Today there exist a common phenomenon called, “Rich is getting richer and poor is getting is poorer”. This post is regarding why such inequality is happening. If you look at all my post, I will try to explain everything in layman terms for beginners. This post will also help the beginners to understand the concepts clearly. If any queries, you can query me in comments section.

 People have different views on this like,

1. Rich people are talented people.

2. Rich people are hard workers and they are working around the clock to achieve the dreams.

 In other way around, if you look at the same issue in more granular way to understand, “Why rich is getting richer.” We need to visualize the monetary system and modern day economics. I can say this is one of the primary reasons behind this inequality (not only the primary reason).

 Policymakers need to focus on the poor and the middle class in resolving the inequality but modern monetary policy focusses mostly on improvising the life of rich. Let us get into detail and I am assuming at the end of this post you will understand be able to understand the below important economic tools.

1. Central bank’s policy – price stability vs. inflation targeting.

2. Quantitative easing.

3. Negative Interest Rates.

The goal of monetary policy varies across central banks of different countries. But most of the central banks in today’s world are targeting inflation. First let us see about price stability and inflation targeting

What is price stability targeting?

Price stability involves targeting a price index value like basket of goods instead of individual goods like rice, corn, butter etc.

For example consider,

Basket of goods in 2015 = 100$

Basket of goods in 2016 = 105$

From 2015 to 2016, value of goods inflated by 5% then central banks will use it monetary tools to reduce the price to 100$.

Again in 2017, if the value is 102$ the central bank will commit itself to bring back the price to 100$. This is quite opposite in inflation targeting and because of this reason, everywhere around the world prices are increased every year.

In price stability, central bank main agenda is to bring the value back to original value (100$) which may involve deflation.

What is inflation targeting?

Inflation means your money will buy less number of goods or purchasing power of the currency is reduced.

Inflation targeting means central bank of the country targets officially certain level of inflation percentage officially. Most of the developed countries central bank targets 2-3% and developing countries central bank targets 5-6%.

 

Is it surprising?

Yes, central bank of the country officially wants certain level increase in price of goods so that economy of the country will grow. Is it really insane? How a common man or old age people will bear the increase of price?

How the increase in price of goods makes economy to grow?

To understand this, let me tell a small story.

If you have $100,000 to buy a house, would you buy it today, knowing that tomorrow the price will drop to $95,000? Now if you know tomorrow the price will be $105,500, would you not buy it today?

Same principle, everything will be more expensive in the future, people are more inclined to spend their money. Inflation discourages stagnant money in the economy and it basically encourages the people to buy or invest something in the economy because in future it might be costly. Because of this reason only central bank encourages moderate inflation and they are say it will encourage investment which in turn boost the economy.

Now let’s just look into a story for inflation targeting vs. price stability targeting.

Let us assume for this story, a person who works hard and earns 100$ a year and have an expense of 90$ (net savings is 10$).

Year 1 (savings) = 10$

Inflation in year 2 is 10% but still the income is 100$. Since the person is having 10$ savings, he is able to manage the inflation.

In price stability mechanism, central bank will try to bring price back to 100$ hence no need to worry about the price increase in year 3. If there is drought or some unforeseen circumstance then only price increase will happen.

Now let’s see how inflation targeting works.

In inflation targeting, central bank of the country officially targets inflation. Let’s say the inflation is 5%.

Then person should earn in

Year 2 = 105$

Year 3 = 110$

Year 4 = 115$

To achieve the above earnings, person needs to work hard, increase the productivity, wage increase demand etc.  As per the modern economics, gradual increase in the price of goods creates demand in economy which in turn creates more business, employment etc.

Will this create problem for common man (lower and middle class people)?

Answer is pretty straight forward and it is “YES”.

How retired person (old aged people) will be able to withstand the price increase? Until or otherwise they have inflation protected investments.

How low wage workers will be able to withstand price increase? Is there any rules in any country, wage should be increased along with central bank targeted inflation rate?

All the savings of the people is getting eroded because of the price increase until or unless they have invested in some inflated protected investments. Do you think low/middle class people are doing this? Is there any enlighten happening to educate them?

Inflation targeting policy helps mostly rich people of the country and it really creating havoc problems for fixed wage workers because it really erodes the purchasing power. Persons who hold shares or stocks of companies gain during inflation. When prices increase, business activities expand which increases the profit of companies but they do not increase the wage of its employees. As profits increase, dividends on equities also increase at a faster rate than prices. But if you look at fixed wage workers or lower class people mostly keep the savings in savings account or fixed deposits which carry a fixed interest. It causes loss during inflation, because they receive a fixed sum while the purchasing power is falling. We need a proper education system to educate them.

