Sunday, 25 March 2018

Why the kid who wished to print money and give it to his friends was wrong?



Learn about inflation with the help of an example


Few years ago on a Saturday evening, I was shopping in the dairy section of this big retail store. While deciding which company’s milk to buy I noticed a kid nudging his mother to the foreign chocolates section and to his surprise his Mother was reluctant to budge as she was busy in choosing the size of the butter packet she needed to pick up.

The kid being frustrated by his mother not willing to move asked her,

‘Mother, why can’t you buy me that packet of 50 colorful chocolates?”

“I will buy you a lollipop from the billing counter when we bill our stuff, son”, his mother replied.

“But, I want that packet of chocolates. Those look very colorful. None of my friends probably have eaten such chocolates and I believe they will also enjoy them.”, the kid said with innocence.

“Son, I have to still buy a few things and we are running out of money, so I can’t buy you those chocolates as they are very expensive.”, the mother replied calmly to the kid’s groaning.

Clearly, in the era of credit cards this was a pretense which the mother came up with.
When the kid heard his mother’s reply, he jerked both his hands down in despair and told angrily to his mother

“I wish you had bought me a money printing machine instead of the GI JOE you bought me on my birthday. If I had a money printing machine I would have printed more and more money to buy things I always needed like this packet of chocolates”.

The mother chuckled at the innocence of the child and asked him, “and then when you are done buying all the things, what would you do then?”

The kid said, “I am going to distribute money among my friends so that they can also buy stuff they like”.

The mother was pleased at the innocence of the child because he was good enough to think about friends.

I couldn’t help but overhear the entire conversation. Soon both of them left but the kid gave me an important question to find an answer for.

As we have all heard that we have printing presses in the country so we have enough power to produce more money to make everyone rich but why don’t we do that.

And of course, there are numerous theories one of which is that every country needs to deposit gold in World Bank, depending on which it can have money in the country in that much amount which is true in case of few currencies.



So, why we simply can’t print more money?



We simply can’t print a lot of money because it is going to increase the supply of money more than it is demanded for.

The global economy as well as the economies of the countries depend on two factors supply and demand.

These two factors must always be in equilibrium with each other for the things to run smoothly. 

If one of the things outperforms another then prices fluctuate and things start falling apart.



The Kid and The chocolates example


Suppose that the kid achieved his dream of printing money through a money printing machine. Now if earlier he used to have Rs 10 a day for consumption with this glorious money printing machine he now has Rs 100 a day for consumption.

With his compassionate attitude he printed more money and distributed it among his 9 other friends. Now all of his 9 friends have Rs 100 each for consumption on a single day.

This chain didn’t stop here as the friends of the kid have friends of themselves and so they keep distributing the money to their friends as well.

The kid kept printing money and eventually, one day came when around 10,000 kids had 100 Rs per day to spend.


Now, let’s assume the chocolate company coincidentally had all these 10,000 kids as its only clients. Earlier, before the glorious money printing machine, a kid could buy a packet for 10 Rs on one single day but as human desires are unlimited therefore, with more money in the pocket every kid is tempted to buy 9 more packets as he has Rs 100 now to spend.


Does the chocolate company think the same way?



The chocolate company is experiencing a sudden rise in demand of their chocolate packets and to feed the demand they will have to increase the supply.

This means that they have to buy more coco, more machines and equipment and to process coco, and enough man power to produce more chocolates and satisfy the demand of its 10,000 clients who have 100 Rs each to buy chocolates.

To bring in additional machinery and equipment, manpower and raw material the company will have to put more money in the business which means that its operational cost will increase.

Earlier, a packet of chocolate used to cost the company 5 Rs which would give the company 5 Rs operational profit, but now, with a sudden increase in demand and with its increasing operational costs, the company will be compelled to raise the prices.

So, let’s assume that now the company’s cost per packet increases to Rs 98 and in order to maintain its profit of 5 Rs, it has set the market price of 1 chocolate packet as Rs 103.

So, the next day when the kid will go to the market in the hope of buying 10 packets of chocolates, he will be surprised to find the fact that he can’t afford even a single packet of chocolates now.

When the kid is not able to afford even 1 packet of chocolates, this means that the purchasing power of the money he has is reduced and this phenomenon when the purchasing power of the money reduces is termed as ‘Inflation’.

Now, imagine this phenomenon spreading to all the chocolate companies in the country.
How will it impact those kids who still have Rs 10 per day to spend?



Hyperinflation



The incident described above is an example of hyperinflation when the prices rise by more than 50% in a small period of time probably in a time span of less than 2 months. 

Usually, this type of inflation was witnessed around 80-85 years ago in a few countries like Germany where a whopping soreness in prices of general commodities, after the great depression, was encountered.



