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  • What makes money, money?

    By definition, money is anything that is accepted as a medium of exchange. When we use the term “medium of exchange,” we mean we can use it to buy or sell anything (good or service) and that the other person will easily accept and use it for his/her transactions. Money is also a measure of value, which means a product’s worth (value) can be measured in the monetary unit. Just like gold and precious metals, money is also a store of value* (see note below), and a standard of deferred (future) payment, which means you can use the money to pay someone in the future and it will be acceptable by that person.  

    How did money come into being?

    Long time ago, when coins and currency were not there, people used to exchange goods for goods. That system was called a barter exchange system. But there were several problems with it. The most important was the lack of double coincidence of wants. Let’s understand this with an example. If, person A is growing rice and has extra rice than he needs, he has an option to trade it with someone who wants rice in return for something he wants. Now let’s assume person A actually wants wheat, he will have to find a person who has extra wheat and at the same time that other person (person B), must want rice in return for this trade to happen. But if person B doesn’t want rice instead wants something else, then there is going to be a problem in doing this commodity to commodity exchange.

    This Barter exchange system became very difficult to continue as the population grew, because searching for the “right” person to exchange one’s extra produce was not easy.

    Another problem with the barter system was that it didn’t have a store of value. Perishable items like milk, meat, and vegetables that people wanted to trade couldn’t be stored for a long time and would lose their value once they went bad. Nonperishable items may have a store of value but, were not always easily convertible into other things with universal acceptability.

    This lack of store of value also made this barter system very difficult to carry on. Also, the barter system could not make future payments.

    People needed something intermediary, something that both parties could accept to help the exchange of goods and services. Thus, all of these problems were eliminated by the introduction of money. As I mentioned in the first paragraph, there were various advantages of having money. The most important being its universal acceptability of being a medium of exchange and a measure of value. It also is a store of value and can be used for future payments. Though when inflation is really high (above the target level), money can lose its capacity to act as a store of value.

    The currency and digital money that everyone is using nowadays only came a few decades ago. Money had evolved over time into different types, and various items were used as money at different periods in history.

    In the past, people had used cows, salt, and stone wheels as money, as they were widely accepted as a medium of exchange for goods and services. The central bank of Brazil published this article about the origin and evolution of money. However, there was always the risk of diseases and death with cows, and people wanted something easier to carry.

    Then, there was commodity money like gold and silver coins, which people could use in exchange for goods and services and they also had their own intrinsic value as well. By intrinsic value, I mean gold and silver always have had worth to people because of their uses for jewelry, etc. The minting of gold and silver coins prevailed for many centuries.

    Then came the representative money which was a paper certificate that you could exchange for gold in a bank for the underlying commodity. As people started trusting these paper certificates same as much as gold, it led to the creation of modern money which is also known as the Fiat money.

    Fiat money does not have any value of its own, (just a piece of paper or metal) but it has a guarantee from the government of the issuing country.

    It is declared as the legal tender and is an acceptable form of payment backed by that country’s Central bank. We all know if we have paper currency or coins, we can use them anywhere and they will be accepted as a form of payment. In today’s modern economy, most of the time we don’t even hold currency, as all the payments and receipts can happen online, where the money gets debited or credited directly in your bank account from another person’s bank. A lot of countries have gone virtually cashless because a large number of people use smartphones nowadays and internet access has become much cheaper and wider. This has made the digital transfer of funds between two people just with a click of a button on phone. It is important to note that a credit card is not considered money* (read the section below Supply of money).

    Is there a thing called a Money market?

    Just like any commodity, money also has a demand and supply, and thus, has a market. The interest rate at which we borrow money is the price of money.

    Demand for money

    We hold money for two reasons. First is to make transactions, so we can make payments for our various expenditures. The transaction demand part is positively proportional to the real GDP and price level. In other words, people will demand more money when there is inflation and higher real GDP. It is simply because they will need more money to be able to purchase more goods and services (real GDP) and at higher prices (inflation).

    The second reason why people demand more money is for speculative reasons. To understand the speculative reason, first, we must understand that when we hold money, there is an opportunity cost for it. Opportunity cost, in economics, means the cost of missing the next best possible use of something. Which in this case is the sacrificed interest that we could have received if we had saved money in a time deposit with a bank instead. When there is extra money in people’s hands (high money supply), they can use it in two ways- spend it or save/invest it.

    When banks are charging and paying a higher interest rate, demand for money gets low because of two reasons. First for a borrower, the cost of borrowing money gets high, so he will borrow less and hence demand less money. Second reason is that when interest paid on our deposits are really high, we will expect interest rate to fall in future and want to convert their money in bonds. Bonds pay fixed interest and principal at maturity, and the interest promised at maturity doesn’t change with market interest rates changes. Thus, it becomes safer to invest our extra money in bonds than in a savings or time deposit with the bank. Interest rates are paid on time deposits, which can vary according to the central bank monetary policy tools. In this case, when the interest rates are high, the demand for money is low. With the same logic, when interest rates are very low in the economy, people expect them rise in future and will demand more money compared to bonds. So, speculative demand for money always has a negative relation with interest rates.

    So, the total money demand is equal to the money demanded for transactional and speculative purposes.

    Supply of Money

    The money supply is the total amount of money that the people in an economy are holding at a particular point in time.

    Central bank of a country has the authority to issue the currency of any country. This currency issued by the central bank is held by the public and by commercial banks.

    In the US, the Fed controls the money supply of the country through various tools by changing interest on reserve balance and thereby controlling the federal funds rate and other interest rates in an economy. You can read about this in more detail in my post here.

    The money supply is a stock concept, which means it is measured at a particular point in time and a country’s central bank usually publishes the total amount of money periodically.

    Money is a financial asset that we can spend to purchase goods or services. When calculating the money supply, the central bank includes financial assets like currency and deposits. On the contrary, credit card debts are liabilities. With each credit card transaction, a new loan is created for the credit card issuer, which needs to be repaid with a financial asset called money. 

