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Concepts of Currency, Inflation, Deflation and Exchange Rate

Akshat Agarwal is working for Indian oil giant ONGC, a GOI Undertaking, in his capacity as Assistant Executive Engineer. He is a Civil Engineering graduate from IIT Roorkee, and likes to write answer on Quora for questions related to Macroeconomics & Indian Economy out of his interest in the topics.

Here in this post, we shall broadly discuss the basic concepts of Currency, Inflation, Deflation & Exchange Rate. I do not want to merely present the definition of these topics for you to read, and that is why, I shall be explaining the above concepts by answering the following 3 questions.
 

 Q1. Why can’t Indian Govt. pay World Bank loan by just printing money?

Q2. Why can’t RBI control the Rupee value against US Dollar by simply printing lesser money?

Q3. On what basis does RBI decide how much money to print? 

At the end of this discussion, though you'll not come across an exact explicit definition of subject topics, but you shall definitely have a thorough understanding of each one of them. Above questions have been answered in the chronological manner since answering one will invariably incite your curiousness and make you ask the follow up question. To understand the answer to our first question, let us make ourselves our own Economy.

Let us say you are a farmer and you have mango plantation. You do hard labor and work day and night and grow 100 kg mangoes every year. One cannot live his life eating only mangoes, And since mango is a good seasonal fruit, good for health, and not to mention utterly delicious, there would be others who'd happily trade their farm products, say wheat, for some of your mangoes. Realizing this, you decide to exchange your mangoes for other products. You tell about it to your friend who has wheat farms. Incidentally, he happens to be a mango lover and together you develop a rate of exchange, with mutual understanding of course in this example, say, 5 kg mangoes for 10 kg of wheat. You give him 10 kg mangoes and get 20 kg wheat for your family, which you assume should suffice for 6 months. You do the same thing with your other friends as well in exchange for pulses, rice, vegetables etc.

Now, past 6 months comes winter, and your supplies have started to diminish. Moreover, you do not have any mangoes to offer in exchange for wheat and other commodities. But without the commodities you won’t survive for next six months. Now what should, or rather, what could you trade in exchange for wheat?

You find a solution. You go to your best friend who trusts you a lot, and you promise to give him 5 kg of mangoes next summer for 10 kg of wheat right now. He thinks about it for a while. There are of course things to be concerned here. What if you refuse to give him mangoes later? What if the mangoes you give him aren't good quality? What if next year is a drought and there are no mangoes?

Let us say for the sake of simplicity here that your friend here thinks about it but on goodwill and years of friendship, he trusts you and agrees. Similarly, you go to your other friends, gain their confidence and promise them some mangoes next summer for providing you with supplies right now. Now, what you have done here is that you have developed a trading system wherein you trade items and commodities for other items and commodities. And the trading currency is none other than the "items and commodities".

But now, since you are trading with so many different people at different time, it is getting difficult for you to keep track of how much mangoes you owe to whom. So what you do is that you start handing over promissory notes to the people you trade with, with your sign on it and the amount of mangoes you owe them. So next summer, whenever you have mangoes harvested, people come to you, show you the promissory note with your sign on it, and take the mangoes.

But there is a problem with this system: you are promising X kg of mangoes which you have not harvested yet, i.e., which do not exist. Similarly you would have supplied mangoes to someone for a certain commodity he'll have in future but doesn't have it now. And then there is always a risk factor, i.e., next year maybe a dry one and you may not have enough mangoes to trade.

Realizing this, you are worried now. You need a damage control. You consult this with your trusted friend and ask him how to avoid possible damage. Now this friend of yours is quite a trader himself and has travelled many cities and traded with many people. He tells you not to worry about it and that he'll let you on a little secret. He explains it to you how people will need mango no matter what: after all it is a seasonal fruit and very delicious. Now if there is less growth of mangoes next year, then he can ask to negotiate exchange rates in his favour, i.e., more commodities for same amount of mangoes. Simply put, due to scarcity, his mangoes will become costly.

You get it a little bit, but you are still confused. You wonder how will you negotiate rates when you do not know how much mangoes you are going to harvest next year; how can you negotiate when there is uncertainty? Your friend smiles, and tells you that you can. He suggests you to issue only a certain value of promissory notes, let’s say  1000, and then do the trading with these notes after declaring their new meaning to the traders. These 1000 notes will represent 100% of your harvest, no matter how much you harvest. So if there is a guy with your promissory notes valuing to 100, he''ll have 10% of your harvest next summer, no matter how much you harvest. He can also decide to not exchange it for mangoes next year when there is a drought, and wait for next to next year hoping for more amount of mangoes then. Let’s call your promissory notes as Mango Currency (MC).

