Jack is an avid gamer. He plays anywhere between 5 to 6 hours a day. His parents don’t mind because he is able to manage decent grades in school. However, sometimes he plays a little too much (9 to 10 hours a day), because of which his grades slip below the minimum acceptable grade set by his parents. When this happens, Jack’s parents restrict him from playing the extra hours in the hope that his grades would come back up. And they do. The economy works just like Jack. You’ll see, in a bit.
Simply put, an economy is a bunch of people, companies, banks, Central Banks, and Governments, interacting in a way that is mutually beneficial to one another. These five stakeholders typically interact by transacting with one another, either by buying and selling goods, or by lending and borrowing money. And every time any 2 parties transact with each other, value is created for both of them – the buyer goes home with a new car and the seller goes home with some money. Similarly, the borrower has money to buy a new car, whereas the lender has created an asset – a promise by the borrower that she would repay the lender the borrowed sum (along with some interest) later.
Thus, transactions are what drive the economy. The greater is the number of transactions between these 4 entities, the more prosperous would be the country and hence more rapid would be the “economic growth”. “Transactions” are really all there is to understanding how the economy works. No more, no less. If you want to gauge how prosperous a country is, simply count the number of transactions that are occurring within the borders. Well, of course transactions that occur with entities outside of our borders also contribute to a nation’s prosperity and economic growth, but for now, let’s limit our scope to just domestic transactions.
So, companies are entities that produce various goods and services that can be bought by people like you and me. And where do we get the money to buy these goods and services? We have jobs of course, that pay us fairly for the time and effort that we dedicate towards the job. However, if we want to buy something that our income cannot directly provide for, we visit a bank and request the friendly bank manager for a loan. She happily obliges and everyone is happy. Thus, in order to buy something, we can either pay from our pockets, or borrow money from a bank. And herein lies the pivotal role that a bank plays in boosting the economic growth of a nation – by lending money to a borrower, it is enabling the borrower to have more money at his disposal than he otherwise would. And more money in the hands of the borrower means that he can buy more things, which amounts to a greater number of transactions. And more transactions lead to a more prosperous nation, remember? Well, not always. Let’s try to understand why.
Transactions are only good so long as their growth is limited to the rate at which goods and services are produced in a nation. This is because, if the amount of income (and consequently, the number of transactions) grows faster than the production of goods and services in a nation, the market would run out of goods before people run out of money. This would result in a higher demand for the goods (which have become scarce) and thus push the prices up. When prices of goods rise, it is called inflation. Now inflation is bad because it erodes the value of the money that we own. For example, suppose we could buy 10 chocolates with 100 Rs. a year back, today we would only be able to get 6 (because the price of chocolates has gone up due to inflation). Hence, nobody likes inflation and so when it does occur, the Central Bank steps in and brings it under control.
How does the Central Bank do this? Before getting into that, let’s understand what a Central Bank is. Central Banks have been described as the “lender of last resort”, which means that they are responsible for providing a country’s economy with funds when banks can’t. However, the primary objective of a Central Banks is to control inflation in its country. AND how do Central Banks control inflation? Well, they have a secret lever using which they control interest rates – the rate at which all lending activities take place in the economy. When interest rates rise, it becomes more expensive for people to borrow money and hence people inevitably spend less. On the other hand, when interest rates fall, it becomes cheaper to borrow money from banks and hence more people borrow money, because of which spending in the economy goes up.
So, when inflation strikes, should the Central Bank push the interest rate lever up or down? That’s right, the lever should be pushed up so that people are disincentivized to borrow. When the lever is pushed up, spending in the country (and hence the number of transactions) goes down, until the production of goods and services grows faster than the amount of income (the money people earn + the money they borrow). This leads to the price of goods and services returning to normal levels, thus restoring the value of currency. All this is of course assuming that there is no supply shock in the economy, but that’s a topic for another time.
Therefore, the economy works in a fairly predictable manner. When people spend too much, prices rise. When prices rise, the Central Bank raises interest rates. When interest rates are raised, people are forced to spend less and when people spend less, the prices come back down. And the cycle continues infinitely. Isn’t this how Jack operates as well? So simple right? Well obviously, the economy is way more complex than this, but at a very basic level, this is how it works.
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