    The two establishments in any country, the Central bank and commercial banks play an important role in deciding how much money is circulating in an economy at a particular time.

    Since different assets can be used as money, the central banks give various categories and definition to keep track of it. In the US, there are two commonly used measures of money, known as M1, M2.

    M1 is the most liquid and widely accepted. It includes paper currency and coins held by the public + demand deposits of public at commercial banks, + other highly liquid accounts called other checkable deposits. Prior to April 24, 2020, savings accounts, deposits were not part of M1. Savings are now more liquid and part of “M1 money”. Regulation D by the Fed has made savings deposits as convenient as currency. The Fed published data on M1 and M2 every month, As of April 2022, the United states had $20.6 trillion in M1.

    M2 = M1 + small-denomination time deposits of under $100,000 + balances in retail money market funds. As of April 2022, The United States had $21.7 trillion in M2.

    https://www.federalreserve.gov/releases/h6/current/default.htm

    If you are interested in learning about the linkages between banks and the central bank, please click here.

  • What role do models and graphs play in economics?

    Our economies are complex, but by making some simple assumptions, we can focus on what is most relevant in explaining something. For this reason, economists use models to give us logical and precise reasoning behind many questions that come to our minds. Sorry, if you thought of this model as the one who walks on the ramp or does an ad on TV. Unfortunately, here we are talking about a little bit boring, economic models. Unlike attractive human models, these models generally consist of a set of mathematical equations, which are a simplified depiction of the real world. So, even if they are not pretty looking, they serve a very important role in economics. They try to precisely (like theories in science) describe how and why, we, as economic agents, act and are likely to act in future.

    One of the most important models in economics is the demand and supply model, together they explain how the price of anything gets determined.

    Economists use models for a variety of reasons, some of these include:

    • To assist in academic research that supports a proposed economic theory
    • To make economic forecasts so that we can understand the conclusions based on the assumptions made
    • To influence policy making relating to larger economic activities or at macro level
    • To explain and influence company strategies for businesses
    • To explain the growth pattern among countries
    • To understand banking, investment and saving behavior
    • To explain decision making at household level

    And many more…

    Even though, no economic model is a perfect description of reality, the process of making, testing, and revising these models forces economists and policymakers to think logically when trying to propose something. With the help of these mathematical models, they try to accurately depict how the economy works, and what drives economic behavior in people at large. This in turn helps them answer what they should or should not do when proposing a particular policy.

    These economic models use a lot of mathematics, as one of the key contribution of economics to mankind is how to think on the margin. That means calculating the additional benefit, and the additional cost of any particular action. Knowledge of calculus comes in handy in finding these solutions. So, if you or someone you know are planning to study economics in college, make sure they are good at calculus and algebra.

    Economists also use a lot of graphs, as these are a good visual representation of these economic models. The charts and graphs are relatively easier for people to understand as compared to mathematical models. So for my blogs, I will stick to graphs only. 🙂

  • How price of anything is set?

    The answer to this complex question is simpler than you might think.

    Do you think a business can charge whatever price it wants, to get the highest possible profit? But consumers who demand those products would like to buy them at the cheapest price, so how do they come to a consensus? In markets that are highly competitive (see footnote)*, meaning there are many producers and consumers of a specific good or service, the price of that product or service gets determined by the interaction of supply and demand forces. These forces work together in the same manner as the blades of the scissors cutting the paper.

    Wait, but what are these supply and demand forces?

    First, let’s understand them individually, and later we will see how they interact to set the “right” price.

    Demand

    In economics, we assume that people buy more of something when its price is lower. This negative or inverse relationship between price and quantity demanded is called the law of demand. This means the higher the price, the lower the demand is, and the lower the price, the higher the demand is for any normal good or service. Undeniably, a change in people’s tastes, income, and preferences can affect the demand for something, but we will assume that these other factors don’t change, so we can only focus on the relationship between price and quantity demanded.

    Let me explain this with a simple example of the demand for bread. The prices are shown on the Y-axis and the quantity that people are demanding is on the X-axis. You can see this inverse relationship in the graph below that slopes downward.

    If the price of one loaf of bread is $10 there is going to be very less demand for it, let’s say only 10 loaves of bread will be demanded. Once the price is lowered to $6, a few more people will be willing to buy it, so the quantity demanded increases to 20. And if the price is further lowered to $2, more people would be willing to buy it, as more can afford it, so the quantity demanded now is 40.

    Supply

    Now let’s look at the supply pattern. For a producer, if he gets a higher price for bread, he will be willing to make more bread and supply more of it. A higher price or reward encourages producers to supply more, and you can see this positive relation in the graph below as an upward-sloping supply curve. So, the law of supply states that there is a positive relationship between the price of a good and quantity supplied. This means the higher the price, the more businesses or producers are willing to supply, and the lower the price, the less they would like to supply. In the graph below, we can see at $2, producers are only willing to supply 10 loaves of bread, at $4, 20 loaves, and at $10, 40 loaves of bread will be supplied.

    Now when we plot both of them together in one graph, we will see there is one price, where both these curves meet. In economics, we call it an equilibrium point, where the price is just right for the producer/seller and the consumers. In the graph below, this happens at point A, where demand and supply meet or cross each other. The price is set at $4 and the quantity demanded and supplied is 25 loaves of bread. Thus, we saw no one individually impacted the price, but producers’ supply and consumers’ demand worked together to set the price that makes everybody happy.

    You understood how prices can influence how much people want to buy and produce. Now, let’s understand also, how it works the other way round, meaning how much people demand and businesses supply can influence the prices as well.

    If there’s more demand than supply for something (such as point B above), this will send a signal to the producers to increase the price from $2 to $6, because they understand that people are prepared to pay more to receive that good or service. In this case, there is an incentive for the producers to increase the price. If the price goes up to $6, some consumers will drop out as they won’t be able to afford bread at price $6.

