Saturday, November 17, 2007

Is there too much money in the economy??

The Government announced a whooping increase of K3 billion to the National Budget to around K8.4 billion. This is a record breaking budget ever since impendence and it brings a smile to all ministers and members of the Parliament.

Each district has been allocated K10 million which was raised from K1.5 million to K3 million earlier this month. The K10 million for each district seems too good to be true and each district now is preparing to use this money as the next year budget will also be K10 million if the current government stays on.

While PNG is smiling, I am screwing my face behind this computer as my economic senses are being put to test here. I welcome the budget so much…..yet somehow I feel there may be a problem that could be creeping in if our financial planners are not careful.

The problem I see is “Demand Pull Inflation”. Now let me try as much as possible to explain it in a layman’s term. Demand Pull Inflation refers to increase in Inflation due to an increase in demand in the economy. Because there is a lot of money pumped into the economy to be used in a short period of time, there will be a shortage of goods or services to meet the demand. Now because too much money is chasing so few goods, the price of that good will increase.

According to keynesian theory, the more firms will employ people, the more people are employed, and the higher aggregate demand will become. This greater demand will make firms employ more people in order to output more. Due to capacity constraints, this increase in output will eventually become so small that the price of the good will rise

Example: A bag of rice cost K3 at a local village store. Suddenly, 10 villagers who earns money front up to the shop to buy the rice for K3, but since there are only 5 packets of rice available, not all 10 will buy it. And since the shop owner wants to maximize his profit, he will raise the price to K5 to meet the demand.

This is commonly described as "too much money chasing too few goods". More accurately, it should be described as involving "too much money spent chasing too few goods", since only money that is spent on goods and services can cause inflation. This would not be expected to persist over time due to increases in supply, unless the economy is already at a full employment level.


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