it would be almost impossible to run a business if you didn't have a standard unit of account. Otherwise, how could you tell if your business was performing well or performing poorly or if you were making a profit or a loss? There'd be no way to tell.

For example, imagine if you're a farmer, and all that you knew at the end of the month or the end of the week or whatever, is that you started the month with a certain number of chickens and a certain number of eggs and a certain number of eggs and a certain number of bails of hay and a certain number of horses and pigs and whatever else. And at the end of the month, you ended up with a certain number of pigs and a certain number of horses and a certain number of bails of hay and a certain number of eggs and so on and so on and so on. And, you know, all of these numbers changed a bit. Some had changed a lot. Some had changed a little. Maybe a few would stay the same. How on earth could you tell with this mess of different numbers whether you were better off or worse off? I mean, I suppose if you had less of everything, you could be fairly sure that you were worse off.

But if you had more of some things and less of other things, how can you trade off a pig against eggs or bales of hay against horses? there's no clear comparison here, so there's no way to tell if you're doing well or doing poorly. And just imagine timesing that complexity by a factor of 1,000 for modern, very complicated, abstract businesses. And you can see how an economy of any complexity would be essentially impossible if you didn't have a standard measure of account that you can compare everything to. So sometimes people criticize the notion of a bottom line, like reducing everything in a business to just do we make a profit or a loss. and obviously there are legitimate criticisms of that because it can ignore personal environmental issues and things like that. But on the other hand, there's a very significant advantage

to having this simple bottom line because really the whole point of having a unit of account is so that we can compare things that would otherwise be incomparable that otherwise would be different. We convert the value of everything into dollars and then add and subtract those as necessary, and then we come to a final figure of profit and loss or of assets and liabilities or something.

So ideally, what you'd want is some way of converting these additional things that you would want to incorporate into your analysis, say the effect on the environment or the effect on stakeholders, the benefits to workers, or something like that, you'd want to have a way of converting those into dollar terms, and then you could incorporate them into your analysis and use the common unit of account to your advantage rather than trying to fight against it.

But anyway, that's a slight tangent. The main point is that money serves as this common unit of account and is therefore extremely useful in facilitating a complicated exchange. So that's the second main purpose of money, a unit of account. The third main purpose is acting as a store of value. And this one's fairly self-explanatory. People have wealth and they want to store it somewhere where they can keep it safe, and then they can access it and exchange it or retrieve it at a later time,

and they want to do this in a sort of predictable, stable way. And so in order to do that, you need some sort of good that's going to be relatively easy to store and that won't deteriorate over time and things like that. And so money serves as a very convenient way of storing and exchange. changing value in that way, particularly if it's in the form of a precious metal or something like that. So those are the three main functions of money, as a medium of exchange, as a unit of account, and as a store of value. And anything that facilitates those three things is effectively acting as money or a currency. Now, what sort of things are suitable for meeting these three

requirements or fulfilling these functions? So generally, a medium of exchange that's going to be useful for money, needs to have a fairly low cost of preservation, so it's not something that's going to deteriorate very quickly. It would need to be transportable, highly divisible, so you can break it up into lots of small pieces to make transactions of the design size. It will need to have a high market value in relation to its volume and weight, so feathers would be a very poor form of currency, well, I suppose ordinary feathers, because they would just be so bulky compared to their value. And it would need to be easily recognizable and resistant to counterfeiting. So if people could easily make copies of it, then it wouldn't be very useful as a store of value because it could

be counterfeited out of existence, essentially. So if you notice all of these requirements, you know, transportable, divisible, high market value compared to its weight, recognisable, resistant to counterfeiting, precious metals meet these criteria very, very well, especially gold and silver, because they don't deteriorate, they're very valuable compared to their weight. They're very highly divisible and easy to deal with, and they're very recognizable and essentially impossible to counterfeit, or at least very difficult, because it's pretty easy to tell for someone who knows what they're looking for, the difference between real gold and something that's just made to look like gold. So that's why historically, and even still to the present

day, to some extent, precious metals have been used as currency in many parts of the world. And so that's also why gold still has this, there's still this idea that sort of gold or other precious metals are sort of a safe way to keep assets, because gold's sort of always going to have value. People sometimes think it's sort of odd that precious metals, gold, bullion and other things have so much value and historically have had so much value because, you know, you can't eat gold or it's not really useful for many practical purposes, apart from a few relatively obscure industrial applications that most people don't care about. So, you know, why is it so valuable when you can't actually do anything with it? Well, I mean, that might make sense in a sort

of naive perspective, but when you really think about it, it makes perfect sense that gold is valuable precisely because it's so useful as a currency. as a type of money. And money is extremely valuable because, as we said before, having something that's able to act as a medium of exchange and as a unit of account and as a store of value dramatically improves our economic well-being. Just imagine how horrible it would be if you didn't have anything to fulfill those requirements and you had to reduce everything to barter and you had no means of account or no way of storing value. That would be just a tremendous loss of welfare. Any sort of sophisticated economic activity would become pretty much impossible. So of course,