    On the other hand, if there is more supply than demand (shown as point C above), this is a signal to the producers to lower the price from $6 to $2, because the price at $6 was too high and there is a very limited number of people who are willing to buy it. Now some producers, might drop out and can’t lower the price to $2, because they can’t cover their cost of production.

    Over time the price will keep moving upwards or downwards until it reaches a point where demand is equal to the supply, at point A ($4).

    Today, you learned two fundamental concepts in economics: the law of demand and the law of supply.

    If you are wondering about whether it is possible to plot these demand and supply curves in real life, the answer is, yes? In economics, a graph is just a simple representation of economic principles or behavior observed. Economists survey people and collect data and plot that data using easy-to-understand graphs. In the demand and supply curves we looked at today, the slope could be steeper or flatter. In order to learn what decides how steep or flat (demand or supply) curve will be, we will have to look into another important principle in economics called elasticity. More on that will be in my future posts. For now, if you just want to know why economists use models and graphs to solve real-world economic problems, please read my post here.

    *In non-competitive markets, like monopolies, where one company controls the market, it gets more control in setting the price. The demand and supply forces don’t work very well here. Producers want to get the maximum profits by setting the price higher and can do that as well. In the absence of other competing businesses, consumers who want to buy their product or use their service, don’t get other options. Hence, they end up paying a higher price than they would have paid if more companies were in the market for that product or service. Usually, to prevent businesses from exploiting consumers, some government intervention is required so these monopolies don’t create artificial barriers to entry.  

    It is worth noting that, some monopolies can happen naturally and not all monopolies are bad. We will look at this more in detail with real-world examples in another post.

  • What are our real earnings when we deposit money in our savings accounts?

    If I asked, “What’s the interest on your savings account?” many of you will tell me the interest rate that the bank is stating. However, you need to understand the difference between nominal and real interest rates.

    In this post, you will learn about the true return you get by saving your money in a bank.

    What is a nominal interest rate?

    When you deposit money in your savings account at the bank, you get something called nominal interest. So, if your savings account has a 2.5% interest rate, that is actually a nominal interest rate.

    A nominal interest rate is the interest rate banks and financial institutions give to you. It is the actual rate they will pay on your savings balance. This interest rate is not adjusted for inflation.

    Before we dig into real interest rates, we need to understand what inflation is and how it impacts the real return on savings.

    What is Inflation and how does it affect your actual return?

    Inflation is the general increase in the prices of everyday goods and services we use. It is important to note that the price of one item can go up and down, but the increase in any single item won’t qualify for inflation. Inflation happens when price rise for a majority of goods and services we use. In other words, inflation only happens when the average price level is going up. For example, when the prices of food, housing, gas, and other items we use, all rise for a while. I have written a detailed post on inflation in another post if you are interested.

    Real interest rate – the one that actually matters!

    If there is any inflation in an economy, money loses its value or purchasing power. So, the interest you earn from the bank won’t buy the same amount of things it could before the price rise. Thus, we need to calculate the real interest rate. This is the rate we get after subtracting the inflation rate from the nominal interest rate your bank quoted to you. So, the real interest rate r is

     r = nominal interest rate- Inflation rate

    This is called Fisher’s equation in economics, named after American economist Irving Fisher. He explained the difference between true or real interest from nominal interest.

    Thus, we will only earn interest income on our savings, when the real rate of interest is positive. If this number is positive, we haven’t lost money and actually gained some by keeping it in bank.

    Let’s learn this by an example. Think of a big balloon with some air. Here air is the money you deposited in your savings account (balloon). Now, let’s think of the “nominal interest” you earn on your savings as the rate you are blowing air in the balloon to make it bigger. But let’s suppose there is a hole in the balloon, which is making the air come out of it as well. This air coming out of the hole is representing inflation in an economy.

    If you’re blowing faster than the air that is coming out of the hole, your balloon will become bigger. And if your balloon is getting bigger, then purchasing power of your money in a savings account will grow over time. This is when you are earning interest in a real sense, and you will be able to buy more things.

    But if the hole is bigger, the air will come out faster than the air going in. This will cause your balloon size to decrease, which means your purchasing power will go down.

    So even if you are getting a nominal interest on your savings account from the bank, because of inflation, you will only be able to buy fewer things with that money in the future.

    So, the real interest rate could be positive, zero, or negative depending on whether the inflation rate is less, equal, or more than the nominal interest rate.

    If the real interest rate is zero or positive, then saving your money in a bank is still better than keeping it with you.

    When you keep money in your house, it certainly will depreciate by the rate of inflation. The only time keeping money in the house will help is when there is a deflation, which means the general price level is going down.

    In the chart below, you can see how inflation affects your true savings return.

    Does anyone benefit from stable inflation?

    Savers, borrowers, and lenders all benefit when the inflation level is stable and low (around 2%). For borrowers, it helps them pay off their loans because they are paying a little bit less in real terms.

    Banks know the target rate of inflation, so they keep their nominal lending rate of interest higher than that. This helps them get some real return on lending money.

    Similarly, for depositors, if inflation is stable, they get the real return as the excess of nominal return over the inflation rate.

    However, if inflation is more than the normal 2%, then both lenders and depositors will lose money.

    To learn about what measures the Fed takes to keep inflation stable at around 2%, please click here.

  • GDP in the US decreased in the first three months of 2022

    You might have heard in the news might have heard that the US economy has contracted in the first quarter of 2022. When we talk about economic contraction or expansion, we look at the % change in the most widely used statistic to measure the overall economic health of a country, also known as the GDP. Many were surprised by this decline, and it’s said as the worst quarter since the pandemic started in March 2020. To know more about what GDP is, please click here.

    The official source of publishing GDP numbers in the US is the Bureau of Economic Analysis. In their April 28, 2022 press release, they projected an annual 1.4% decline in the real Gross Domestic Product of Q1 2022 vs a growth projection of 6.9% in Q4 2021.  If you want to see the details about the calculation, data, and assumptions, you can check this page here. https://www.bea.gov/data/gdp/gross-domestic-product

    What were the reasons for this decline?