Most of the people are not aware of the inflation and many are considering this as price hike.

 

 Why prices are not falling even when inflation is getting low?

Inflation is not related to price decrease. If inflation is getting low means prices are not rising in the economy and look at the factor called deflation which measures the decrease in price.

You can calculate the value of the money using the below formula

Reduced amount = amount/(1 + inflation rate)^number years

Let us assume you have 10,000$ and you like to calculate the value of $ after 20 years. By applying the above formula you can derive the value (assume inflation is 2%)

10,000/(1+0.02)^20 = 6711.41$

Required amount to compensate the inflation is calculated by the below formula

Required amount = amount * (1 + inflation rate)^number years

Required amount = 10,000 * (1+0.02)^20 = 14,859.47

You should have 14,859.47$ today to compensate the inflation after 20 years.

Central banks mostly controls inflation by Interest rates and the most modern day tool is

1. Quantitative easing

2. Negative interest rates

Quantitative easing is one of the tools used by central banks of US, Europe and Japan especially after the 2008 financial crisis. This policy was first used by Bank of Japan (BOJ- Japan central bank) in early 2000’s to control deflation and this policy is used by U.S Fed, UK BOE (Bank of England) and Euro zone ECB (European central bank).

What is quantitative easing (QE)?

QE is nothing but expanding the balance sheet of central bank of the country through asset purchasing program.

(Or)

Quantitative easing (QE) is an unconventional form of monetary policy where a Central Bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the economy and return inflation to target.

 Is it confusing?

QE is nothing but printing out money in thin air by central bank of the country to purchase corporate bonds or stocks to create money supply for business expansion. 

Banks earn profits when they create new money through lending, but they lose money when they make bad loans. After 2008 crisis, banks are not willing to lend money. This results in minimizing the business expansion eventually layoff/job shrink will happen in economy. Since US is the world giant economy let us look at the Fed stimulus policy.

 

 Fed expanded its asset purchases program (QE) in the various intervals in the form of QE1 (December 2008), QE2 (November 2010) and QE3 (September 2012).  The Fed’s balance sheet expanded from about $850 billion to more than $4.4 trillion. Although the Fed has not announced an official end to the program, it began purchasing smaller amounts of bonds, referred to as tapering. 

Is really QE helps to simulate the economy?

If you take a close look at QE, a major direct benefit of this program is institutions (got access to cheap credit) who play a major role in economy and not the daily wage worker. Expectation is that because the cheap credit business will expand, new jobs will be created. But inequality will increase rapidly, the low wage workers who don’t have access to cheap credit. They are also affected by inflation (new money printing always create inflation). To understand more on the impact, refer the below link which really depicts this issue clearly

http://www.cnbc.com/id/49031991

Negative interest rate

Negative interest rate is another unconventional monetary policy used by few central banks of the country to stimulate the growth in economy.

What is negative interest rate?

Once we keep our extra money in commercial bank deposits, then they are giving interest as an incentive to us. In the same way commercial banks keep their extra money in Central bank of their country then the Central bank will give interest as an incentive to the commercial bank. Banks also sees this method is risk free because they are parking the excess money in trusted place and they are earning interest as well. Even though Central bank interest rate is low, commercial bank sees this approach as risk free. But in the view of growth based economy, stalled money is not good. Basically money should be invested in some business then only economy will grow.

To encourage lending, central bank started to charge negative interest rates for commercial banks. Basically they cannot park the excess money with Central bank and if they do profits of the banks will get reduced due to negative rate hence they are forced to lend the excess money.

Who will get benefit from this policy?

Banks has to lend money and also they need to find risk free borrowers like highly paid professionals, big companies etc. Assumption from this policy is that borrower will buy new car or new house or renovating existing house which in turn stimulates the spending and results in growth. But this free money only increases inequality and the rich is getting richer easily and low wage workers are getting suffered because of the price increase. Just look at the housing bubble impact today, normal person is not affordable to buy a house in any cities of the world.

This article is not to pointing out the mistakes or blaming the policy and the current system which makes rich richer without considering the fact of fixed wage workers. Basically along with growth we need to reduce the inequality in this world, if only few sector of people in country are growing means, it’s not healthy growth and it is called bubble. People may argue that since we live in capitalist policy and everything is market driven but still majority of the world’s wealth is owned by few individuals. We need to educate the people about inflation and government should provide more stimulus in rural areas. Hopefully my views helps someone to get some enlightenment about monetary policy who is reading this.Thanks everyone!