Visual economics

Economics Economics Questions
1

I like to visualise things, so in this case I imagine the money supply as bits in a fixed container. When you add more bits to the container, you have to squeeze it in so it fits, but now all the other bits get smaller (lose buying power). You will need more bits to pay the same service => inflation.

A similar image is useful in describing the opposite: deflation through scarcity in the money supply.

How accurate is the scenario below?

Here’s how I imagine the effects of imports would look on the current market (but suppose there are no tariffs or import taxes):

  • In order to buy something from another country you must first buy it’s currency on the foreign exchange market.

  • Step 1: sell RON (I’m from Romania) and buy EUR. There is now less EUR in their market and less RON in mine. Bits have been removed from both containers. Temporarily (theoretically), both RON and EUR benefit from an increased buying power in their respective markets, where they’re used as currency since now they’re scarcer.

  • I now enter the foreign market with the EUR as currency. For the foreigner on the foreign exchange market, the RON is a comodity (because he can’t buy anything with it).

  • I give the EUR back to their market and I get the product I want. The buying power of their currency is restored.

  • Outcome: the foreign market just recycled their currency. We used currency to intermediate a barter: I gave them RON and they gave me the product I wanted. Their money container remained the same, while our money container lost a bit, so RON gained in buying power due to my transaction. Everything should be cheaper by a certain %.

  • In addition to this, the .Ro market gained a product (expanded the container), which further increases the buying power of RON, since the same amount of money is used to describe more goods.

2

You’re confused about how the carry trade works.

Suppose that interest rates in the USD are 2% and interest rates in Euros are 4%.

I borrow $1B dollars. I’m not borrowing from someone else. I’m borrowing brand new dollars into existence.

I sell those dollars and buy Euro and then buy 1 year Euro bonds. This is inflationary pressure on the dollar and deflationary pressure on the Euro.

A year later, I redeem my bonds and repay my loan, keeping the profits. The dollar has inflated more than the Euro in the meantime, making a further profit for me. Alternatively, I could hedge with currency futures and make a practically guaranteed riskless profit.

The point you’re confused about is that the money supply isn’t static. When you borrow, you’re literally creating brand new money.