    The main reason that made the GDP growth negative was the trade deficit, meaning imports were far more than our exports, as US domestic supply couldn’t keep up with the domestic demand.  In addition to the trade deficit, the GDP was also deflated by the omicron variant of COVID that shut down some businesses, and the government-funded pandemic relief to businesses and households decreased or stopped altogether by the first quarter of 2022.

    Should we worry about this slowdown?

    Despite the projection, economists are saying that there is no reason to panic yet because this GDP decline happened due to the net export component. In the chart below, data collected from BEA shows the percent shares of each of the four main contributors to the US GDP in the 2022 Q1.

    The two major contributors to the US GDP have been consumption and investment, and both remained strong. Consumption, which is the most important driver of the US economy (contributing to almost 70%) increased during the first quarter at a rate of 2.7% annually, compared to 2.5% during the fourth quarter of 2021. Similarly, the business investment such as capital expenditure on factories, equipment, software, etc. remained robust and hence should increase productivity for the remainder of 2022. Firms’ investment had grown at a rate of 9.2% in the first quarter of 2022 which is a significant increase from the 2.9% increase in the last quarter of 2021.

    In summary, even though the GDP first quarter fell, it is not indicating a recession coming. A recession is defined as a fall in GDP in two successive quarters. And we may only hope for a better future and some happy news in the economy.

  • Gas prices are too high, but why?

    Both gasoline and diesel prices are still up. Drivers across the US and globally are feeling pain when they visit gas stations to pump gas. You can see that both gas and diesel prices have been trending up in each of the regions in the entire US from October 2021, with a steep rise after Russia started the Ukraine war. I got these charts from the US Energy Information Administration, which is the US official source of data for energy information.

    And since gasoline and diesel both are needed for the transportation of many goods, the increase in fuel prices has several linkages to other industries as well. In this image, taken from the US EIA website, you can see, that the national average for a gallon of gas in the United States was $4.11 and $5.12 for diesel as of April 2022.

    What has caused the continued rise in fuel prices?  

    In most simple terms, it is the imbalance between the supply and demand of crude oil. There is an increasing oil demand, while there is not enough supply. Gasoline and diesel both are made from crude oil. The petroleum refineries make gasoline and other petroleum products from crude oil.

    You might ask why the gas price is high in the US when it only imports a very small percent of crude oil from Russia. The answer to this lies in the fact that crude oil prices are set in the global market.


    In this chart, you can see the supply and demand imbalance.

    On the x-axis, we have the quantity of crude oil demanded and supplied and on the y-axis is the price of crude oil. For any commodity, an equilibrium price is set, where the upward-sloping supply curve and the downward-sloping demand curve intersect. That is the quantity that the producers are willing to supply and the quantity the consumers are willing to buy at a price that works for both.

    If the producers supply more than what consumers demand, then the price of that commodity will fall because there is excess supply. On the other hand, if demand for a commodity is more than what the producers can supply, it causes price to increase because there is excess demand and consumers are willing to pay more. In the case of oil price hike, the latter has happened. This has led to both a rise in price of crude oil and a lower equilibrium quantity of crude oil consumed and supplied. The above chart shows that as Q1 and P1.

    The economic sanctions put on Russia by the United States and the European Union in response to Russia’s invasion of Ukraine have had a shattering effect on the Russian oil supply to the world. Many countries have cut trade ties with Russia, leading to a lower supply from Russia. Even though, US has become the largest producer of crude oil. Russia is still one of the biggest crude oil producers in the world, so it has a significant influence on the total industry output in the global oil market.

    When Russian oil is not available to its full capacity, the world supply of crude oil has dramatically decreased. This has caused crude oil prices to rise significantly. During the early part of 2020, when the demand for transportation dropped significantly due to the lockdown, crude oil was at an average price of $39 a barrel. This was its lowest price since 2003.

    However, as the lockdown eased and economies returned to normal, there has been an increasing demand for crude oil. With people commuting to work again, traveling on vacation, and going out more, the demand for gasoline has resumed. While the suppliers are not able to increase the supply of crude oil, there is an increasing demand. The price of crude oil in the international market exploded to $139 before settling at $123 a barrel. Much of the inflation is due to a rapid rise in crude oil.

    Crude oil is used to produce gasoline, so fuel refining companies like Exxon, Chevron and others are passing the higher costs of production on to consumers by raising prices at the pump. This is the inflation caused by supply factors.

    Million dollar question in everyone’s mind is when will the fuel prices go back to normal?

    The sad news is that Economists don’t expect gas prices to fall anytime soon, unless war in Ukraine comes to an end and and some sort of order is restored in Europe. Until then, the world oil market will continue to struggle to provide an adequate supply to meet worldwide demand meaning that crude oil prices will remain high. This of course will keep prices inflated at the pump and drivers will struggle to fill their tanks.

    Additionally, as summer approaches, the demand for travel will continue to rise and the average cost of a gallon of gas might peak at $5. Many economists believe that even if supply issues are fixed and prices start to decline in the coming months, the average is still expected to remain over $4 nationally until at least November, as the adjustments take time.

    Going forward the best strategy for countries will be to keep extra reserves when the crude oil price is low. Investment in alternative energy sources will be the strategy for the future to withstand such supply shocks.

    If you want to know more about it, you can also refer to CNN’s article on June 1. Is it just a coincidence that a famous news channel published this article a few days after I did? It is not. This is just what everyone wants to know. https://www.cnn.com/2022/06/01/energy/record-gas-price-causes/index.html

  • What are the different types of economies in the world and where does the US rank in terms of economic freedom?

    We know economics is all about putting resources to their best use, so we get the most out of it. Economists use a fancy term called “allocative efficiency” to describe it. By resources, we mean land, labor, capital, entrepreneurial ability, and time.