Controlling Inflation


The countries’ central banks like US Fed in the United States and RBI in India play a key role in controlling inflation.


Remember, that is why you read in the newspaper about RBI changing the interest rates or keeping them unchanged (well this will be covered in some other article in the future).



Countries with High Inflation



Usually, hyperinflation occurs due to big unpleasant events like the great depression, the recession period of 2008, due to mutiny or political unrest in the country.

It should be now clear for you to understand that the countries with high inflation have a very limited supply in answer to a high demand.

This limited supply is generally due to the corruption in the government or the whims of a few power hungry people who find pleasure in loading their bank account by controlling demand and supply.

Below picture tells you the countries which are going through a period of highest inflation –

Data of Countries with high inflation rates




Do we really need Inflation?



Almost everyone’s Grandma has told him/her at some point of time in life that too much money in too little time is bad for you and people around you.

Well, if we associate Grandma’s teaching with inflation then she was absolutely right.
And if you are thinking that there shouldn’t be any inflation in the country then you are not completely correct. The opposite of inflation is deflation which means that the purchasing power of money increases.

In relation to the above example it means that now the packet of chocolate which costs Rs 10 now will cost Rs 5 when deflation kicks in. This is really detrimental to the economy’s health as it can have a downward spiraling effect.

It leads to the mindset that “the prices are going down daily hence I will wait till the things I want to buy become cheaper”. This sentiment leads to decreasing demand and the supply looks huge in contrast. The deflation hurts companies and businesses because of the decreasing demand and so, in turn hurts economy.

Inflation in a contained amount is very necessary for a country. Why?

Because it means that the country’s economy is progressing.

So make sure that the money in your bank account is beating the inflation rate every year in order for you to progress with the economy of the country.

So, is there anything more you know that you want to add to this article?

Did you already know how printing more money that can’t keep up with the existing demand can hurt the economy?


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The Sovereign Debt Crisis of Europe : Why everyone attributes the slowness in their economy to Europe?

Brexit: Read in short but know it completely 

Saturday, 3 March 2018

The Sovereign Debt Crisis of Europe : Why everyone attributes the slowness in their economy to Europe?




Sovereign debt crisis is something that everyone has heard of but very few people know it from within.

The term itself is so heavy that most of us think of leaving it to the professionals while the general take away is that there is some financial crisis going on in Europe because of which the risk of decreased economic growth is looming over our businesses and jobs.

When you get involved in a discussion in college or at work during lunch hours, the topic of Europe’s economic crisis must have surfaced several times by now, but, have you been able to contribute to the discussion more than by just saying that the economic growth of European nations is not good which has affected our businesses too? If yes then good.

Well, certainly after reading this complete article you will be able to contribute much more to the discussions of worldly matters and not only that you will emerge as an inquisitive and knowledgeable person too.

This article will not directly take you to the topic ‘What Sovereign Debt Crisis is? ’ but it will first make you familiar with a few terms after which comprehending Sovereign Debt crisis will become a piece of cake.

So, let’s start!!



What is a Sovereign Bond?

A country needs money to run its operations, for its government backed banks, for providing basic infrastructure to its citizens, for its army, navy, air force, for building hospitals, providing health care, running employment programs and many more.

A country’s central government’s source of revenue is the money received from the tax payers which are the earning citizens of the country. Due to different expenditures, many times government falls short of money in its treasury because of which it becomes mandatory for the government to borrow money from people who are in the state of lending it.

The country therefore issues sovereign bonds based on which it borrows money from foreign investors and countries.

The bonds are generally issued in the denomination of foreign currency, however, the country can also issue bonds in its own currency but this totally depends on how stable the currency of the country is.

If the country is stable and is not going to through a social upset or a coup d'etat (pardon me if I am exaggerating here) then it doesn’t face any problem in issuing bonds in its own currency.

The treasury bills which are generally issued in countries like India and The United States are short term examples of such bonds.

What is Sovereign Debt?

As stated above, when the country issues sovereign bond it borrows money from other countries as well as investors, it therefore incurs debt.

Suppose you are an investor with tons of dollars in your bank account and you are finding sources to invest your money. It comes to your notice that country ‘X’ is issuing sovereign bonds in the denomination of dollars because it needs money to support development in the country.

When you provide money to country ‘X’ you now hold the sovereign bond issued by the country and ‘X’ owes you the amount of dollars you invested which it will have to return you with timely interest after a specified time period.

Now, as an investor you cannot right away lend money to ‘X’. There are ‘n’ number of factors which you will take into consideration before lending money such as the currency stability of the country, social status inside the country and above all, the sovereign debt rankings.

