The story of Money; what causes Inflation.

[Rational Head]

Whole world is facing the steep inflation. People wonder what the causes of this inflation are. Some believe that inflation is a good thing and if stable and controlled it shows progress. But majority of middle class suffers the fears of high prices.
Let me explain you the whole concept of Money and Inflation with an example.
Let’s assume a small city called San Andreas located on an island of Andreas. It’s a fully self-sustained city, and it produces everything it needs. Barter system works here. If a tailor needs food then he exchanges it for the clothes he made from the farmer who grew wheat and needed clothes.
The problem came when people's need grew up and they needed more products, now a doctor could not take 20 suits in exchange for providing health care to a tailor, because he simply does not need 20 suits. So tailor had no way of paying doctor, as it’s really difficult for him to acquire all the things doctor requires. So what he does is, exchanges suits in exchange of cigarettes, even when he does not require cigarettes. He exchanges cigarettes because everyone wants cigarettes, so he would exchange the cigarettes to someone who needed cigarettes and provided something he required.
Even when the other person who lets say in this case made metal tools does not need cigarettes he will still take it in exchange of giving his tools because someone else might accept it.
In this whole situation, cigarettes act like a currency. People don't really need the product as such but they just accept it anyways because other people are ready to take it.
Soon the problem with Cigarettes arrived. You can't really store cigarettes for long, and you can't create smaller units or combine them to make larger units. Plus if you need to buy a car from it, you will have to supply a truck full of cigarettes which is inconvenient.
So People soon found out that metals prove to be a really good currency, they are malleable, they are ductile, sturdy and they can survive extreme temperatures. So soon people started to make currencies out of say like copper, and tin, when better metals came up, people started to use Silver and Gold as the currency because they fit in all the requirements of a currency perfectly. You can store gold for long, it doesn't rust, and it’s very malleable and ductile.
Let’s get back to San Andreas, the gold smith of San Andreas made gold coins of a specific weight which carried a specific value. If you wanted to take the services of a teacher, you pay him in those coins, if a teacher wants to buy the shoes you made, he pays you in gold coins.
There is a goldsmith in San Andreas called Mehta Jewelers, deal with a lot of gold so they did the job of molding a gold coin, and printing its weight on it. They buy other stuff from people, like a bullock cart, wheat etc and gave them these gold coins in return because it was much easier to take a gold coin from the jeweler with its weight printed on it rather than taking an unmarked piece of gold, weighing it, testing it and then completing the transaction.
Soon everybody starts accepting only Mehta Jewelers gold coins, if someone had a piece of gold they want to exchange with, they went to Mehta Jewelers, who measured it and provided them with equal amount of marked gold coins, and then later turned that piece of gold in further marked gold coins.
Now the thing is Mehta Jewelers does not really owns a lot of gold, he just basically takes gold, turns that into marked gold coin and gives it back to the person who brought it to them.
One day, Mrs. Mehta was going through the market and she really liked an Elephant which was for sale. She came back and demanded Mr. Mehta to buy her the elephant, but Mr. Mehta wasn't that rich to buy her an elephant, but since she insisted a lot so he thought of a clever trick, he took some spare metal which looked like gold, mixed it with some copper and bronze and created a coin which looked like gold, and marked it with equal weight of gold, and used it to buy that elephant.
Now you would call it as counterfeiting or forgery. But wait isn't Mr. Mehta was suppose to be the one to make the gold coins? So if Mehta jewelers made that coin, it can't be called as forgery or fraud? Haha, I am sure nobody is going to buy that reasoning. Mehta Jeweler is a fraud. As soon as someone in the city uses Archimedes principle to measure the weight of that coin they will find that it’s not made of pure gold. So this is what happens, someone in the city finds out that this coin is not real. People approach Mr. Mehta and he is found guilty of committing fraud and his status is taken away. Same holds true for any jeweler in place of Mr. Mehta, if they try to forge coins they will be caught some day.