    Now, you may ask could there be different types of economies or economic systems to make the best use of limited (scarce) resources? Yes, indeed. These economic systems help to answer the three essential economic questions of what to produce, how to produce, and for whom to produce?

    Let’s take a quick look at the three most common economic systems around the world: they are 1. free market, also called the market economy, 2. centrally planned economy also called the command economy, and 3. mixed economy or Keynesian economy

    I don’t want to bore you with lots of text, so briefly I will explain these. But before you leave, make sure to scroll down to check an interesting chart comparing different countries in 2022. I know we all like visuals to better understand something.

    So here are the three famous systems:

    Market economy: In this type of economy, goods and services exchange freely through market supply and demand forces. In economics, it’s called Laizzes Faire, which means a policy of letting things happen their way, without interference. So, in this system consumers and firms interact freely and maximize their incentives without government intervention. Now, you as a consumer should typically act to satisfy your utility by demanding products you want or need. Similarly, all consumers will do the same. So, consumers signal the producers in the market about what to make and what not to make based on their demand. This helps to answer the question of what goods and services to produce.

    Firms act to satisfy their profit motives by producing products at a minimal cost. Because businesses want to get maximum profits, they will adjust the production process to minimize costs so there’s less wastage of resources. This helps to answer the question of how to produce goods and services. Also, no single producer is required to know all the information in terms how many competing producers are there, and what is alternative use of his resources. Prices set by demand of consumers, and supply of every other producer can give him that signal to produce in the best possible way. Because if he charges more than others or don’t make the products people demand, people will not buy his product and go to the one next to him, given the other producer is local and they sell identical products. This has become easier with so many online shops now a days. Thus, the invisible hand or natural market forces will answer the question for whom goods and services are produced.

    Let’s take an example, if more people demand more of a specific good, like iPhone, its price tends to rise as well. This happens because we as consumers are willing to pay more for that good. Acting in response, producers wanting more profit, will increase production to satisfy the demand of people. As a result, a market economy tends to naturally balance itself.

    Whenever we see a rise in prices in one sector of an industry due to high demand, the scarce resources, such as land, labor, capital, and entrepreneurship shift to those areas where they’re needed the most. In the free market economy., the role of the government is only limited to protecting property rights, this way there is a guarantee of fair competition in the marketplace. People can protect their ideas through patents and copyrights, and this encourages innovation. Thus, a free-market economy is the one with the least amount of government intervention.

    Command economy: On the opposite spectrum is the command economy, where the entire price set up and distribution of goods and services are controlled by a central planner or the government. All economic and political decisions are taken by the government or a central committee of very limited people. They decide how to allocate the country’s limited resources. North Korea is one example of this type of economic system. This type of economy is commonly seen in communist countries. Natural market forces of supply and demand can’t decide the price and quantity of goods and services produced and consumed.

    Generally, people living in these countries don’t have a high standard of living and don’t enjoy economic freedom. By “economic freedom” we mean the ability to choose to produce something or consume something based on your ability and need. Since the government fails to collect all the information correctly about what to produce and how to produce, a lot of wastage happens. People who advocate a command economy think this system is more equitable because everybody gets an equal share. But at the core of economics is the belief that people want to act for their self-interest. As a result, there is less incentive for businesses to work hard and employ better production techniques to maximize profits. Because if someone doesn’t get to keep the extra share, why work hard for it?

    There are flaws in both pure market economy and command economy

    Let’s investigate, why both these economic systems are not perfect. We just discussed why the command economy is not a great system, but we also need to know what the limitations of a free-market economy are as well.

    In a free market, sometimes, markets can waste scarce resources by producing products at higher than necessary costs. This usually happens when there is very less competition or if one producer displays a monopoly. Due to a lack of competition, there’s no real pressure to bring down costs as a result, prices are inflated. The second type of market failure happens in the case of public goods. Private businesses don’t want to produce these public goods, even though we all collectively enjoy these, and are very necessary for the safety and well-being of our people. Since these types of investments are usually not profitable for private firms to produce, they don’t do that. Services like infrastructure or military, police services or fire departments, parks, basic k-12 education and healthcare for the poor. So, if we are only left to the free market, the people would go without these goods and services and not have basic needs and wants met. Also, there will be more unequal distribution of income and people may have extreme inequalities. So, to solve this problem, some role of government is vital. This type of system is called a Mixed economy.

    Mixed economy: Thus in the real world, pure market economies rarely exist because there is usually some government regulation or intervention needed for smooth function. In most countries, like the US, public education, security, law and order, nuclear energy, social security benefits, public goods like parks, and defense are provided by the government. The government also provides regulation, so businesses don’t create monopolies and exploit people by charging very high prices. The government also invests in scientific research to develop future businesses and industries. Additionally, when the economy is not behaving optimally, ie. when a lot of people are unemployed (as in a recession) or if the prices are too high (inflation), government intervention is needed to get the economy back to full employment and achieve stable prices.

    How much role the government plays in an economy can vary between countries, but in countries with higher real GDP per capita, there has been less government intervention and more free-market play. In this economic system, the government or the public sector and the free market also known as the private sector, work together to meet social needs. The free-market system is allowed to work independently, but the government intervenes to avoid market failures. Thus, we see this mixed economic system as the most common economic system around the world today.

    Here’s a chart from Heritage Index showing how different countries enjoy economic freedom. In their study, they used twelve economic freedom categories. Within these categories, they graded the freedom of doing it on a scale of 0 to 100. It’s interesting to see the twelve economic freedom indicators, which they use to calculate a country’s overall score. Here is the list, I got from their website. https://www.heritage.org/index/about

    • Rule of Law (property rights, government integrity, judicial effectiveness)
    • Government Size (government spending, tax burden, fiscal health)
    • Regulatory Efficiency (business freedom, labor freedom, monetary freedom)
    • Open Markets (trade freedom, investment freedom, financial freedom)

    The study gives equal weight to each of the above factors.