All goes good and the mangoes, being good quality and sweeter than its competitors, are valued more. People want to buy mangoes from you even if they have to pay more. This means the value of MC gets more, only a few people can afford it. The very lower class, who wants to eat mangoes but cannot get hold of MC due to its high value is suffering. This also causes you loss in business since people are now holding MC instead of trading it for mangoes since the value is increasing. Since mangoes are not being traded, they are rotting in the collecting compound with very less people to buy them, causing you huge loss. You now need to keep the value of MC in check so that people do not hold up to it.

You go to your friend again and consult him on how to keep value of MC in check. He tells you to simply issue more promissory notes. Since the total sum of promissory notes is equal to 100 % of your harvest, if you issue 1000 more promissory notes in addition to the initial 1000 that you've had, the value of MC would be halved. 100 MC that was 10% of the harvest would now only be 5% of your harvest. (This is also how RBI keeps the value of Rupee under check, else Economic activity of country would go down)

Now you have developed a good trade system and also know how to keep the value of MC under check by regulating the supply of promissory notes. Now you decide to expand your business. You go to your best friend who deals in wheat and has currency WC (Wheat Currency). He is already doing very good in business and has surplus money. You tell him about your plans to expand our business and your requirement of more money for expansion purpose. He listens to you and agrees to lend you some money at certain interest rate: he already has enough money and extra money sitting at home isn't earning him anything, so lending it to you for certain interest seems a good deal.

You borrow 500 WC from him. Now WC is quite strong in market. So much that 500 WC costs around 1000 MC (how much % of wheat harvest it represents doesn't matter).

Now, you use up all the WC for expansion but suffer heavy losses. All the WC went down into the drain. You bought some stuff from it and have it still, but it is not bringing you any revenue and nobody is ready to buy it back. You are now left with only a few MC (remember, your currency is also floating in the market; you have maybe 1200 MC at hand). To pay back 500 WC, you need 1000 MC. But if you give 1000 MC right now, your remaining business will not be able to sustain itself with only 200 MC at disposal and you'll eventually end up bankrupt.

You now think about possible way out. You plan to issue 2000 MC more, exchange 1000 MC for WC and return the loan. But if you issue more MC, the value of MC will be halved. Moreover, you cannot think of cheating because the value of various currencies is now checked by Association of Auditors and you need to report any more printing of currency to them before it can be floated in the market, and all the currencies are numbered to keep the authenticity in check.

Basically, you are now left with only one option: to try to get your act together and grow your business back to what it was, and then further more to get enough MC with sufficient value, to be able to return the loan amount.

Now in the above scenario, let’s replace you with our country India, and replace mangoes you harvest with the economic activity that takes place in country; and replace your promissory notes, valuing to 100% of your harvest, to 100% of the economic activity in the country.

Now, back to the question: What happens when RBI prints more money to pay off bank loans? You should be able to guess it. More the money printed, lesser the value of currency. Money flowing in the country is nothing but standardized promissory notes issued by RBI. They are equivalent to the total economic activity of the country. If the economic activity does not increase in proportion to the money printed by RBI, the value of Indian Rupee will go down.

And obviously, value of MC will go down with respect to promissory notes issued by other people for other commodities. So when value of Rupee goes down, it does w.r.t other currencies, USD being one of them.

It’s not difficult to guess that loans provided by World Bank are in USD. If money is printed to pay off the loan, value of Rupee goes down, which means you need more Indian Rupee to buy USD. As you can see, you cannot repay the loan unless you actually have the money, over and above what you'll need to run the country.

Now, a moment of truth: this is not how an Economy works. That is to say that money is not issued in the manner explained above. The take away from the story is that money gets its value from the amount of goods being produced in the country, like mangoes in this case. For an actual economy like India, these goods will range from matchsticks to Airplanes. Not only products, but services are included as well; intellectual work also has its value. All these is collectively termed as Economic activity of the country, i.e., activities which produce some output, physical, intellectual, or work (labor). In essence, the money in any economy gets its value from the amount of economic activity in the country.

