Inflation Of Money Supply Responsible For Speculative Bubbles

Inflation of money supply is responsible for speculative bubbles. Consider this scenario.

A farmer owns a piece of land, working hard day by day, and he has money (say $50,000), deposited in the bank. Assuming the bank’s reserves requirement stands at 10%, it implies $500,000 of capital can be issued, of which most of it is loaned out to earn interest.

Next, we have a situation where an investor decides that the farmer’s land is in a prime location and he has big plans to develop it. He takes out a $300,000 loan to buy the farmer’s land and the farmer agrees, seeing that this represents twice its original value. The transaction takes place and the farmer is seemingly richer by $300,000.

Ownership of the land is transferred from the farmer to the investor, or rather the bank, since it is held in collateral and liable to be confiscated in the event of defaults, and the whole transaction is made possible by the farmer’s original deposit.

This is money created out of thin air and it is paper money or just a meaningless electronic figure. To balance the increase in money supply, there are only two alternatives. Either the economy has to create tremendous amounts of products and services to justify the sudden wealth or even more money has to be printed to maintain the same growth. Everything around the farmer starts to get more expensive, his wealth is eaten slowly away under the effects of inflation.

There are a lot of ills in our global monetary system and the use of a fiat currency which are now coming back to haunt us. Warren Buffett has said that it will take a long time for the economy to deleverage, you better believe him.

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Filed under Banking, Currency, Economy, Inflation

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