Gold has tremendous value in that respect because it's so useful fulfilling this purpose as acting as money. And because it has these really rare and unusual properties of being easy to transport and recognisable and easily divisible and so on, then of course it's going to have very high value. Plus it also has a certain aesthetic value, but even aside from that. So it's really not surprising when you think about it in this way that gold and silver have always been and still are very valuable because of the important functions they serve as being able to act as money in a very good form of money at that. Okay, so now let me just outline a very brief history of money. So the earliest types of money were what we call commodity money,

where the value of the item comes from, originally came from the commodity of which it was made. So wheat, for example, was used in ancient Mesopotamia as sort of a form of currency. People traded in consistent and well-defined units of wheat or other grains. And many sorts of commodities like this have been used historically as mediums of exchange throughout the world. I mentioned gold and silver and copper before. Also salt, peppercorns, decorated belts, shells, alcohol, cannabis, cocoa beans, and even cigarettes and very large stones, round circular stones called rye stones,

have been used as currency. These rye stones are particularly interesting. They're used on, I forget the name of the island, one of the islands in Micronesia here, traditionally as a form of currency, the biggest of these were so huge that they were almost impossible to move, but it wasn't necessary to actually move them, because they were marked and people knew where they were, and so essentially when a transaction was made, the ownership just passed on orally, and that was retained in the oral tradition, so everyone knew which stone belonged to whom, and they served all of the functions of money quite well. I mean, let's think about them. They served as a medium of exchange, because we can exchange things in terms of these rye stones,

instead of having to have that double-coincidence of wants things, we can use them as a unit of account because we can reduce the value of different things to the value in Rye Stones. And we can certainly use them as a store of value because they're pretty much impossible to steal or take anywhere. Probably the main disadvantage of these is that they're not very divisible, but they were larger and smaller ones, so I suppose they found a way around that.

Certainly very resistant to counterfeiting, which is another big example. So the point is it might seem ridiculous to use Rye Stones as a currency, but if we actually think about it, they serve most of the purposes that we would recognize as being constitutive of a good currency, of a useful form of money. And so, you know, why not use them as a currency? It really doesn't matter. Indeed, there's a case that I read about where apparently one of these big rye stones was being transported over a river or something, and the ship, not the ship,

the transport that it was being carried on sank, and the stone was lost. But everyone agreed that even though they had no idea specifically where it was, they couldn't see it and it was never recovered, they all knew that it must still be there somewhere, so they just kept using it as a currency anyway. They just agreed, well, you know, it's still there, so we'll just keep trading it and keep using it. So it's sort of amazing how resilient money can be in this sort of way, that as long as people recognize that it has value and are willing to trade it, then it can serve as money. And these days, what we use as money is far more abstract, even than Rye Stones. It's obviously just essentially digital information that we send around the internet.

But I'm jumping ahead a little bit there because I was talking about the various forms of commodity money that have been used throughout history. And the first coinage, that is, small pieces of precious metal that were specifically stamped and marked with particular common values, the first coinage that we know about was mentioned by Herodotus, the Lydians, Greek people living in current-day Turkey, who made the first, I think it was silver coins, around the 7th century BC. And of course we know that after that, you know, the Greeks and the Romans and many other civilizations also produced coins. And so coins were sort of the most common form of currency throughout sort of the classical and medieval periods and early modern periods. However, at some point, this happened both in China during the Tsung dynasty and later and also in early modern Europe. Various banks and traders began to, because it was very inconvenient to move around all of this,

and sometimes dangerous, to move around all of this gold and silver, various merchants and bankers and other people began to issue promissory notes essentially saying well we owe you this amount of gold we're not actually going to pay you in the actual physical gold right now because it's too annoying so we'll just give you this note here and if the reputation of the place is good enough then people are willing to accept these and even trade them as if they were money

so no longer do you actually need to have the money in a cart out the back to buy something or to sell something you just have to have this promissory note that says this well-known merchant banker or something owes you a certain amount of gold that you can cash in when you go there. And that was good enough. And so this basically became the first use of paper money or banknotes in, as I said, China, and later on, similar systems were used in early modern Europe. And banknotes became increasingly common throughout the 18th and 19th century in Europe and the Western world. After World War II, most currencies were pegged to the US dollar,

and we'll talk about what pegging means a bit later on, and the US dollar in turn was convertible into a set amount of gold. So one US dollar was defined to be worth, I think it was 35 ounces of gold. They were joined directly to each other. However, in 1971, the US government basically gave this up. They suspended the convertibility of the US dollar into gold, and most currencies are now being depegged from the US dollar. So basically what this means is that these days,

most countries in the world operate under what we call a fiat currency, that's FIAT. And this is where the currency is not derived, sorry, the value of the currency is not derived from any commodity or intrinsic value at all, or even from convertibility into gold. It's purely, the currency purely obtains its value by the fact that the government asserts that this is the legal tender and the people are willing to accept it in that particular territory.

So this is historically quite unusual that you would have a fiat currency with no backing in any type of gold bullion or other type of commodity money. But as I've outlined before, as long as it fulfills the criteria of the functions of money, then it's perfectly possible for fiat currency in this way to serve as money. And it doesn't matter whether it's actual notes and bills or just numbers in your bank account or even just digital information sent over the internet. It's all really the same thing as long as the system continues to work and is expected to work by the people who accept the money.

