Before I start explaining this entire story let me make some basic “assumptions” to clearly explain this question.
1. GDP is the exact tool to measure growth without any considerations or exceptions.
2. No Veblen goods (Diamonds, Gold and other luxurious products) exist in economy for “purchase purpose” to purchase in this particular scenario.
3. 100% Employment for all the citizens or at least (purchasing capacity).
4. Money is the only means of trade without any coupons or barter systems.
Now let’s consider, there are only two products available in the country a.)Rice and b.) Vegetables, also only 2 families (Chiranjeevi and Balakrishna) exist. Their monthly income is Rs.400 and Rs.200 respectively. With which one family purchases 10 Kgs of rice at 300 Rs and 10 Kgs of Vegetables at 100 Rs and the other family purchases 5 Kgs of rice at 150 Rs and 5 Kgs of vegetables for 50 Rs. One fine day “Chiranjeevi” decides to increase his income by printing currency and gives “Balakrishna” a small share of his money. Now Chiranjeevi’s income is 1000Rs where Balakrishna’s income is 600Rs. Since the purchasing capacity has increased the GDP(Total income of country) increases from 600 RS to 1600 Rs and the standard of living rises creating a hike in prices of goods since the quantity is same as previous but the demand is more.
Applying the basic law of demand and supply we can see that the demand for both these goods has increased but there is surplus wealth for both of them. This causes rise in price of the goods in the country (inflation) and hence “Chiranjeevi” cannot print money according to his will. But, he can print money only when there are enough goods and services available in the country through which he can exchange his income.
Ex: If the rice and vegetables are also produced in abundance then they can buy more goods with the excess wealth they have.
What If the money is cut down in half?
Now imagine Chiranjeevi’s income is reduced to 200 Rs and Balakrishna’s is 100 rs. The quantity of rice and vegetables are same. Since they can now only afford 5Kgs of rice 2 ½ kgs of vegetables and 2 ½ Kgs of rice and 1.25 Kgs of vegetables the prices of the goods fall down causing deflation where supply or availability is more but demand is less.
Now apply the same concept to the entire country. If the RBI prints Millions of rupees and increases everyone’s wealth, the cost of all goods in the country would double or triple. Imagine if everybody has more money suddenly, the demand of every goods and service would also increase. Now everybody becomes rich and wants to own a Mercedes, fly in a business class planes. This would lead to an increase in the price of all the goods and services in the country (inflation). Therefore to become rich, the country (its people) has to increase its production. That’s the reason why countries are crazy about GDP (a measure of production).
Hence we can derive two basic points here:
1.) The printing of money can be done only when there are enough resources to support its value.
2.) If the value of the currency has to be increased then the supply and services of goods also to be increased to support its exchange value, else we can see any one of the above scenes.
Article sourced from a question thread on Quora.
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