    Economic systems and economic freedom experienced in countries of the world

    As you can see, countries with the highest score in economic freedom from 80-to 100, are in darker green. Countries with the least economic freedom are in red.
     
    From the chart, you can see China, North Korea, Zimbabwe, Cuba, and Venezuela have the least economic freedom because of a command economy.
     
    On the other hand, Singapore, New Zealand, Ireland, Switzerland, Luxembourg, Taiwan, and Estonia have the most economic freedom. When we look at the real GDP per capita of these countries, the people living there mostly have a higher standard of living. All these countries are highly advanced, free-market economies, mainly because of their open and corruption-free business environment. In all these countries, there is a well-secured property right to stimulate entrepreneurship and innovation. There is also a very high level of transparency and government accountability.
     
    Many other countries, like India, Mexico, Brazil, and Russia show poor to moderate levels of economic freedom. Even though countries like India are opening from their initial planned structure, there is still a lot of bureaucratic red tape that hinders setting up new businesses easily there. In addition, there is a lot of political corruption and scandals. Unfortunately, many of them are not even reported.

    Originally from India, I can’t stop noticing the score India got in this ranking. Unfortunately, it still got very low score in the economic freedom index. Despite considerable liberalization since 1990s, India still has a lot of government controlled sectors and capital market. International participation in many industries is still limited compared to many other countries that rank higher in the economic freedom index. Also, In India, property rights are not very well established, which hinders free enterprise and technological innovation. Reservation system based on cast, instead of socio economic status is another deterrent in its economic performance. All of this combined has caused the infamous brain-drain, where a lot of highly skilled class move to other countries for a better lifestyle. Unless all these changes are made, India is still has a long way to catch up in the economic freedom score.
     
    The US and the UK and many advanced countries are mixed economies. They are under the “mostly free category” denoted in the light green color. According to their report, the US economic freedom score is 72.1, which makes it the 25th freest country in the world to do business in. The US private property rights are secured, and contracts are protected and enforced.
     
    It’s interesting to note that countries with higher economic freedom also have higher GDP per capita and higher happiness indexes. So, we can conclude that, overall, less government intervention (only limited to areas where the market fails), is needed for countries to do better economically.

  • We hear this word so much in news, but what exactly is an economy?

    Has it ever happened to you while listening to the news that there is some big scary vague thing called the economy that’s just out there? You might think you have no control over it, as most of it is based on business and government decisions. You are wrong here!

    You are also a very important player in the economic game. The economy is just all of us together, acting in our own individual best interests, deciding how to use the limited resources we have, to get the maximum happiness. By pursuing our selfish interests, we indirectly contribute to the growth of society, by the magic of some invisible hand.

    We all are in the economy as everyday people, who are going about everyday tasks and decisions. The main point is that we’re all actors in the economy rather than spectators. So, we are not passively looking at this thing called economy but taking an active part in the economy all the time.

    In other words, an economy is a large set of interconnected production, consumption, and trade of goods and services that help in determining how scarce resources are allocated. I know in economics some fancy words are often used, such as “scarce”. By scarce we mean limited, something that we don’t have an infinite amount of.

    It is true that in the news, macroeconomic indicators are discussed more often, like inflation, GDP, unemployment, etc.  But believe it or not, a lot of times, the decision-makers behind these big indicators are millions of small entities like you and me. In microeconomics, we look at how people can make the best decision they can to make their lives better by making good choices.

    We apply an essential economic tool called “thinking on the margin” in our daily lives. It essentially means evaluating the benefit of one extra unit of something vs. the cost of one extra unit of the same thing.

    For example, should I spend one more hour studying? Should I eat one more pizza slice? Small decisions like that are also economic decisions. Households, businesses, and governments all think about tradeoffs and marginal cost vs marginal benefit analysis while taking many decisions in life.

    For an individual, it is a personal decision like should I spend a few additional minutes reading this article or should I switch to some other activity that may give me more marginal benefit? Similarly, firms must decide whether to hire additional labor to increase production and by how much? Will the extra revenue generated from hiring that extra labor to be enough to cover his cost of wages?

    Lastly, on a macro (aggregate) level, governments make the monetary and fiscal policies to make more significant decisions by doing the same marginal analysis. Should they build an extra park or use the money on healthcare? We need to remember that the principles of economics can provide guidance across all sectors, be it at the micro-level or macro level.

  • What is causing the prices to rise the world over? Understanding inflation and its causes

    The most talked-about topic affecting everyone for now almost a year is inflation. Your money loses its purchasing power, you need more money to buy the same amount of goods and services you purchase or use. If you are hiding a lot of money under your mattress or in a safe place at home, trust me it’s a bad idea. You will only be able to buy fewer items with that in the future than now.

    The easiest way to define inflation to a layman is the sustained increase in the average prices of a basket of goods and services that we buy over a specific period. So, when there is inflation, the cost of living goes up. This becomes a real problem if your income doesn’t rise as quickly as inflation, then with your current income, you will only be able to buy less same stuff than before.

    The inflation rate is expressed as a percent change from the previous period. Below is the actual inflation rate in the US in the last 6 years. So if the annual inflation is 6%, it means on average, prices have risen 6% from the last year. As you can see, the inflation slope became steeper in 2020, after the pandemic hit the global economy.

    So, what causes inflation?

    This can happen in two ways: either through demand-pull factors or through cost-push factors.

    The quantity theory of money explains inflation caused by demand-pull factors.

    Demand-pull inflation

    This occurs when people have too much money and they want to buy more, whereas there is not enough supply to meet that demand. Or in other words, too much money is chasing too few goods. This usually happens when the economy is at (or very close to) full employment/full capacity. By full employment, we mean people who are looking for jobs can find one. Also, in this situation, the country’s GDP grows at a rate faster than its long-run trend rate. This happens when there is too much money in circulation. If the bank interest rates are too low, people, both households and businesses can borrow easily and as a result, can buy more goods and services than what the firms can supply. We call this phenomenon “too much money chasing too fewer goods”. Producers increase prices and profit because they can’t increase supply in the short run.

