Sunday, September 9, 2012

Why are we still struggling despite our Government's claim of improving Income

Ever wondered why we are still struggling even though our incomes have increased for the last few years? Our government’s propaganda machinery also had us believed that our lives had improved due to the increase in disposable income and hence everything is in good hands. By doing so, it will ensure that they will be re-elected in the next election. But why are we still hard pressed to meet ends need despite improving economic fundamentals such as higher economic growth rates, lower inflation, increasing GDP per capita, booming housing sector, improving external sector and so on. 

The following is Malaysia's GDP/capita chart from 2007-2011. It showed the GDP had been rising from $6905 in 2007 to $9656 in 2011 despite a slowdown to $6902 in 2009 due to the Global Financial Crisis.



Source : World bank

Everything seems to be falling into places and our standard of living should next be elevated to a new sustainable level. Why is this not happening?

What are the causes?

In his daily life, an individual is faced with problems in compromising his choices between his ‘needs and wants’. There are certain basic needs that you have to satisfy in order to survive such as food, lodging, transport and etc.
Due to your limited resources (income), you had to carefully allocate it so as to maximize your final objective within your budget. Unfortunately, however well you plan and budget your income, you soon realized that an increase in income actually causes more difficulty for you in meeting your budgets. In other words you may look better off outwardly but in actuality you are struggling to meet your monthly bills. Why is this so? The main reason is due to inflation.

Who is responsible for Inflation?

Who is responsible for all the inflation in the economy? The answer is the Government and how can it manage to do that? There are three ways the Government can inflate the economy.

  1. By printing more money or Quantitative Easing as it is known without any backing of real money like gold. It is merely turning on the Printing Press and print or in other words COUNTERFEITING.  To illustrate how would an increased in the money supply causes inflation, we shall use the following example hypothetical economy.


Total Money supply is $100
There are only 2 products in the economy - a chicken and a duck.
Each of them are priced at $50 each

What will happen when the Money Supply is doubled to $200? Although the Money Supply is doubled but the supply of goods remains the same – one chicken and one duck. Since there are more money to spend the people will eventually bid up the prices for the chicken and duck in order to obtain what they want. In the end the price will have to go up until an equilibrium is reached between rise in price and the Money Supply.

  1. The second method is through the Banks. Since the banking sector operates on the basis of Fractional Reserve Banking and by increasing the amount of funds the bank can lend out, it greatly help increase the Money Supply in the economy. Banks are required to reserve a certain percentage (normally 3-10%) of their deposits in order to remain solvent, maintain investor confidence and also act as an insurance against a ‘bank run’. This reserve is known as the Statutory Reserve Ratio (SRR) and Central Banks can either increase or reduce this percentage so as to manage the Money Supply in the economy. An increase in the ratio means Central Banks are moping up excess liquidity and is aiming for a ‘tight money’ regime  in the economy and vice versa.

Say for example the bank receive a $100 deposit, it can lend out $90 after deducting $10 for the SRR. Then when the borrower of the $90 writes a cheque to somebody who will later deposit it back into the bank. When the bank receives the $90, it can then lend out 90% of it which is $81 and this process will go on until finally it will reach $1000 or ($100+$90+$81+….. = $1000). By the time it reaches $1000, the bank had already made more than 40 different loans from the original $100. So the leverage in this case is 1 to 10 ($100 to $1000) and can be best shown in the table below.

NumberAmountLess 10%
1
100
90
2
90
81
3
81
72.9
4
72.9
65.61
5
65.61
59.04
6
59.04
53.14
7
53.14
47.83
8
47.83
43.04
9
43.04
38.74
10
38.74
34.87



What will happen if the SRR is reduced to 5%? Again the bank when receive $100 will lend out $95 and the $95 will again make its way back to the bank and the process will go on until it reach $2000. The process can be shown in the table below.



NumberAmountless 5%
1
100
95
2
80
90.25
3
64
85.73
4
51.2
81.45
5
40.96
77.37
6
32.76
73.5
7
26.21
69.82
8
20.97
66.33
9
16.77
63
10
13.42
59.86

By the time it reaches $2000, the bank had already made more than 100 different loans from the original $100. So the leverage in this case is 1 to 20 ($100 to $2000). So in conclusion, by reducing the SRR from 10% to 5%, central banks will be able to increase the Money Supply in the economy by 100%.

  1. The third method is through the government’s Open Market Operations of securities such as bonds. When the government made a purchase of bonds or also known as ‘open market purchase’ it will increase the money supply in the economy. How it works?  When the Government purchases a $100 bond from a bank then it will need to issue a cheque for the purchase. The bank in return will either have to deposit it into its account with the Central Bank or cash in for currency which will be stored in its vault.  The end result is the Central Bank will end up with $100 more in bonds and less $100 in reserve while the bank will end up with an extra $100 in reserves and less $100 in bonds. Hence there will be an increase of $100 in the Money Supply.