You may ask, if this is not how money is issued then how else? You’ll get the answer further in the post. But, for now, let’s consider other takeaways from the story above: increase in printing of money decreases its value & vice versa.
From above story, what you understand is that the farmer cannot print excess money because of the ‘Association of Auditors’. You may ask here is, what is this Association of Auditors in our national Economy?

There is none. Let’s forget that there is an association of auditors in above case and he prints money without actually telling anyone and issues it. What would happen if everyone with the money came at the same time asking for their share of mangoes? Since the currency value has not changed, the actual % of harvest that the money will represent will be more than 100%. Hence, it is more sort of a damage control.

But again, that is also not how the Economy works. Value of any currency follows demand-supply principles. If more money is available to citizens, they’ll be willing to spend more. Prices of products & commodities will increase, effectively reducing the value of currency. Similarly, shortage of money supply in any economy will lead to increase in its value and reduction in prices of commodities.

These effects are called Inflation & Deflation respectively.

Moving on to the second question: "Why doesn't RBI simply print lesser money in order to keep the value of Rupee against Dollar under check?"
I’ve already explained above the effects which printing excess amount of currency in any country causes (the basic demand-supply concept of goods & services: more demand of goods than supply, or more supply of money than demand results in more value of goods or less value of money, and vice-versa). To cite an example, refer the case of hyperinflation in Zimbabwe, wherein the Govt. printed money like paper, and that’s what the currency’s value came to be like. I suggest the readers to read the wiki article on Hyperinflation.

Now, let us apply the same concept here. Let us assume the RBI decides to stop printing the currency for a while. Quite opposite to inflation, where value of money decreases, value of money starts to increase here, i.e., you can buy more goods and services for same amount of money than you could before. Another way of saying it would be: the prices of goods & services are falling.

Now let us stop here for a while and think over the situation with the help of an example. Let us take gold. Somebody tells you the value of gold is falling down, i.e., you can buy more gold for same amount of money. Further, he tells you that value of gold will go down even further. (Lets just say that your source is impeccable and if he says so, it's going to happen). What would you do?

You, as an investor, would not buy gold right now. Instead, you would wait till the prices are little more down so you could get a better deal. It is human nature, you cannot help it; neither can rest of the population in the country. So everyone waits, nobody buys, hoping for the prices to fall further.

Now, let us replace gold with other goods and services. The basic concept remains same. People do not buy goods or services in hope for a better deal later. They wait. Result: the aggregate demand goes down.

There is a fall in how much the whole economy is willing to buy and the ongoing price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further. The fall in demand causes a fall in prices as there is excess in supply. This becomes a deflationary spiral when prices fall below the costs of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. As can be seen, the overall economic activity of the country is reduced.

This whole process of reduction in value of goods and increase in value of money is called Deflation. There could be many reasons for deflation; read Deflation

Now, Deflation is generally regarded negatively, since it causes a transfer of wealth from borrowers and holders of non-liquid assets, to the benefit of savers and of holders of liquid assets and currency. Simply put, the land you owned now has less value than it had, and the money in my hand now has more value than it did.

While an increase in the purchasing power of one's money benefits some, it amplifies the sting of debt for others: after a period of deflation, the payments to service a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as an effective increase in a loan's interest rate.

Deflation, like Inflation, is not good for an economy. This is the reason why printing of the currency has to be regulated: you cannot print too much and you cannot print too less either.

Few questions that some of you may have:

Q: How is printing lesser INR related to USD?
A: Isn't it? Think about it. A certain service X here costs Rs. 10. Govt. decides to double the supply of money. Consequently, the prices rise and same service now costs 2x, i.e., Rs. 20, since value of money is halved.

Now let us assume the exchange rate for INR to USD be 50, i.e., 1 USD costs Rs. 50. Think from the point of view of a nation: would you pay twice the amount for same service just because the other nation decided to double money supply and screw their own economy? No, you won’t.

Initially, US could get 5X for 1 USD. Why should it change? But back here in India same service now costs Rs. 20. Hence, to get 5X for same 1 USD, exchange rate has to be at the rate of Rs. 100.

Similarly for printing less: it would then be Rs. 25 for 1 USD.

Q: So you agree that rupee value against USD can be increased by printing less?
A: Well, that will be one initial effect, yes; provided that the overall economic activity of the country remains same. But as you can see from the answer above, there would be a reduction in economic activity. Hence, the value of rupee would start to fall again, and this time beyond its original value against dollar.