    Using the demand and supply curves, I explain this idea. You see that the demand curve always slopes downwards, meaning people always want to buy more items at a lower price, Also, note that the supply curve faces upward, which means the firms producing those goods would like to supply more at higher prices, With the same assumption that is everything else staying the same. Equilibrium price and quantity are established at P and Q where the supply and the demand curve meet. We call them P and Q.

    To explain this graphically, let’s look at the demand and supply model. On y axis, we denote the general price level, since inflation reflects general price level rise. On x asis we will show the real quantity of goods and services or real GDP. In the graph below, demand will be aggregate demand as this is represents demand from the whole economy. This demand is also downward sloping curve, as the demand for any normal item will be. It shows people overall demand lower quantities when the prices are high and demand more quantities when the prices are low. With the same assumption that nothing else is affecting the demand and everything else stays constant. The aggregate supply curve always is upward sloping meaning producers are willing to supply more at higher prices, so they can get more profits and vice versa. With the assumption that everything else is staying the same, the price level and quantity are set where aggregate demand meets aggregate supply at e. This is the price level consumers are willing to pay and producers are willing to accept and is denoted by P. And the corresponding quantity supplied and demanded is denoted by real production of goods and services or real GDP at Q. Economist call this equilibrium price level and quantity.

    If there is excess money in circulation in the economy, people can afford to buy more, so for each price level, there is an increased demand. Or in other words, too much money is chasing fewer goods.

    In our graph, you will see the aggregate demand shifting to the right or upwards. Now we get the new equilibrium e1, where the new demand and supply meet, and you can see that the new price and the quantity both have increased to P1 and Q1. This happens in the short run when producers don’t increase the supply of goods and services but instead, charge more prices because of increased demand.

    Over time when producers can increase their production, the supply will be increased. In the graph below, this will mean the supply curve shifts to the right. So we can see at the new equilibrium, the prices will fall back. How much the prices fall, will depend on how much adjustment (increase) in supply is made in the long run. If the supply is adjusted enough to meet the increasing demand, then the prices will back to level P and the quantity demanded and supplied will be even higher, as shown at Q2. And the increase in the general price level is controlled.

    Cost-push inflation

    When the supply of the good is reduced due to an increase in the price of inputs in making that good or service. Supply shocks can cause cost-push inflation. Supply can fall due to a variety of reasons, such as if the cost of inputs for production goes up or if there is a natural calamity. Most recently after the pandemic, lockdown jams in major ports have contributed to a slowdown in the supply of a lot of items.

    In the graph above, supply shock has pushed the price up to P1, and Quantity is reduced to Q1.

    How to calculate the inflation rate?

    Inflation is expressed as a % change in the price level of a market basket of goods and services over a period. To understand how inflation is calculated, let’s start with a very simple economy, where people only bought and consumed 3 items – bread, internet, clothing, and a house.  You spend 30% of your yearly income on bread, 10% on clothing, 10% on the internet and 50% on renting an apartment. Then let’s assume the price of bread in year 1 is $2 and the price of internet is $45, price of clothing is $10, and rent is $25000. The price of bread in the year 2022 goes up to $2.5, price of internet becomes $60, price of clothing increases to $15 and rent in year 2 is $30000. We also, in the table below, list the proportion of income or weight they spend on all these items. The sum of these weights needs to add to 100%.

    Inflation from year 1 to year 2 is calculated as (CPI2 – CPI1)/ CPI1 * 100 where CPI1 is the price level in year 1 and CPI2 is the price level in year 2. CPI is a weighted average price of many day-to-day goods and services that a typical American person living in a city buys at a particular time. Don’t be frightened by the term “weighted average”. Weight here refers to the importance of spending on a particular item compared to total expenditure. It simply means more weight is given to goods and services where you spend more money of your income. This could be because you buy that thing more often like, daily or you spend a lot of money buying it.

    If we change the weight of some things from table 1, even with the same absolute increase in price, the inflation % will change. As you can see in table 2, it became 20.02%.

    If the change in prices is more compared to that from table 1, even with the same % of weight, the inflation % will be greater.

    BLS calculates and publishes inflation in the US

    However, our consumption is not just restricted to these four items. In fact, a typical American urban consumer consumes a wide variety of goods, known as the market basket of goods.

    In the US, the Bureau of Labor Statistics calculates something called the CPI (consumer price index). To collect the monthly price data, BLS-trained representatives make personal visits, phone calls, and get online surveys to collect data on what goods and services American people are buying.

    The price and weight info are essentially based on a survey of people of what proportion of their income people spend on a given good or service. BLS tries to calculate the prices of the same basket of goods and services. Now, here some people will argue that what if people don’t consume the same things after some years? That is a subject of further investigation, but the general idea is that the BLS tries to calculate the prices of the same goods and services consumed by the average person over a period for which it is calculating the inflation rate.

    If you are interested, you can check the detailed report here with relative weights and price changes by category. https://www.bls.gov/news.release/pdf/cpi.pdf

    Since CPI is a sample of retail prices and does not cover the complete universe of all prices, it is subject to some errors. However, that sampling error is not statistically significant to change the calculation by a lot. You will have to get into statistics class to understand the more technical aspects of what is considered a significant error or not, but for now, you can understand the error possibility is very small, so it is a reliable indicator of how the prices are behaving in general.

    But when do we need to worry about inflation?

    Well, some inflation is not bad and is considered healthy for the economy. Since our salary/wages have also increased over time and in most cases, some general rise in price level doesn’t hurt our purchasing power.

    The BLS calculates this measure at 1-month, 3 months, 6 months, and 1-year intervals, and publishes that data. Over the last 40 years, we have seen this inflation % on average staying close to 2% annually. That means the same basket of items that you buy is 2% more expensive from 1 year to the next. The goal of monetary policy is to keep the inflation number close to this target-rate.