People will accept money as long as they expect to be able to, in turn, use it to buy something else. As long as people expect to be able to use this money that you're giving them to buy something else, then they'll accept it. So it's all about whether people trust the system of money enough to accept it. If people begin to doubt whether the money will be useful for them, then they'll begin to be more reluctant to accept the money, and therefore the money will in fact lose its value. So it's very much an issue of a confidence sort of thing,

which is quite interesting as to how that works. There's one more point I'd like to make about money, and that's that it's very much an emergent phenomenon. That is, money has emerged many, many times throughout history without any particular person deciding that, oh, this is, we're going to do this now, and there's going to be a thing, and we're going to call it money. That's why we have so many different, diverse types of commodity money that have been used in different times and places. One of my favorite examples of this emergence of money is in prisoner of war camps in Germany during the Second World War,

where Allied prisoners began to use, spontaneously use cigarettes as a currency in the camp, because they weren't allowed to hold money of their own, but they did have a certain ration of cigarettes. They came in Red Cross packages and other things. and cigarettes, if we think about them, while they're very preservable and recognizable, they're hard to counterfeit, they have a pretty high value compared to their weight and volume, and they're quite divisible and easily transportable, so therefore they can serve the purposes of money, they can act as a minimum of exchange, a unit of account, and a store of value. So people would, you know, exchange all sorts of things for each other in the common currency of cigarettes. So even if you didn't smoke, you'd be willing to accept cigarettes in exchange for something,

because you know that you can then spend the cigarettes to get something else later on, be it chocolate from someone else's Red Cross package or whatever it be. So the point of that little interesting anecdote is that pretty much anything can act as money as long as it fulfills the criteria and can serve the purposes of money. And it's all about whether other people are willing to accept what you're giving them as money, and it's nothing really about its sort of intrinsic value. All right, so now moving on from the definition and purposes and history of money, I want to talk a little bit about what we call the money supply,

which is simply the total amount of money that's available in a particular economy at a particular point in time. Now, you might think that that's a pretty boring concept, because wouldn't you just count all the money and that's the money supply? Why would anyone care about that? Well, one thing is that it's actually very difficult to define what the money supply is, because it really depends on what you include as money. So there is no single correct measure of the money supply. There are many different measures which are classified on a spectrum from narrow to broad, So narrow includes very few things, and broad includes increasingly more things as counting as money.

And you might think this is very strange. Well, how can you have different things that count as money or don't count as money? Surely, you just count up the notes and coins and, you know, the bank deposits and that's it. Well, no, actually, it turns out that it's much more complicated than that. Let me explain. Probably the easiest way of explaining this is just to outline some of the different measures, and they're traditionally classified under using the capital letter M and a number. So, for example, M0 is the most narrow measure of money,

and it goes even up to M4 in some accounts, which is the very broadest measure of money, and there are also some other ones too. But let me go through them, and I'm going to simplify a little bit as to exactly what they include, but hopefully it will just give you the flavor. So M0, the narrowest measure of money, includes only what we call the monetary base.

So that's actual cash, notes and coins, that's in bank reserves or in circulation. So that's what we ordinarily think about as money. So that's actually just M0, and that forms only a very small fraction of the total money supply. It varies from time to time and from country to country, but I don't know. It's like 10, 20%, something like that as a very small fraction. So most of what we talk about as money is actually not cash in terms of notes and coins.

That's just M0. M1, the next level up from that, is M0 plus what we call demand deposits and a few other similar things. And that basically means the type of bank accounts that you deposit money in at a commercial bank and then can withdraw that money at any time. These are also sometimes called checking accounts or checking deposits because you can write a check against them. Now, these are effectively money because you can directly transfer the funds from your account to someone else's account by writing a check or these days by credit card. But the point is you can transfer this electronic money directly from one account to another or from one person to another. You don't actually need to use cash at any point.

So what you're doing is you're using the deposited money in the account itself as a medium of exchange. change, and so it itself is actually money. This is very confusing for a lot of people, because it looks like we're sort of counting the money twice. For example, let me explain. If I deposit $100 in the bank, the bank does not keep that $100 sitting in a box with my name on it. It keeps a little bit of the money in a box, well, not with my name on it, but just in the general vaults. Let's say maybe it's 10% of the money that they keep, and that's what they keep as their reserve. But then what do they do with the other $90? Well, they lend it out to someone else who wants to borrow money from a bank. That's where the banks get their money from to lend, from the people

who deposit money there. But then what happens when that person gets that loan of $90? Well, they probably also deposit it in the bank. Maybe the same bank, maybe a different bank, but it doesn't really matter. They deposit that $90 in a new account, because people don't usually hold lots of cash sitting around. And then the same process happens again. The bank puts $9 away into vaults and then lends out the $81. Someone gets, borrowers the $81, then they put $8.10 the bank that gets that deposit puts the $8.10 inside their vault and lends out the remaining 72, whatever. And so on the process goes.

So what's happening here is that we're actually increasing the size of the money supply, because there are two different things we're counting now. So there's the initial $100 in actual cash, notes and coins. Some of that's in circulation. Some of that's in the bank vaults as deposit reserves. So there's that original 100, but now there's all of that money that was deposited in the bank accounts, well. So there was my $90 that was lent out to someone else, and the second person is $81 that

was lent out, and the third person is $72 and so on and so forth. All of that counts as money well, because I can spend it directly. I can go into my account, and, well, I don't have to go into my account. I can go into a shop, pay with something using my debit card, my credit card, and the money is transferred directly from my account to the account of the shop that I'm purchasing something from. No cash needed to be involved in this process. So I've just used that money in my account as money. But actually, there wasn't any cash there. There's no notes or coins changing hands.