A new Gold Smith called, Patel Jewelers take place of Mehta Jewelers as appointed by the city. Now Mr. Patel in order to deal with the "problem" of cumbersomeness of gold coins and the fact that physical transfer of those gold coins is too dangerous, Patel Jewelers started to introduce promissory notes, a bond on which Patel Jewelers signed that they will provide the producer of this note the specified quantity of gold.
Everything was going fine until one day Mrs. Patel who was going through the market saw a very expensive dress in the market, that dress was really costly and she went back to her husband and demanded that he buy her that dress. Now Mr. Patel didn't really have that much amount of actual gold, so what he did was he printed a paper on which he promised to pay the bearer the specified amount of gold even when he didn't have that much amount of gold actually. He hoped that since there won't be any demand for all the gold in one time, so he will never have to worry about not having that much gold with him, but then this thing goes on and on and soon there are too many promissory notes out there and simply not enough gold to back it all up.
So one day, though its a rare circumstance, there is a rush to the jeweler and everyone presented the promissory notes they had to the Jeweler, the Jeweler is not able to pay them all the Gold, this is considered as a fraud and Patel Jewelers is punished by the city for committing fraud.
Now the city council is too furious that these things are happening so they decide to take matters in their own hand. The city council decides that now they are going to print the notes. But there is a catch, since the city council does not have their gold of their own; they issue these notes without any gold backing.
Of course no single person is in charge of city council so nobody is directly printing the notes for their personal use. But here is what happens. The overall business of the city goes down because of insufficient rains, so the city council sees it as a recession and since people are crying so they decide to deal with it by providing a stimulus package, basically they issue more promissory notes to the people, since these notes do not necessarily reflect actual labor and people who receive them(usually poor people or city council workers) they spend it and buy stuff which is not through actual labor.
Lets go a bit deep in this part of example, lets say there are 100,000 Andorra (the currency of San Andreas) out there in market. Every Andorra is supposed to fetch 10 gms of gold back in the days of Patel Jewelers. Now there is a recession so the city council prints 10,000 Andorra more and give it to the poor.
Now what has happened that any poor guy who was not able to buy a quintal of rice because the price has gone up to 10 Andorra from 2 Andorra(remember, it didn't rain well this year that means lesser production of rice, so higher prices).
So government gives 100 Andorra to every poor guy(100 poor guys) they all are now able to pay 10 Andorra for the price of per quintal, but wait!! Do we really have that much rice to be sold to the people, just because government printed more money? NO! So what happens is that the price of every quintal of rice has gone further up from 10 Andorra per quintal to 20 Andorra per quintal, effectively making rice out of reach of the poor people again(so no matter how much money city council prints, the price of rice will go up and up).
At the same time, people want to buy other products too so their prices will also go up. Overall this is called inflation, and more the government prints the money, more it goes up.
Now what I have written about inflation, this holds true if the market is really dynamic, but this is not the case, it takes time for inflation to be reflected everywhere. The prices of Rice will not go up in one day, so the people who get this newly printed money (usually the "poor") and the salaried individuals employed by city council, they get the quickest advantage. They spend the money and buy the products, now the burden is shifted to the person on whom they bought the product. These people then spend money on something else, and this spreads all over the economy and hurts till the person who tries to spend the money the last, or who saved a lot. His money is now of less value because the prices of everything has gone up.
Another harsh reality you have to keep in mind that the poor people aren't really the most productive people of a free society, basically anyone who gets the advantage of economic stimulus package did not deserve it, and it harms the more productive man who works really hard and saves a lot of money, because once government prints more money, his savings are now worth less than they should have been. If he saved 100 Andorra, after introduction of those newly printed Andorra, his savings are now only 100*100,000/(100,000+10,000)=90 Andorra.

So he lost 10 Andorra out of nowhere, because City Council (or in real world the Government) printed more money.
originally posted at http://designinglifenhappenings.blogspot.com/