Category: Economics

Nowadays, almost everything concerns gas prices and inflation. I have been reading everything with great interest and actually observed the two build-ups since February this year. And somehow I had treated the two as separate matters happening simultaneously, coincidentally.

One day, as I was lying on bed and almost bored to death, my mind wandered to the two issues and I said “Eureka!”

Let us touch on inflation first.

Inflation occurs when there is too much money being printed by the central bank. Inflation also erodes the real value of things related to money because unfortunately and weirdly, a lot of contracts are set in nominal term. Yet, despite inflation’s somewhat acidic nature, inflation is not at all that bad as long as it is not turning into hyperinflation, of which my professor describes as inflation on steroid.

The reason is because the ability to print money — the source of inflation — brings a huge benefit to the economy. One benefit of increasing the money supply is lower interest rate. (Another advantage of printing money is seignorage but only a myopic would consider this)

Larger money supply decreases the interest rate and a low interest helps stimulate investment. And at the same time, the stock market is a proxy of investment. Whatever good for the stock market is good for investment. Whatever good for the investment is good for the output.

The Federal Reserve has kept a very low interest rate for the past few months. It has been so low that cutting the interest rate further is almost impossible. This expansionary monetary policy — hand in hand with Bush’s expansionary fiscal policy — has helped the US to get out of the recession.

As a result, consumers demand more stuff; more stuff is being asked at a given price level. Now, given supply is constant, price will go up.

Let us move on to the second picture.

The crude oil price – which pretty much influences a lot of other stuff – has been going up mercilessly. A few things accredited to the rise of gas prices are China’s rapid industrialization and the US economic recovery. If this price shock is temporary, the short run aggregate supply should go up and then return to more or less its previous level as what had happened during the oil crisis in the 70s. This happens with the assumption of all things being constant, of course.

But, a recent report by Reuters suggests that high gas prices might be a permanent instead of a temporary phenomenon. This is consistent with the expansion of the aggregate demand. Plus, our voracious appetite for gas and the decreasing supply of gas probably tops up the effect of greater aggregate demand on prices.

And all the time, we are complaining about inflation and gas prices but I believe we are barking on the wrong tree. Rather, we should be whining on over-expansion that is happening, probably, on all fronts.

This growth is not sustainable. It is clear that supply can no longer keep up with demand and in some instances, supply is dropping. Thus, we must slow down before hell breaks loose.

And you know what could have slowed down the growth and prevented all of these nonsense?

I bet my head on externalities of the now nearly defunct Kyoto Protocol. But no! Somebody says the Protocol would limit economic growth.

Well, I say have fun with your growth and your $2/gallon gas.

Earlier, some time around January or February this year, the USD exchange rate took a nose dive and became very weak. A weak USD should, would or could increase export because a weak USD means local goods are made cheaper relative to foreign goods. This would make the local consumers to switch from foreign to local goods. Also, foreigners’ demand for local goods should rise. This directly means that import should fall and export should rise, resulting in lower/bigger trade deficit/surplus.

However, quite the contrary, instead of being reduced, the US trade deficit continues to grow. Currently, the trade deficit is at a record breaking $46 billion. According to an AFP report:

“It probably suggests the US dollar has not depreciated enough over the last couple of years to stabilize the external balances”

That is the easy explanation to why the trade deficit does not follow the marcoeconomics theory.

Economics is an easy science, isn’t it? When something doesn’t go with the theory, let’s assume we have a can opener.

But of course, despite the notorious term of ceteris paribus (a latin term which means all things equal), there are other reasons that need to be considered. Other then AFP, both CNN Money and Reuters state that the high crude oil price helps fuel the trade deficit.

This sounds a good explanation, I guess, because oil does seem to have a low elasticity of demand. A low elasticity of demand translates to the phrase “a huge increase price would not affect demand greatly”. I don’t see people quit driving their car despite seeing the rise in oil price.

This makes me wonder – how high does the oil price need to go until demand for oil actually falls substantially?

p/s – The US registers a budget surplus for April.
pp/s – propaganda against H2 via Seat of the Revolution.
ppp/s – for those of you who are interested in seeing the Nick Berg beheading video, it can be found here and here. Courtesy of Wikipedia. Be warned, it is graphic. I hope justice will get those bastards.