It's just the dollars in the accounts. So both the cash and now the deposits in my account are serving as money. So the money supply is increased by this process. This process is called fractional reserve banking. What it means is that the bank does not retain 100% of all of the money that's deposited in it. That would be full reserve banking. Instead, it only retains a fraction of that. Maybe it's 10% or 20% or something.

depends on the time and place, but it's only a small fraction of the total that's kept as a reserve, and then the rest of it's lent out. And that amount that's lent out is then sort of repeatedly lent out and deposited back in the bank, or in other banks, and therefore it increases the total supply of money. This is why the total money supply is not just the same as the monetary base, because only a small proportion of the total money supply is actually in notes and coins. Most of it's in these demand deposits, this money that doesn't actually exist as notes and coins, it's just sitting in the banks. But that's only M1.

That's not even the broadest measure of money yet. We've only gone from M0 to M1. The next one up is M2. M2 is demand deposits and the monetary base, so that's M1, plus we add on some extra things. So in particular savings deposits. So, you know, like a savings deposit or a time deposit where you have a certain amount of time,

you know, maybe it's six months or a year or something like that, that money has to remain in there, and you can't withdraw it within that timeframe, or if you do, you have to pay a fee or something. Well, those are pretty close to money. as well, because I can basically withdraw the money or maybe withdraw it in a month's time or withdraw it with a small fee. So it's still what we call very liquid. Liquidity is this sort of metaphor used in finance and economics to talk about how easy it is to convert some asset into cash.

So your house is quite illiquid, for example. It's pretty hard to sell a house. It takes quite a lot of time. But savings deposits are very liquid because it's very easy to convert those into cash. So if liquidity is a difficult concept, just imagine how easy is it? to convert that thing into cash. The Mona Lisa, for example, to take an extreme case, is, well, I have no idea how valuable it would be if sold an auction. But the point is it's so unique and recognizable that it's absurdly illiquid. There's almost no way you could actually convert it into cash, even if you wanted to.

So not all assets are necessarily as useful as assets, even if they're very valuable, because they might be very illiquid. Anyway, so savings deposits and time deposits are pretty much like cash, or they're pretty close to demand deposits in particular, but they're not quite as liquid, they're a little bit harder to get to, and so they're kind of a bit less like cash, and so we put them at the next higher level, M2 instead of in M1. But we can go up to higher levels as well. M3. M3 is equal to M2 plus some other things like money market funds and short-term repurchase agreements. Basically, these are other assets that financial firms and investment banks and other

organizations like that own and are trading with each other all the time. And they're not really money in the ordinary sense that we think about it, but they're just so liquid, they're so easy to sell and re-buy that they're just very, very close to money, and so for some purposes you can just treat them as money. And M4, the next level up again, includes everything in M3, plus some other things like T-bills and commercial paper, which, again, these are just different types of assets. So, don't worry if you didn't follow all of the different categories there, that's not the main point. What I wanted to emphasize was just that there are different definitions of the money supply, and what you include depends on how narrow or broad you want to be in terms of

defining money. And there's no real right answer to this question. You want to sort of take a look at the different measures and see how they're comparing to each other if you want to get a hold on what's happening to the money supply overall. Okay, so that's enough on the money supply. Let's move on to talk about something that you've probably heard of a bit more about before, and that is inflation. What is inflation?

Well, inflation is usually defined as a sustained increase in the general price level, the general prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency, so each dollar or each yen or whatever, purchases fewer goods and services, which means that the currency that you're using is losing its value. It's becoming less valuable in comparison to goods and services. The real value of the money is less in terms of goods and services. So this is most noticeable over long periods of time.

So in America, say, a hundred years ago or 50 years ago, $1 could buy a lot more than could $1 today. Why is that? Because there's been persistent inflation over that period of time, meaning that prices have gone up, and therefore the real value, the buying power of a single dollar, has decreased. So $1 doesn't get you as much as it used to. It's important to understand that there's a big difference between inflation and simple price rises. Inflation refers to the sustained and systematic rise in the general. or average price level of goods and services in an economy.

Prices of some goods and services are always going up and down relative to each other all the time. So some prices go up, some prices go down because of demand and supply and all sorts of other factors. That in itself is not inflation. That's just price fluctuations. Inflation refers to the broad overall trend of the rise in the average price level. This is often measured as the CPI or the consumer price index, you may have heard before. It's a common measure of inflation, although again, like the money supply, there are different ways to measure inflation. Of course, it depends on how you define the money supply and how you define what goods and services you're considering and all sorts of other things like that.

The main important point, though, is that inflation average rise in overall prices over time, not just rise in this price or that particular price. Indeed, if you just see that one price has gone up, you can't really conclude anything about inflation. You have to look at a broader range of prices to say anything about that and over a longer period of time as well. So that's what inflation is, but what causes inflation? Most Western countries since the end of World War II have seen persistent inflation of at least several percentage points a year. You know, 2, 3%, it's fairly low inflation, you know, 5, 6% is higher inflation. There's a sort of more moderate inflation, then, you know, 10% will be quite high inflation,

especially by today's standards. Inflation's higher at some times and lower in other times. It tends to be higher in times of an economic boom and lower in times of economic recession, so inflation's been fairly low in the US over the past few years because of the economic downturn. But what's the cause of this persistent inflation? Why does it happen? How can prices be always going up over time?