An ‘open market sale’ of bonds will have a reverse effect and it will cause a contraction of $100 in the Money Supply. Such operation of buying and selling of securities by the Central Bank is similar to the job of a floodgate controller in a dam. By releasing or closing the gates, it can then manage the level of water in the dam.   


Coming back to our main point on why we are worse off despite our increased disposable income throughout the years. We present to you another hypothetical case study. Our case study is based on the following assumptions.

  1. An individual with an income of $1000
  2. No other source of income
  3. He has a basic set of needs and wants


The following table describes his basic needs and wants.

Table 1 - His Monthly Budget on Basic Needs



No.Description       ($)
1
Food
150
2
Housing
200
3
Clothing
80
4
Education
100
5
Transportation
130
6
Medical
70
7
Entertainment
90
8
Insurance
100
9
Savings
80
TOTAL $
1000



Table 2 - His other wants (Gratification)



No.Description       ($)
1
Super Bike
150
2
Swimming Pool
100
3
A new MPV
120
4
A bigger House
180
5
A dream holiday
100



As can be seen from the above table, there are certain basic needs that must be satisfied in order to continue living. He family need food to survive, clothing, education for children, transport to work, a house to live in and etc. After deducting these basic needs he is left with $80 for savings for the future.

You notice that apart from the needs he also has a list of wants which include a super bike, swimming pool, a new MPV and etc. Due to the budget constraint of being left with only $80 after all the expenses he cannot afford to have any of the other things that he wants. One way is to sacrifice some of the basic necessities in order to get one of the things that he love to have but he is unwilling.

What happen if he had a pay rise?

Then it will be a different story. Due to the Government’s pump priming and its inflationary effect on the economy, it causes an ‘appearance of a boom in the economy’. Bosses thinks that the economy is reaching a new plateau and orders are coming in, he decided to hire more workers and also giving a pay rise to existing workers. Say he got a pay rise of $100 from his boss. Assuming that this individual neglects the effects on inflation and he is overjoyed by the pay rise and soon went to purchase a Pool with a monthly commitment of $100. In other words he is back to square one and only able to save $80 a month.

What he failed to foresee is the effects of inflation through an increased in the paper money supply brought about by the government that is about to begin. He will realize that after a few months it will cost him more than the increase of $100 per month to maintain his present lifestyle. In other words his pay rise had been completely absorbed by inflation. He had to pay more for his basic needs than what he is paying now.

As a result of inflation, his cost of living had indeed gone up. The table below shows his new cost of living as a result of inflation.

Table 3 – Inflation adjusted Cost totaled $1100



No.Description       ($)
1
Food
165
2
Housing
220
3
Clothing
90
4
Education
120
5
Transportation
150
6
Medical
100
7
Entertainment
100
8
Insurance
120
9
Savings
35



Reduced standard of living

The above table shows that he may just made it through his monthly budget with a savings of $35 a month. However there is a little problem because he had earlier bought a Pool with a monthly installment of $100. How is he going to pay for this? There are two ways for him to get around this problem.

  1. Take out any of the items listed from 1 – 8 in the above table.
  2. Reduce the expenditure on the items above

Needless to say he will opt for choice number two where he will reduce the expenses in some of the items. After some consideration he decided to change his lifestyle to the following.

Table 4 – Adjusted lifestyle with pool



No.DescriptionOld  ($)New ($)
1
Food
165
150
2
Housing
220
220
3
Clothing
90
80
4
Education
120
120
5
Transportation
150
150
6
Medical
100
90
7
Entertainment
100
80
8
Insurance
120
100
9
Swimming Pool
100
10
Savings
35
10
TOTAL $
1100
1100



When he is faced with limited resources he had to make a choice on which of his basic needs that had to be trimmed down in order to absorb the expenses of the pool. For as long as he had to pay for the monthly installment of the pool he had to scale down his spending on some of the things he had taken for granted. From the above table after his revised budget, his monthly expenses on food, clothing, medical expenses, entertainment and also his monthly savings have been reduced.

Deceived into thinking of better off

What can be conclude from the above is that although the amount of things he is entitled is more than before (10 items inclusion of the pool) but the monetary distribution of his spending had been altered due to the effects of inflation. Had he know the effects on inflation before hand then he would not have bought the swimming pool. He had a choice of getting rid of the pool so as to maintain his former lifestyle but he didn’t. Now his life is less enjoyable because of the reduce budget on the few things that he earlier enjoyed. He thinks that he is better off because he was deceived into thinking he now have more things in life. In actuality has his life improved due to inflation?  

 

  

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