    But in some countries like Zimbabwe and Venezuela, the prices had risen to a level making it very difficult for people to hold on to their currency. That situation where general prices rise at a rate of 50% per month is called hyperinflation. People know that they won’t be able to buy the same set of goods with that amount of money, even the very next day, so they demand more wages to cope with it. This, in turn, causes firms to pass this burden by increasing the prices of goods and services they provide. This, in turn, causes an increased demand for higher wages and the spiral continues. This is called the wage-price spiral. This can cause a severe crisis in any country.

    To know more about how the Fed uses monetary policy to control inflation, click here.

  • How is GDP calculated?

    Economists have some simple key models to understand our complex economies. One such model is the circular flow model. This model comes handy when we understand why GDP from income method and expenditure method should equal.

    There are two main ways of calculating nominal GDP and will discuss these in detail later in this article. These methods are known as the expenditure method and the income method.

    But first, we should understand the relationship between the income method and expenditure method of calculating GDP in a circular flow model.  The circular flow model shows the linkages between two groups of economic decision makers, households and businesses. It also tells us that there are two types of economic markets, the resource or factor market, and the product market for goods and services. Once we understand this simple circular flow model, it will be useful to understand the complex economy and the GDP computation. In order to learn more about what GDP is, please click here.

    The model begins by assuming a simple economy with two markets:

    • Factor or resource market: a market for factors of production that the firms demand.
    • Product market: a market for goods and services that the households demand.

    By household, we mean people living in a house. Businesses are privately owned entities producing goods and services to sell in exchange for money. It is important to understand that the households and businesses are both buyers and sellers.

    Households are sellers in the factor market. They sell land (including any natural resource like trees), labor, capital, and entrepreneurial ability in exchange for money. Households are buyers in the market for goods and services. Households give money to businesses for goods and services.

    Businesses are sellers in the market for goods and services. Businesses sell goods and services in exchange for money, which they call revenue. At the same time, businesses are buyers in the market for resources. Businesses exchange the revenue earned in the market for goods and services to buy factors of production i.e., land, labor, capital and entrepreneurial ability in the resource market. Here, the money they spend is called the cost of production.

    Let’s understand it better with a simple example.

    When you go to your local pizzeria to eat your favorite pizza, you give your money to the owner for the pizza you buy from him. When you pay your bill, you are buying goods and services. But the money doesn’t remain with the pizzeria owner for long. The pizzeria owner uses part of this money to buy resources such as wheat flour from a farmer. He also pays wage/salary to the server who took your order and also might spend money to purchase a new equipment for his pizzeria. For the pizzeria owner, all these expenditures are costs of production.  After he pays his costs of production, the remaining income is his profit. This is the money he earns as being an entrepreneur owning and operating his business with his skills. Now let’s say your money went to the farmer and that for her, is her income. But that money won’t remain with her for long as well. She will spend it too on other things she wants to buy, and the entire cycle will start again.

    Thus, this circular flow keeps going on and on. Here’s an animation explaining the model, you can see the circular flow between the product market and factor market. You will also see the flow of money between the two. Money flows in one direction while goods and services and resources flow in the other direction. Through this model, we can see the relationship between households and businesses and how these different decision-makers fit together in our big economy.

    In reality, our economy is more complex and has more elements, like, government, foreign trade etc. and we can expand the model to include all these players. But the basic idea won’t change.

    I hope this made sense. Let’s go back to the two ways of calculating GDP and we can see why these two methods will yield similar results.

    Expenditure method: Since GDP is the market value of all final goods and services produced in a country at a given period, if we add the total spending done by all the people in a country, we can get a number close to nominal GDP. We usually categorize these total expenditures done by these four sectors:

    • Household spending includes any new good or service we buy, big or small. So, we will add all our expenditures be it on buying an apple or a new house, in a given period, to get the private consumption component of GDP. We can denote it with C.
    • Spending by firms/businesses on capital and inventory, which we call investment or I. Investment here refers to investment by a firm in machinery, research& development, inventory, etc. We only include investments done by businesses in real assets in the calculation of GDP. We don’t include any financial investments, like buying a company’s stock or bond or a financial asset.
    • Government, like us, spends money on various things. These include big expenditures on building infrastructure, public parks, public-funded education, hospital, nuclear energy, defense, salaries paid to government officials and small expenditures on office supplies, and many more. All of those will be part of the G component of GDP. But we won’t include government spending on any transfer payments, such as pensions to retired people or on welfare programs and subsidies. Those payments are not counted in GDP because no good is produced or service is exchanged against these payments.
    • Spending by the rest of the world (Exports – Imports or net exports). We denote it with NX. Sometimes, a country produces some goods more efficiently than other countries and can sell them to other countries for profit. Those are called Exports. Similarly, the things a country has a comparative disadvantage in making, it can buy from other countries, which can make it relatively cheap.Since GDP, includes only goods produced “within the boundaries of a country.” we will include foreign people’s expenditure on things made in our country or our exports. At the same time, we won’t include us buying any foreign-made goods or our imports.
    • So, GDP = C + I + G+ NX

    Let’s look at the second approach of calculating the GDP.

    • Income method: Here we add the total income earned by all the people living within the boundaries of a country. Economists classify income earners into four broad categories. Labor, land, capital, and entrepreneurship. These are called factors of production- the inputs used in the production of goods and services. Thus, we sum up all the income earned in a given year by these four factors of production using this formula.

    Wages/salary (earned by labor) + Profits (earned by an entrepreneur) + Rent (earned by landowners) + Interest income (earned on capital equipment).

    There is another method, which is less frequently used and is called the value-added method.

    • Value-added Method: In this method, we add up all the value-added at various stages of production. For example, to make a dress, we will calculate the value of the raw material that a fabric company sells to the dress manufacturer ($10), which he combines with his skill and capital ($40) to make a dress worth $50.

    So, these were all the ways of calculating the nominal GDP. To learn more about US GDP, please click here.