Economics101 - Demystifying Economics


 

 

Economics is one field which completely surrounds us but which hardly understood by us. It is made more complicated by use of a jargon of complex terms. Hence this effort to give the reader a small introduction to this field.

 

The present economic scene is a result of thousands of years of evolution. Hence it will be difficult to explain it all from the present scene. Thus I will try to take up each concept as it slowly evolved to the present.

 

 

1. Barter System

Economics is defined as the science that deals with the production, distribution, and consumption of goods and services, or the material welfare of humankind. The simplest form of which is the interactions between individuals about materials/goods.

 

Barter system is the earliest form of economics. The early society was predominantly agrarian in nature and people directly exchanged good, called barter system.

 

Lets say farmer-1 in his farm produces paddy; farmer-2 produces vegetables; farmer-3 possess cattle. As we can see it is difficult for one person to produce all that he wants. Hence they interchange different goods. Farmer-2 gives his vegetables and gets paddy in return. Similarly a potter gives his pots and gets paddy and vegetables etc. in return. There are no intermediately forms involved and transaction takes place directly and instantly.

 

Initially barter system was only of interchange of goods. Later it was also extended to human services. A laborer will work in farmer’s field and get some amount of paddy in return- i.e., goods in exchange for services.

 

 

2. Metal Coins

There is one main disadvantage of barter system- there is a time limit for you. In this system wealth is stored in terms of goods. However store of wealth in terms of goods is subject to some problems such as difficulty of storage etc. For example I may grow vegetables today, but after a month all of them will be useless. Similarly, the contractual payments will also be difficult.

 

Thus money transactions in the form of some intermediately goods started. Farmer-1 produces vegetables today and exchanges them for equivalent quantity of an intermediately goods. When he has to buy another goods some time later, he will then again exchange back the intermediately goods for stuff he has to buy. By having a commonly accepted third medium of exchange, expanded commerce became possible.

 

Coins, drilled shells, beads and animal skins were among the early forms of money. In the early forms of money, value came from the rarity of the material or the labor to produce it. This slowly evolved into use of gold, silver, copper coins. The emergence of standardized coins helped the users to easily authenticate the purity and weight of the gold given to them.

 

 

3. Interest

Imagine a situation- I take ten gold coins from you today, I buy a farm, cultivate crops, sell them earn money out of them and then return your ten gold coins to you. Unfair, you will shout as this represents a form of lost opportunity to the original owner of the money. I can do the same with my money, why should I let you use it without any benefit to me?

 

This lead to the evolution of “interest” on the money- as a form of compensation/ opportunity cost. I give you a sum today and I expect you to pay me the original + interest on that.

 

 

4. Bankers/Moneylenders

Imagine you are having some money with you and are not in a position to invest it directly in something new. In that situation, instead of burying that money, you will prefer to give it some other person as it will fetch you some interest on that money. But then whom should I give this money to; can I be sure that he will repay the money?

 

Similarly if you are looking for a lender of money, where can you look, whom can you contact? These types of difficulties come in an individual money transaction.

 

This lead to intermediately moneylenders or bankers. If you wish to save money, then you can directly go to a Banker and save it. The Banker will then explore ways to lend it, along with the responsibility of retrieving it back. He will act as an intermediately between people who have excess money and who want money.

 

 

5. Symbolic Currency (Representative money)

I go to a Bank, deposited my bag of gold coins there. What’s the proof that I have indeed deposited money there? The Banker will then give me a receipt, usually a paper note for my gold coins. This is the earliest form of symbolic currency. This was usually in paper form; tally sticks were also used in England at one point of time. It didn't take long before the receipts were traded as money, because everyone knew they were "as good as gold"

 

Even today if you see a currency note, it will read “I promise to pay the bearer the sum of ____ Rupees”, signed by Reserve Bank governor. The note in itself is nothing more than a piece of paper and does not have any inherent value. In principle any Bank can take deposit in the form of gold and give equivalent symbolic currency in its return.

 

In the mediaeval times, due to various reasons only gold was accepted as an interchange medium. A Bank cannot simply take anything and issue notes (currency) in return. It has to deal only in terms of gold.

 

 

6. National Currency (Central Banks)

Most of the early Banks were privately owned. Essentially any individual can take gold deposit and issue a note. This made the verification of their authenticity very difficult.

 

Moreover, there are also cases of cheating by people. The banker who is giving me receipt in return for gold can also fraud and give more receipts to himself without any gold at all.

 

Hence the central currency system evolved. Each nation has a recognized central bank either owned by govt or private individuals which will oversee issue of notes in that country. Reserve Bank of India is the central bank of India and has the sole authority to issue currency.

 

I am sure most of you had the same question in your childhood- why can’t the govt simply print more money and solve the problem of poverty? The answer is that currency itself has no value. It is a symbolic form of something valuable. Thus reserve bank cannot go on printing notes. They have to be compensated by equivalent Gold reserves.

 

Thus as I pointed out earlier, the currency note reads as “I promise to pay the bearer the sum of ____ Rupees”, signed by Reserve Bank governor. On the top it is written “Guaranteed by the Central Government” symbolizing that this promise/symbolism is endorsed by Governmental authority.