Well, in order to understand this, it's useful to think about it's useful to think about it in terms of a sort of a war between supply and demand in one sense. What I mean by this is that there's sort of a battle. On the one hand, the amount of goods and services that are available to buy that we can potentially purchase is generally growing over time because of economic growth, increased productivity and so on. On the other hand, the amount of money that exists,

the money supply, as I mentioned before, the total amount of money in the economy, also tends to grow over time, for reasons I'll get to in a moment. So the question is, which of these grows more rapidly? Is it the supply, or is it the demand as manifested through the money supply? Because, of course, if people have more money,

then they are going to spend more of it. So more money supply means more demand in the form of people buying more stuff or wanting to buy more stuff. So, which wins out? Is it the supply or is it the demand? Well, the answer is, at least since World War II, it's been persistently the demand, by which I mean the money supply is growing faster than the supply of goods. So both have tended to grow, because we've had economic growth,

but the money has grown faster. And so therefore, prices have had to go up. If you think about it, it's a simple logical point, really. if I have $10 and I want to buy one apple, then it's $10 an apple. But if I have $100 and I want to buy two apples, well, it's $50 an apple. That's just how it works. And if you just extrapolate that out to the entire economy, that's basically what's happening. If there's only $10 billion in the entire economy, then you can only spend $10 billion worth of stuff.

If, on the other hand, there's $100 billion in the economy, then there's a lot more to be spent. And so prices can be higher. In fact, they'll have to be higher because people will compete against each other to try and buy that limited supply of goods. of goods and services that are available. So that's the basic cause of inflation, the fundamental underlying cause of persistent inflation. It's just the money supply is increasing over time. Now, in the short term, there can be other causes of inflation as well.

For example, there are things called supply shocks, where there's a sudden, generally short term, a decrease in the supply available, of some good that's available. A good example of this is back in the 1970s when there was a series of oil shocks due to political events in the Middle East, the supply of oil available to the United States, was dramatically and rapidly decreased.

That had the effect of pushing up prices and leading to rapid inflation. This is an example of what we call a supply shock. Another example could be if the country gets into a war and most of its factories are bombed or its farmland is destroyed or something like that, then there would be a dramatic reduction in the supply of goods available,

but of course the same amount of money is around as before. And so therefore there's more money chasing fewer goods, and so the money supply wins out or demand wins out in the battle I mentioned before, and therefore we have inflation. So sometimes you can have supply-side, a supply shock-induced inflation. But for the most part,

there are limits to that, obviously, because if the supply kept falling, everyone would die of starvation pretty quick. So that tends not to be the main cause of inflation. The main cause of inflation is persistent growth in the money supply, because there are not so natural limits to that. Now, often inflation continues on at a moderate pace, you know, 5% a year, or even 20% a year,

or 30% a year in developing countries. But there are times when inflation can get really out of hand. And when this happens, we call it a hyperinflation. And this tends to happen in countries that have just undergone very significant political disturbances. So the main causes tend to be war or revolution or some combination of those things, or very substantial political upheaval. So the most famous episode of hyperinflation is probably that in Weimar, Germany, in the early 1920s following World War I and the payment of reparations

and all sorts of other complicated things that were happening there at the time. Prices, over the course of 1923, went up very, very dramatically. We're talking like thousands of percent every month. And, you know, it got to the stage where you can see photographs of people using wads of notes as kindling for starting a fire because it was actually cheaper just to use the notes to burn the notes than it was to buy some kindling,

to buy something to start the fire with and then burn that. You can see people using money as wallpaper because, again, it was cheaper to use the money than to actually buy wallpaper. I've seen photos of people carrying wheelbarrows full of notes just to buy a loaf of bread or something like that because things just became so expensive. The single most severe case of hyperinflation in history occurred in Hungary after the Second World War,

and at the peak of that hyperinflation, the monthly inflation rate reached 41.9 quadrillion percent, in July of 946. So if you don't know what that number is, there's a million, and then a thousand times that is a billion, and another thousand times that is a trillion, and another thousand times that is a quadrillion.

So 41.9 quadrillion percent every month, which, to put it in another way, means that prices were doubling every 15 or so hours. So, you know, from the time you wake up to the time you go to bed, prices of bread or of clothes or of alcohol or whatever you wanted to buy have gone up double, have doubled. And you could just imagine what kind of effect that would have on economic activity. Hyperinflation like that basically destroys an economy. It means that people just don't want to accept money anymore because it's just worthless.

I mean, it's a single unit of currency is just worth so little. It's not even worth bothering with. And also, the value is falling so fast that people just don't want to accept money anymore. Instead, what tends to happen in these situations is people start to use foreign currencies, often US dollars, or they just resort to barter and other things like this. So hyperinflation is very, very damaging, and they can often lead to further political unrest and civil disorder and so on. The most recent hyperinflation occurred in Zimbabwe recently, which you may have heard about. Inflation just got to absurd levels, and it was ended, as hyperinflation often is, by the adoption of a new currency. In this case, there was spontaneous what we call dollarization.

