The subject of the article is very demanding and I am going to touch much conceptual stuff in this article. thus I have tried to keep economic jargon as brief as possible. simultaneously I have tried to answer all possible questions that might arise in your mind while reading this article.
as per the title of this post, There are 4 broad areas that I have tried to elaborate. Depending on your requirement you can simply jump to the relevant part of your interest. However if you are new to economics, then I will recommend you to go through the article sequentially.
NOTE: This article is for understanding purpose only and and although the concepts and data mentioned here are valid and correct, they are expressed in very simple manner.
The covered subtopics are,
Basics of economics
Economics is not a difficult discipline to understand but to understand an event in economics, you are supposed to know all associated factors and concepts, and that makes this subject challenging. So to understand Euro zone crisis and Policies of deregulation going in India you will need some basic understanding of economics, which starts with fiscal deficit And then little about GDP and growth rate.
What is fiscal deficit?
A government (G1) runs like a home. You earn money from your job and then you spend it on your daily activities and when you need more money than you earn, you simply borrow it. Similarly government earn money from various sources like taxes and duties, public sector company revenue etc. and then it spend this money on government employee salaries, developmental projects etc.
often government spends more than it earns and this difference between spend amount(S) and earned amount(R) is called as fiscal deficit(D) i.e. S-R=D. (u know, fiscal=related with finance & deficit=shortage)
how world economics carry out its activities or Business
government need money equal to its fiscal deficit to carry out its business; but devoid of internal sources of tax n duties, government take help of other means i.e. it resort to borrowing money and it issues bonds. (bond, in general terms is a fixed deposit account) besides bonds, which are purchased by either financial institutions(big banks) of the country or mostly by other country`s government (G2).
But funny thing is other government G2 is also suffering same problem of fiscal deficit like G1!
Now a simple question arises, if both are suffering then why would G2 will help G1? (if this question has not raised in your mind just skip following para.)
Well, the answer is simple; today the governance has also become a business. Let’s understand this with an example of US and china. and then you will also understand why n how China is said to be a world power.
(Here I am going to use a term GDP (gross domestic product), if you don’t know what it is, don’t bother, just for time being assume it as total money generated in a country in 1 year)
for 2010 China`s GDP is ~$5trillion and fiscal deficit ~223billion while USA has GDP of $15trillion and fiscal deficit of ~$1.5trillion. thus considering the hugeness of amount, obviously USA`s fiscal deficit is more as compared to china.
To fill this deficit government of both countries will issue bonds. as matter of fact, USA being the richest country, it is considered as safe place to investment. also the government of USA has never defaulted! and value of US dollar hardly fluctuates and mostly it appreciates making more returns at maturity for the bond.
so with this lucrative offer, Suppose china buys these bonds and invests their money in USA fixed deposits. then china has a security that USA will return its money after maturity of bond plus china will get some interest on these bonds!
And from where china will get that much money? Simply via the ‘made in china’ stuff! The international trade is carried out in US dollar only; and china has plenty dollars earned via the export based trade, as the international trade is carried out via US dollar. (for same reason, USA has strongest economy!) so there cannot be a better and safer place than USA to invest the huge chuck of money! Above all its china`s money that will be supporting USA economy(as it is fixing fiscal deficit) so obviously USA will have a soft side towards china. And this hugely matters in international politics. (Obviously you will be grateful to the person who is helping you.) Thus china prefers to invest in USA`s debt.
And to fix its own debt, china also issues bonds which are bought by other countries just as mentioned above. Thus, the universal principle governing global economics is bigger economies gets cheap funds from other big economies to fix its deficits. And such investments are done to gain favour from other countries in international politics. (As matter of fact, by means of bond, today USA owes china about a trillion USD!)
why not print more currency to fix deficit?
After above business another question might creep in your mind, why so complex? Why borrow money? Just print more currency n fix deficit! When I was studding this stuff I had asked my teacher same question Then he answered, ‘a note is simply a treasure bill that is issued against a fixed asset’. And I was more confused! The economists love to see the expression of frustration on your face and they get extreme pleasure in talking that jargon! (But you see, he used just 13 words to answer correctly! N I will be devoting a para to answer the same.)
So in simple language, the money or a note of Rs.100 or Rs.500 that we use is issued by RBI against some fixed tangible asset owned by the government. traditionally This asset was gold as per gold standard; that is a central bank was supposed to keep gold of same amount aside to print notes. however with maturity of economy today it is carried out on basis of bonds. Here the government issues bonds to central reserve bank, and upon this bonds central bank issues currency.
The bond remains liability of government. but you see, the bond is a type of debt and RBI issues money based on debt! money created out of debt! funny right? but that’s how it works. :)
now, If government asks RBI to issues more notes, then it will dilute worth of money already in circulation. it simply works on principles of demand and supply! if a commodity is more its value will be lower. More money in peoples hand more mouths to eat, but with fixed production, scares becomes the resources. And thus with simple rules of demand and supply, higher the demand and less is the supply, scares will be the resources leading to higher prices and hence inflation. (and this is the reason for current inflation in India. We will come to that again in last section.)
Thus a wise government never opt to printing more currency to fill the deficit.
in economic jargon, the currency floating in economy is also called liquidity. Its just like melted water out of frozen iceberg and the RBI maintains the iceberg, by various ‘fiscal measures’(REPO and reverse REPO rate) central bank (RBI in India) controls this ‘liquidity supply’