 

 

7. International Exchange- Gold Standard

Consider the situation. I am an Indian citizen and have some earnings in the form of Indian Rupees. I go to US… there these Indian Rupees will be of no value. Hence a standard to interchange currencies is necessary.

 

But how can the interchange are done correctly? The solution is simply- go back to basics. A national currency is the symbolic value for gold; hence the interchange value will be ratio of gold prices.

 

For example lets say India was 100 kilos of gold reserves and it printed 10 crores of Rupees in exchange; and lets say US 3000 kilos of gold reserves and printed 6 crores of US dollars, then the equation will become: (10 crore rupees/100 kilos gold) = (6 crore dollars/3000 kilos gold) ==> Dollar/Rupess = 50.

 

Gold standard was not a direct historical invention. Various standards and metals have been used throughout history. But Gold standard became semi-official in the world after the Bretton Woods system was set up between US and England after WW2. This system pegged the value of the United States dollar to Gold and all other currencies will then be evaluated relative to it.

 

 

8. How is Money Produced?

We often hear things like XYZ country’s economy is growing, it is becoming rich etc etc. So this demands the fundamental question – how is money produced in the first place? Till now we have seen only ways of interchange of money, not its production.

 

Money is produced in two forms: from natural resources and human workforce.

 

Let’s take an example: A person goes to a forest, cuts some trees and sells the logs for some money in a nearby town. Here money is produced by that individual. When we say that, what we mean is a symbolic representation has been assigned to: (1) the natural resource, tree in this case (2) human effort in transforming it. The money then is thus produced.

 

The same is also valid on a much larger scale: let’s say an investment is done and a steel plant is constructed. Then iron ore, coal etc (natural resources) are transformed through human effort into commodities which then can be exchanged with other commodities or paper money.

 

Hence economic growth of a country reflects two things: (1) the increasing productivity of its population (2) higher rate of consumption/transformation of natural resources.

 

 

9. Fiat Money and Credit Money

Earlier we have seen how a currency is a symbolic value of its equivalent gold reserves. Though Gold standard was in place till 80’s & 90’s, it is no longer in use today.

 

One major difficulty with gold standard is that one hand the economy and the amount of money transactions is growing but on the other hand the amount of gold today is by and large stagnant. Thus one hand we have constant amount of gold and on the other hand an increasing demand for gold (or its equivalent money) altering the demand-supply curve.

 

Before we proceed into the next step, first let us have a look at how gold centered economy works- a central authority mines its gold reserves. Then it distributes this natural resources to its state machinery like soldiers in the form of salaries in return for their work. This state machinery then utilizes this gold to either invest for future or to give to some seller XYZ to buy some other goods like food, house commodities. The seller XYZ in turn invests this gold again. Gradually due to gold being locked up in the form of bank reserves most of the time and all the transactions happening in the form of  paper money, the gold too became a symbolic representation of money (isn’t actually it so from the beginning). What’s the end result of this whole cycle- peasants & workers give a share of their produce to govt/state in exchange for the security/services provided by them and the gold still remains locked- earlier it was earth’s crust, now it is bank locker!! ) Thus this gold reserve system in principle is no different from exchanging in the Rs 100 in the form of ten 10s or two 50s.

 

The natural line of thinking then will be: why to first have a symbolic representation of money-1 (gold) and then exchange it with another symbolic representation of money-2 (currency notes). Why can’t we instead directly deal with the secondary representation of money directly?

 

This lead to adaptation of Fiat Money; the paper money itself acts as a means of transactions. This is a simplified version of how this works: currency notes are produced by Reserve Bank. This then are given to various Banks (subject to some securities by them). These banks in turn loan the currency to govt/organizations/individuals. Individuals will then invest this in something and generate more money. The govt will invest this in some form of public works and collects taxes from citizens in return. The money then returns to Reserve Bank. What happened during this is that the natural resources through the medium of human workforce are transformed into commodities, useful to the man and the printed notes of Reserve Bank are back in its coffers. Reserve Bank then, thanks to the increased economy will produce more notes are release again. Thus the cycle continues.

 

If we look closely, not much has changed- be it gold or paper currency, their value is usually representative of something else. The amount of gold locked in banks in the earlier case or the amount of Fiat Money printed later reflects the economic activity of that country.

 

Let’s say that there is 100 tons of gold locked in the bank and equivalent currency notes are in running the country; this has later increased to 150 tons of gold locked in the bank and equivalent currency notes are in running the country. Essentially this means that the economic activity has raised from X to 1.5X and so has the corresponding number of currency notes. If that is the case, then I can simply cut the drama of mining gold and then storing it up.

 

In simple words- earlier currency was a symbolic representation; now I will make it commodity in itself.

 

 

10. Controlling the Amount of Fiat Money

The real problem in the case of Fiat money is controlling the value of money. If the currency flow in not controlled properly, inflation may sometimes lead to stuff like this where a woman in 1923-24 Germany feeds her tiled stove with German currency notes as that money was worth less than firewood.