Yes, that is actually word dollarization. Zimbabwe adopted the U.S. currency as their official currency. Well, actually, people just started to use it, and unofficially, and then it became so widespread that effectively the government had to recognize that, and now it doesn't have its own currency anymore, it just uses U.S. dollars. So how can hyperinflation like that happen? Well, it's really the same reason as inflation of the ordinary sort happens.

It's just dramatically intensified. That is an increase in the money supply. usually what happens in those situations is that the governments, for various reasons, are unable to raise sufficient revenue through taxation or other sources, whether it be to pay for a war or to pay war reparations or whatever else, or to rebuild after a conflict. And therefore, in order to make up the difference, they gain, that they start to print a very large amount of money, literally printing new notes and spending those. So they don't have to raise new tax revenues to do that. The trouble is that they can only do that once. you can only spend a new piece of currency once, and then if you want to spend some more money, you have to print another new bill and another new bill.

And pretty soon the money supply just starts going through the roof, and inflation starts accelerating dramatically. And once it takes off, it's very hard to rein in because of the effect of expectations. So if people expect prices to go up, you know, if people expect prices to double every week, well, then what do you think they're going to do? They're going to demand pay rises of doubling every week, and shops are going to raise their prices by twice doubling their prices every week because, of course, they have to do that in order to pay their rent, which is doubling every week,

because the landlord knows the price is doubling every week. Basically, if everyone expects prices to double every week, then prices will double every week, because people will double prices every week because they know that prices are going to double every week, and so they do double every week. It's a sort of self-fulfilling loop of expectations, which is really hard to get out of. In order to break that vicious cycle, you have to have some sort of outside intervention, which can make a credible promise saying, it's going to stop now, we're going to stop printing money.

Often the government itself can't do that because people don't trust it. I mean, how did you get in this situation in the first place? You just started printing money without any concern for this sort of thing. So merely to announce that you're going to restrain yourself, the central bank's not going to do this anymore, it is not very credible. So often you have to adopt a foreign currency, which is credible because the government in question doesn't have the ability to print that.

So, for example, in Zimbabwe, dollarization ended the hyperinflation because the government of Zimbabwe doesn't have the ability to print US dollars. Well, I suppose they could try counterfeiting them, but they'd pretty soon get into a lot of trouble if they tried that, and people would be able to tell the difference anyway. So the Zimbabwe and government doesn't have the ability to print U.S. dollars, so people in Zimbabwe now knew that, well, prices aren't going to go up nearly as fast as they used to,

because they simply can't. The government doesn't have the ability to do that anymore. And so people expect prices to go up less quickly. They expect inflation to stop, and therefore it does. So expectations are actually very important when it comes to inflation, and that's been something that's recognized, being recognized increasingly in sort of recent years in economic analysis. So that's a little bit about what causes inflation, but why do we care about inflation so much?

I mean, obviously, if there gets hyperinflation, you can obviously see how that's bad, but what about just sort of ordinary inflation of, you know, three or five percent a year? Is that an issue? Why are we so worried about that? Because certainly, you know, people in the Federal Reserve and other Reserve Banks around the world and in the government talk about inflation a lot, worrying about inflation getting too high or having to restrain inflation. The worry is that inflation has negative economic effects, and usually it's agreed that above very small levels, inflation starts to have increasingly significant harms for the economy. So very small levels of inflation, not too much to worry about,

but as it gets higher, it becomes more and more problematic. So what exactly is the problem with inflation? What does it do to an economy? Well, there are a number of reasons that inflation at sample. One is that it just adds uncertainty into the mixture. If you know that some good is going to cost $10 this year and $10 next year and $10 the year after that, it's easier to plan and to have expectations that will be met, because you know what's going to happen in the future. If prices are changing rapidly every year, then it's just less certain. You don't necessarily know that the price is going to go up by exactly 10% next year. Maybe it goes up by 5% or 7% or or 13%, and you don't know exactly. So the higher the rate of inflation is, the more uncertainty

or noise there is in price signals and making this decision. So basically it becomes harder to make rational economic plans. And that's a significant cost, because it means people make mistakes more often. They make an investment where they shouldn't have, because they thought that the price of whatever they were selling was going to go up by this much, but it didn't go up by quite that much, and therefore the investment was a bad decision, and they wasted that time and money, and you can imagine how this goes on. So this uncertainty is a bad thing. There's also what we call a shoe leather cost. Now, the basic idea there is that high inflation means that you have to spend money more quickly, because the higher the rate of inflation is, the more quickly the money

losing value, and so you want to get rid of it as soon as you can. And so that means more trips to the bank and more transactions. You pay your rent every week instead of every month and so on, similar things like that. You go grocery shopping every, you know, twice a week instead of just once a week. So making these increased number of trips and individual transactions just increases the number, increases the cost of these sorts of things. So the sort of traditional way of thinking about it is that you wear out the leather of your shoe walking to the bank. And of course, that's not literal. That's figurative. It's just the fact that, of making transactions itself is costly.