Q: Shouldn't there be a sweet spot in between where the inflation rate reduces but still remains positive? Why not just hit that spot? Why not ensure a small positive rate of inflation (say 5%) - which seems to be ideal for everyone.
A: Well, you are correct in your thoughts; although, an ideal rate of inflation is around 1-2 % and not as high as 5%. But then again it varies from country to country. For example, Indian Govt. recently informed that the sweet spot of inflation they are targeting is around 4%.

A low but positive rate of inflation is always desirable for number of reasons, but mostly because other scenarios are not desirable. Following the method of exclusions, following is not desirable:

1. Very High Inflation: For reasons explained above: it is costly.

2. Negative Inflation or Deflation: Again, for reasons explained above. It should be known that deflation is much more costlier than a similar rate of inflation.

3. No Inflation or very low inflation: At very low rate of inflation, interest rates are close to zero, thus limiting a central bank’s ability to respond to economic weakness.

A constant inflation at 1-2% checks the point 3 above, and is, hence, most desirable of all the scenarios.

Although in current scenario, RBI should not and would not resort to such method since strengthening of Rupee right now will promote imports even further, and reduce exports. This is not desirable as it would further reduce value of Rupee.

Q: So are you saying that any attempt to increase the value of rupee would increase imports creating an additional lack of demand of rupee (thus devaluing it again) to such an extent that the net effect would be a decrease in its value?
A: Without going into technical details, broad concept is that strengthening of currency favors imports and discourages exports, and vice-versa.

Already the Indian economy is not in a very good state, our imports being huge and exports less. This is not good for any economy. If anything, RBI would try to keep the rupee at the same value, if not let it fall further, to support the exports and discourage the imports. If RBI tries to strengthen rupee, imports get favored and value of rupee starts to go down. As can be assumed, it would be oscillation rupee value. Why would RBI try something like that??

Final outcome in terms of rupee value cannot be measured since it would depend a lot more factors.

Now, for our 3rd and final question: “On what basis does RBI decide how much money to print?

First of all, let’s start with the assumption that Govt. knows how much money to print. Let this quantity be X. Now, what happens if Govt. prints more than X, or less than X? You already know: decrease or increase in value of currency.

If you print more than X, Inflation occurs and prices start to rise; if you print less, Deflation occurs and prices start to fall. The negative effects of both have been brought out in my answer above. What we need is to print neither more, nor less, but just the right amount so that excessive inflation or deflation does not happen.

Now, how is this amount is determined by the RBI? The answer is the Economic Growth of country, or simply GDP. Actually, GDP is also not the exact measure of growth, which is explained in the subsequent paragraphs.

GDP is basically a number which is sum of all the products & services produced in the country during a financial year in Rupee terms. Simply put, numerical measure of goods & services produced in a year. Quite obviously, more goods and services produced in a country, more would be the GDP, right? Not necessarily.

Let’s say 5 products are produced in a country, each costing 20 bucks. So GDP = 5x20 = 100. Let’s assume this is also the amount of money RBI has circulated in the country. Now, assume RBI doesn't print any more money the next financial year, and the number of products being produced rises to 10. Now GDP = 10x20 = 200? Wrong!

Since money circulation hasn't increased, Deflation occurs and prices go down. This would be in inverse proportion to increase in production and hence price would be now 10 bucks only. Hence GDP = 10x10 = 100 only. Note that there is no increase in GDP despite the fact that production of a country is DOUBLED!!!

Now, you already know what happens when Deflation occurs and we do not want it to happen. And you also know how to tackle it: print more money. And somewhere in your mind, you already know how much to print so that Deflation is tackled without causing any Inflation: you measure the growth in your Economy/Production, and increase the money supply accordingly. So, RBI prints 100 Rupees more; price rise back to 20 bucks a product, and GDP = 10x20 = 200. (This is also the example of why GDP is not the exact measure of growth in any country: it could deceive you. But, if we keep the prices of all goods and services constant, that the only way GDP can rise is by ACTUAL increase in production/services, and hence the economy)

This is what RBI does as well. Only difference is that the RBI estimates this demand on the basis of the growth rate of the economy, the replacement demand and reserve requirements by using statistical models, due to the complexity of any economy.

In addition to this estimated demand due to growth in economy, the amount of money that needs to be printed also includes replacement of damaged notes, reserve requirements, circulation purposes, etc.

And with this, we have come to an end of our discussion here. In case of any doubt, please feel free to message me on [email protected]. I’d be happy to answer your queries. Cheers!