 

If we produce too many notes, then the value of the Rupees owning to the excess availability of Rupees will fall down. Suppose there are X number of Rupees in the market. I suddenly produce (usually to meet an immediate requirement like making a war) more Fiat Money (Rupees) and introduce it into the market. Then the number of Rupees in the market has increased from X to X+Y, but the amount of commodities has not yet risen at the same rate. Hence the rate of commodities goes up (actually it’s not the rate of commodities going up; rather it is the value of Rupee going down). This phenomenon is what is called inflation.

 

If you did not understand that demand-supply curve, then let me explain the phenomenon of inflation in other words. Today I have Rs 1000 with me and I can buy say a chair with that money. Now let’s assume that the Rupee is suddenly mass produced/printed by govt. Then Rupees are easily available and hence the number of people who can afford to buy that Rs 1000 chair will increase. When the number of people who are willing to buy that chair increases, the natural result will be that the cost of that chair will go up.

 

On the other hand lets say the amount of Rupees in market is not increased, but the amount of chair produced in the market has gone up, then owing to the less buyers, the cost of chair will go down.

 

Hence the amount of Rupees is maintained in such a level that it is proportionate to the increase in the economic production. Thus when the amount of chairs produced in the market increases, the amount of Rupees is also raised accordingly to over all keep the cost of the chair constant. Of course they don’t call this control of amount of Rupees as “printing” more money; there are more sophisticated terms for it.

 

Fiat money is in a way the representation of the economic activity in that country. This field of controlling the amount of Rupees in accordance the economic activity is called monetary policy. That is a separate topic in itself. Refer to this link if you wish to know more. Let’s just contend ourselves here with the broader principles of working and hope that some experts sitting in the Reserve Bank will be working out the finer details.

 

 

11. Foreign Exchange

When currencies were pegged to gold, foreign exchange was pretty straight forward. But when the world economies adapted Fiat Money, the currency too became a commodity to be traded in the market. In that case, how to fix exchange rates?

 

The simplest is to fix a exchange rate as part of agreement between two countries. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the end of World War II until 1970, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system.

 

But this system requires greater confidence between those countries as one currency is pegged to the other. In the later 60s the problem of France was that the US economy was sliding down and hence the value of dollar was falling down. As Franc was pegged to US dollar according to the Bretton Woods system, it too started falling, though the French economy in general was doing well.

 

Thus most countries usually trade their currencies in foreign exchange markets. They let the value of the exchange rate be determined in a Foreign Exchange Market (usually referred as Forex). This is the case with Dollar-Rupee too.

 

This is how it works: some Indians want to buy goods from US (i.e., import goods into India). To do so, they want dollars so that they can pay the sellers in the US in dollars. Similarly some Americans may want to buy goods from India (i.e., import into US and export from the p.o.v of India). They will then want Rupees so that they can pay their sellers in India in Rupees. So there is a group of people who want dollars in exchange for their Rupees and similarly there are a group of people who want Rupees in exchange for dollars. They two meet up and trade the currencies (this is not done directly by individual players. Instead it is done indirectly through some registered Banks)

 

If the number of people who want to import into India is more, the number of people who want dollars will be more than the number of people who want rupees. Hence the value of rupee will fall relative to dollar. If on the contrary if the number of people who want to export from India is more, the number of people who want Rupee will be more and thus the number of dollars will be more. Hence the simple thumb rule in foreign trade is that if the exports more than imports, the economy is doing well.

 

However in India, the value of Rupee is not totally left to the market, but is partially regulated by the Reserve Bank. This is how it is done: If the imports of India are greater than exports, then the number of people who want dollars will be more than the number of people who want rupees. In that state, to stop the rupee value from further falling down, the RBI used to take loan from international groups like World Bank. These obviously were in dollars. It then used to pump this into the Forex markets. This will then balance the demand and supply of dollar-rupees, thus arresting further decline of rupee.

 

As you can see this is just an artificial arrangement. We have artificially arrested the decline of rupee, but in the process we have filled ourselves in loan. What we have done is that in order to balance the trade deficit (difference between imports and exports) we have taken some loan and pumped it in to nullify that trade deficit.

 

The result was that by 1991, India was in deep debts and none of the international agencies were ready to loan more money to India. As a result of it, the Rupee had to be devalued (i.e., instead of pumping money in the form of loans, allow it drop to a fixed rate). As a result the value of Rupee fell from Rs 18 in 1990 to Rs 25 in 1991.

 

The economic boom of later 90s has increased the amount of exports. Thus there were more demand for rupees vis-à-vis dollars. Hence what RBI will do is take the dollars itself and give back rupees which can be transferred to the Indian sellers. These excess dollars that comes into the RBI’s coffers as a result of trade surplus are referred to as Forex Reserves. India’s forex reserves touched $ 100 billions in Dec 2003.

 

Today the Rupee value is largely market determined. However RBI does intervene once in a while to ensure smooth changes.

 

That in short(?) is how our economy works!

 

PS: I focused more on explaining the principles than the facts. Thus I did not lay too much importance on exact factual details. For example here I have explained Fait currency concept evolving after Gold reserves concept. However, history has seen oscillation of these two types in addition to other similar systems like Gold+Silver system etc.