And so you have to do that more often if your money is losing value more quickly, and therefore there's this added cost to higher levels of inflation. There's also something called menu cost, which is the cost of changing prices itself. So again, the traditional notion here is that a restaurant has to print a new menu every time it changes its prices. But again, that's just sort of an analogy. Most firms aren't literally printing out new price tags,

although that does happen for supermarkets and things like that. But even for lots of other firms that may even just change prices electronically, the main cost is actually sort of time and effort into deciding, well, how much should we raise the price? And should we raise the price today or should we wait till tomorrow? You know, our company spend a lot of time and energy and resources thinking about exactly what price should we set and how often should we change it and how much should we charge for this model compared to this other model or for this product compared to this other product.

Every time you want to change prices, you have to make that decision again. And so it becomes very, very problematic. I mean, you might just think, well, why don't they raise all prices in life? with inflation. But again, it's not so easy. I mean, for one thing, inflation figures take a while to come out. So we don't know what the inflation is right now. We only know what the inflation was maybe three months ago or something like that, and maybe it's changed. And also, we can't necessarily tell the difference between our particular industry and the average inflation rate. So should we raise our prices by the inflation rate or by a little bit more than the inflation rate because

our industry is doing particularly well? Or maybe it's a little bit less than the average inflation rate because our business isn't doing too well and the new product isn't going so well. it's much harder to make those decisions when you've got this added noise and uncertainty and complexity of inflation, confusing the issue. And so therefore you have greater menu costs of figuring out how to change and when to change your prices. And then, of course, just, again, the actual mechanical costs of printing the new price tags or whatever it be. So for these and a number of other reasons, inflation is generally thought to have fairly negative effects on the economy. Certainly if inflation gets too high, and, you know, there's no hard and fast level there about what too high is. Certainly if you get to double-digit levels, so more than like 10% a year, that's generally thought to be a bit too high and you want to try and reduce it below that.

It's also generally thought that something called deflation, which is prices falling every year, so negative inflation. It's generally thought that's a bad thing as well for various complicated reasons we need to get into here. So most economists think that the best strategy is to go for positive low levels of inflation, like 2% or 3% or 4% a year, something like that. And most economists generally think, yeah, somewhere around there's probably the best. But there's certainly no like right level or optimal level of inflation. It's messier than that. There's just a couple of things that I want to mention briefly before we finish out this episode. One is the notion of interest rates, which are a very complicated phenomenon in it of themselves,

and I just want to introduce the idea here. Interest is a fee paid by a borrower of assets to the owner of the assets as compensation for the use of those assets. So the most common type of interest rates, probably the most people are familiar with, are when you borrow money to buy a house, you take out a loan, which is called a mortgage, and you have to pay interest for that money because the bank's given you a whole chunk of cash. They could have been doing things with that cash, so they're going to require you to pay some fee for use of that cash over the years that you're going to be holding up those assets.

And this fee we call interest. And often we calculate interest as a percentage of the principal, which is the amount you borrow, which you have to pay back every year extra to the principal. So, for example, if I borrow $100,000 to buy a house, and if my interest rate is 5%, that means every year I have to pay an interest fee of 5% of $100,000, which is $5,000, to the bank just for the privilege of borrowing the money. That's completely separate to the question of then paying back the actual loan, paying back the principal. You have to pay interest plus the original loan back. Interest rates can be thought of as sort of like the price of money, which might strike you as sort of an odd thing,

how can you have the price of money isn't money like a price itself? Well, not really. Prices are just ways of comparing the value of two objects. So I could measure the price of a computer in terms of carrots if I wanted to. This computer is worth X number of carrots. That would be a rather pointless thing to do, but I could, and it would still be just as much of price as anything else. So I can talk about the price of money as being a ratio between how much money I have to pay back tomorrow versus the amount of money I'm able to borrow today.

So interest rates are a way of representing the, to use the jargon, intertemporal price of money. That is how much extra you have to pay for the benefit, for the privilege of getting money now instead of having to wait in the future to get the money, loosely speaking. Anyway, that turns out to be very important because it crops up in interest rates crop up in monetary policy, which is, you know, the Federal Reserve and how it changes the interest rate and all that sort of stuff. That's what the, that's called monetary policy. And that's something that I'll talk about in more detail in a future episode. I just wanted to introduce the concept of interest rates now because they fit into this discussion of money and inflation, because they can be

thought of as sort of the intertemporal price of money. Another important point that I wanted to mention is the difference between nominal and real interest rates. Now, remember, I talked about inflation before? Well, if I borrow money and have to pay back, say I have to pay back an interest rate of 10% per year, but what if the inflation rate is 5% per year, which means on average prices, including my income, but also other prices, are rising at 5% per year? Well, that means, that means that, means that in real terms, I only actually have to pay back 5% per year, 10% of the nominal rate, the rate that's written down on the contract, minus the 5% inflation. Because I kind of get that 5% for free.

I'm just going to get that at the end of the year as a pay rise or something like that. So I kind of don't have to worry about that 5%. I just have to worry about the other 5% that's left over. So this sort of leftover bit is what we call the real interest rate. It's the nominal interest rate, the rate that's actually written down in the contract, or on the price tag or whatever, minus the inflation rate. the rate at which average prices are going up every year. And it's often the real interest rate which is actually much more interesting

because it's sort of the real cost of borrowing money. If you have to pay back 10% interest, but every year your income is going up by 10% because of inflation, well then basically you don't actually have to pay any real interest. You don't really have to do anything. You don't have to find extra resources to cover this burden. So it's not a real burden. So we say that that's the real interest rate that you have to consider.

