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The Island Economy
10 people are stranded on a deserted island. Totally isolated from civilization, the 10 people develop their own economy. Everybody counts all the money they brought with them, and between them, they find that there's a total of $1000 for everyone on the island (or $100 for each person).
Each person is assigned a job. Some fish. Some pick coconuts. Others built huts. Prices are established for each good and service by island supply and demand forces. The total value of all these goods and services is $1000.
At times, there is a shortage of one thing or another like coconuts. The price of coconuts would increase. But when that happens the price of something else like fish has to drop because if people spend more on coconuts, they have less money with which to purchase other fish. Demand drops on fish and the price of fish has to be lowered. Also, there is only the same total $1000 in circulation. The sum total value of absolutely everything could never be worth more or less than $1000.
But then, one member of the group (a fellow by the name of Central Bank or CB) finds an extra $500 in cash somewhere. CB doesnít tell anybody else about, but slowly begins to add it to the money supply by spending an extra dollar here and an extra dollar there until he has spent $120 out of the $500. Because there are more dollars competing for all goods and services, demand increases and becomes slightly out of balance with supply which causes prices to rise. The "real" inflation rate has risen 12 percent because the sum of the price of everything had gone up 120/1000 or 12 percent.
Soon the other members of the group notice the rising prices and try to find out whoís got the extra money. Failing to do so, they appoint someone in the group to be an economist whose job is to study the inflation. Since it would take too much time and effort to track the price of absolutely everything in the economy (real inflation), one person suggests that he monitors the price of coconuts in order to watch inflation. This works because in the growing island economy, coconuts are an ingredient in virtually every meal as well being a critical component of clothing, housing, fishing, and almost every sector of the island of the economy. Soon, this economist is using coconut prices, which he calls the Coconut Price Index (or CPI for short) as a way of determining when any islander is spending money that wasnít in the official pool of $1000.
With all this taking place, CB decides heís better off not spending any more new money for awhile. One day, however, he finds a box with more money in it--$100,000 to be exact! CB then begins to realize that he can spend the money however he wishes, at least until the Coconut Price Index begins to head higher.
With his new found wealth, CB tries to use his new buying power as surreptitiously as possible. Knowing that the CPI Index is based on coconuts, he keeps his spending channeled towards other products and services. The first thing CB does is to have the hut-builder build him a bigger hut. The hut-builder gets paid $40 for this extra service and spends only $2 on extra coconuts. The rest he spends on fish, savings, and other goods.
The economist, notices a small increase in the price of coconuts and declares a minimum increase in inflation with his CPI number.
The important thing to notice is that this:
With coconuts representing only 10 percent of the original $1000 economy, the $2 increase in demand had only raised coconut prices about 2 percent. Thus, the economist reported CPI inflation of 2%.
But is that a true reflection of the amount of inflation? No. Remember that CB actually spent $40 to build the hut. The real rate of inflation is actually $40/$1120 = 3.57%.
There is a significant difference between the real inflation number of 3.57% and what is reflected in CPI inflation of 2%. It was only after CPI inflation began to pick up steam that CB had to curb his spending again.
The Island Economy (continued)
Watch what happens if we stir things up in the Island Economy. In the real world, we could have a war, or some natural disaster. For our friends on the island, let's give them a surprise monsoon.
Day after day, rain is pouring. The demand for roof building services rises very quickly.
Let's examine two possible scenarios. First, what would happen if CB could not spend any of the extra money he had found. In this case, the price of roof building services would be bid up only with the existing money supply. When the price for roof-building soars, the price of other goods, like berries and fish fall commensurately, and the price of absolutely everything else remains the same. The only way that many islanders can afford more roof-building services is by limiting their diet to fish and coconut juice and forgoing eating berries. The price of berries drops to almost zero. Because people can't afford to eat as much due to their higher spending on roofs, prices of other foods drop as well due to the decreased demand.
Meanwhile, the only way for the berry-picker to make any money is to become a roof-builder. Soon, however, after a week of intensive roof-building, everybody has adequate roofs. Demand on roof building drops and the berry picker returns to berry-picking.
This analogy shows how a free-market economy would adapt to crisis. There is no distortion of money supply. The island allocates its time-labor-capital-resources in way that allows an easy return to the norm after the crisis is over.
Now suppose however, that CB DOES HAVE ACCESS TO HIS NEW MONEY.
With the new money getting introduced into the economy, CB bids the price of roofing-services to double what it would be without the new money. The berry-picker and the fisherman see dollar signs and the decide to quit their normal occupations and borrow money from CB in order to build their own roof-building factories. The ventures look promising due to the high profits, but unfortunately, they're unaware that much of the incredibly high demand for roofing services resulted from the artificial temporary increase in money supply caused by CB. They do not realize that CB will stop spending at such a high rate once his own roof is built.
The new roof-building factory comes on-line, but with disastrous results. Once everybody is happy with their new roofs, demand drops, and the price of roofing services plummets. The two new factories built by the berry-picker and the fishermen start going down hill. They borrow more money to stay in business. But eventually, they go bankrupt and lay off all their employees. The island is now poorer for the time and capital misallocated to building the factories and for the loans on the factories which defaulted.
Here's what you should take notice of:
A boom-bust economy developed here out of the artificial stimulus of money creation. The islanders were unable to differentiate between real relative demand increase and artificial and temporary new money created demand. Once the pace of new money creation (or spending in this case) slowed, prices shifted, and the allocation of resources became unstable and had to be corrected.
New money creation creates a temporary and artificial source of demand in an economy. As the economy re-allocates and adjusts its resources of capital, labor, and time to the prices created by temporary increases in money supply, it is misallocating resources, and once the temporary pace of money supply creation slows down the misallocation becomes clear and must be adjusted. This creates a boom-bust cycle.