It is obvious that when the sovereign debt rankings are good then only you will take the decision to invest in the country ‘X’

What is budget deficit?

The budget deficit occurs when a government’s expenditures outrun its revenues. 

The budget deficit may occur due to several reasons like when the government spends a lot on its infrastructure, its development plans, its army, navy, air force and its public but it doesn’t receive enough money in the form of tax from its earning citizens due to various tax evasion strategies.

The budget deficit clearly indicates how healthy a country is. If the budget is balanced i.e. expenditure = revenue, it increases the confidence of the investors to invest money in the country. 

It generally indicates to the entire world that the business growth is faster as the economic growth runs fine.

The budget deficit hurts the sovereign debt of a country. Why?

It is obvious that if a government spends amount X on its people and due to corrupt bureaucrats as well as politicians and some of the corrupt citizens it receives only 2% of its expenditure in the form of taxes then how will it be able to pay the debt?

This is a major factor in slowing down the economic growth because of which the government raises taxes and reduces public expenditure which impacts employment rate too.  Sometimes these measure which a government adapt to are also known as Austerity Measures.

When did the Sovereign Debt Crisis start?

The Sovereign debt crisis is said to have started in the year 2008 when the banking system of Iceland collapsed.

The banking system collapses when the borrowers of the money from the bank are unable to repay their debt and no way is the bank able to recover the money from them. When there are too many defaulters like such, the bank itself goes bankrupt and has no money to run its operations.

The peripheral countries of the Eurozone like Italy, Spain, Portugal, Greece, Cyprus were also unable to pay their sovereign or national debt due to the slow economic growth. 


A strong reason of the sovereign debt crisis is believed to be the recession of the year 2008 which was caused when the asset bubble burst in the United States and in a few countries of Europe.

Greece was worst affected by the sovereign debt crisis.
When an investor or an investment country seeks to invest in another country they check its sovereign debt rankings which indicate if the country would be able to repay its debt or not.


The then existing government of Greece revealed that the previous government reported wrong numbers of budget deficit. 

To save its reputation, it reported that the budget deficit was too low but in reality it was huge which proved to be a major cause of the slow economic growth.

Since, Greece was nowhere near to pay its debt hence its debt rankings plummeted at the lowest possible level which meant there was no more money coming in from the investors.

As a result, a bail out was organized by the European Eastern bank and International Monetary Fund in exchange of implementing austerity measures.

The austerity measures when implemented asks a country to keep the public expenditure as low as possible and increase the taxes which itself reduces the economic growth as when the public expenditure is low how will the citizens be empowered to spend more apart from their needs to make the businesses profitable.

If the businesses are not profitable, the industrial output will drop which results in businesses not borrowing enough from banks and when the supply of the money is more than the demand the purchasing power of the money reduces which in turn affects currency ratings.

Apart from Greece, the debt rankings of Spain, Italy, Cyprus, Portugal also fell down and it was believed that Euro was on the verge of collapsing as these countries along with 14 others share Euro as their currency.

Impact on world economy

Bilateral trades are important for any country to grow such that it can make money from its natural resources, minerals as well as the local labour and talent.

A lot of countries, Asian countries as China and India and many more were and still are in trade with the European countries particularly the European Union countries (28).

Due to the lack of economic growth, the consumption demand reduced in the affected countries. When the demand was reduced it affected the countries which were responsible for supplying to the demand.

World GDP Growth 2010-2016
Source  : World Bank Data


The businesses were hit in other countries too and imagine those companies whose only clients were the businesses in the affected countries such as Spain, Portugal, Cyprus, and Italy.

It was recorded in the year 2012, as a result of this crisis, the annual growth rate of the entire world economy reduced by 0.65% and the global unemployment rate increased by 1.81%.

The Indian IT firms most of whose business came from the United States and Europe were affected deeply by both ‘The 2008 recession’ as well as ‘The Eurozone debt crisis’.

China was another nation affected by the Eurozone Crisis as we all know, that it has an upper hand in the entire world when it comes to machinery, electronics as well as raw material processing.

All its exports were affected which contributing to the decrease in its economic growth.
The exports of The United States which is believed to have multiple trade ties with the Britain and other nations of Europe were also affected even when it was recovering from the collapse of its asset bubble.

Conclusion

The Eurozone crisis really hurt the world economy deeply and the world is still recovering from it.
With huge budget deficits on the books, it is a challenge for the governments to increase the consumption demand by keeping the public expenditure low to improve the economic growth. Without improved economic growth, the debt issue is very difficult to be solved.

However, my job thorough this article is not to suggest what governments should do but inform you guys about this topic of Sovereign debt crisis.

So, did you enjoy reading this article?

Do you know anything more about this topic ? If so, I will be happy to include it in this article.


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