Okay, so that's a bit on... interest rates, the final thing that I want to mention is exchange rates, which also can be thought of as a price of money, but a price in a different sense now, instead of comparing the value of money today to the value of money tomorrow, which interest rates do, exchange rates compare the value of different currencies against each other. So an exchange rate is simply the rate at which one currency can be exchanged for another. So, for example, if I say that the exchange rate between Australian dollars and American dollars is, um, 1 to 1.2, let's say, that means that I have to give up one Australian dollar to get $1.20 in American dollars, or it could actually mean the other way around. It sort of depends on which one you list first, which can get a little bit confusing, but anyway, that's not so important for our purposes. Basically, you just give a ratio of the value of the two currencies. So how much can I buy of one compared to how much can you buy another? So some currencies are worth a lot less than other.

So, for example, the Japanese yen, a single yen is worth a lot less than a single American dollar. I'm not exactly sure what the current exchange rate is, but it's something like 100 to 1, I don't know, maybe it's 70 to 1, whatever. But, you know, that means one US cent will buy you roughly one Japanese yen. Now, does that mean that everything's way cheaper in Japan? No, it doesn't mean that, because, of course, things that cost $1 in America cost 100 times that, 100 yen in Japan.

This is a concept that we call purchasing power parity. The idea there is that things, the same, good should cost about the same in real terms in different countries. So perhaps some good costs, let's say, $10 in America, but that doesn't mean it's going to cost $10 in Japan. In fact, that would be ridiculous because one yen is not worth $1. If I wanted to figure out how much this thing, whatever it is, is probably going to cost in Japan, I would first need to convert my American dollars to Japanese yen. Let's say it's a 1 to 100 exchange rate, so my $10 U.S. dollars convert into $1,000.

Well, then, that's basically what I would expect this same good, whatever it is, to sell for in Japan, a thousand yen. That would be at what we call purchasing power parity to the $10 in the American case. If the good sold for less than a thousand yen, maybe it sold for 900 yen, then I could say this good is cheaper in Japan. Because what I can do is if I'm in America, I can take my US dollars, I would only need to actually take nine US dollars, convert them into yen and then buy the good. And then I save one US dollar. So the good is actually in real terms cheaper in Japan. other hand, perhaps in Japan it cost 1,100 yen, in which case I would need 11 U.S. dollars to buy that thing from Japan. But if I could buy it for 10 U.S. dollars just in America, well,

then I wouldn't bother. I just buy it for 10 in America. So in that case, the real cost would actually be higher in Japan. Now, generally, according to purchasing power parity theory, we would think that the real cost, you know, once you've converted into the appropriate currency, of the same good in different countries, should be about the same, because otherwise you'd just buy the good in where it's expensive and sell it where it's cheap and pocket the difference. I've said that the wrong way around, didn't I? You'd buy it where it's cheap and sell it where it's expensive and pocket the difference. But, of course, that doesn't always work because you can't buy and sell everything. So Big Macs are an example that people like to use. Big Macs vary dramatically

in their real price, even when you convert it into US dollars in different countries. And one reason is, of course, you can't really transport those around the world. They have to be produced locally. So purchasing power and parity theory doesn't hold exactly, but it's still a sort of good guess as to how much something would cost. in different countries. You work at what the same equivalent price would be using the market exchange rates. One more point that I want to make about exchange rates

is, as I said before, an exchange rate is just the ratio at which you can change one currency for another. But some currencies are more easily exchangeable than others. So some currencies are what we call free floating. This means that anyone's allowed to buy and sell them basically wherever they want. There's no restrictions on buying and selling the currency. And so its value just fluctuates with supply and demand

in the free market. and this is what you see every day in the financial news or whatever when they talk about all this changing exchange rates. These things are changing all the time, like literally every second because of so much transactions around the world. These are all free floating currencies. There's also such things called peg currencies and fixed exchange rates, which have greater restrictions on who can buy and sell the currency. So a good example of this is the Chinese currency, the Runminbi, which has some restrictions on who can buy and sell it, and also the central Chinese bank intervenes in the market to try and well, to maintain a certain band of a loud level.

So the price of the Chinese currency can fluctuate a little bit, but it can't fluctuate too much, because if it does, the Chinese bank comes in and manipulates the demand and supply so that it maintains the level that it wants. We might talk about this a bit more detail in a future episode. The details aren't so important for us. Just what I hope you would understand is the difference between a fixed exchange rate, which always stays the same. Often it's one currency is pegged, what we call pegged, to another currency.

and this is a term I mentioned earlier. So, for example, one Chinese UN might be worth 20 US cents, and that's defined to always be the case, so that doesn't change over time. Or maybe it changes every five years when they adjust it or something like that, but it doesn't fluctuate every day. Whereas a floating exchange rate is one that fluctuates freely with supply and demand, with really little or no restrictions,

and the price of that changes all the time as conditions change. So historically, as I said, a lot of currencies used to be pegged to the US dollar, and we used to have these exchange rates. But since, you know, roughly the 70s, 80s, many of the developed countries, and even actually many of the developing countries around the world have freed up their exchange rates. And so now most currencies are either free or mostly free exchange rates. There aren't too many ones that are purely fixed these days. Okay, so that's all I had for this episode.

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