Are environmentally friendly projects likely to increase the market price?

The US government seems to retreat from its previous environmentally friendly projects, some rumours suggest that the US government may put tariffs on solar related imports. When the US government increases the costs for the solar industry and other environmentally friendly industries, thus increasing the prices for these environmentally friendly products, the prices for environmentally friendly energy industries' substitutes, fossil fuels, are likely to increase as well.

Usually, when there is an increase in the oil price, there is an inflationary pressure in the world economy, as an increase in the oil price implies an increase in production as crude oil is the main resources for energy as well as the main raw materials for many other products. However, the increase of tariffs does not imply there is an increase in the world outputs, as it increases the costs of production and supply and lowers the market supply. Therefore, it is possible to have an increase in the market price due to the reduction in the supply side rather than the increase in the demand side, which I usually see as an unhealthy inflation. Increasing spending on environmentally friendly projects is very likely to lower the price levels as it can lower the oil price in the short term.

In the long term, as there is a natural cap for natural resources, the supply of natural resources will eventually diminish in the long term, so the prices for natural resources will eventually rise in the long term. Environmentally friendly projects can lower the price levels in the long term.

Overall, I think environmentally friendly projects will lower the price levels in the short term as well as the long term.

Splitting the market

Nowadays, there is no economy that can be solely satisfied by domestic production and supply, and the imports are necessary. I discussed previously that the domestic supply side is the first to enter the market to fill the demand in the market then the foreign supply would enter the market to fully satisfy the total domestic demand. This point is based on several assumptions.

The first assumption is that domestic goods and services are more competitive in terms of their price levels. This assumption is very important because only when the domestic goods and services have price advantages, they can be the first to gain the market share for certain. This assumption is very realistic, as even in other countries production costs could be lower than the domestic production costs, governments can use tariffs to add more costs on their imports, thus making the costs for imports higher than the costs of domestic goods. The second assumption is that the market prices are set above their production cost levels.  This assumption implies another two assumptions that the market is not perfectly competitive and there is an excess of demand; otherwise, tariffs can fully prevent foreign firms from entering the domestic market, and prices are equal to their costs of production. Such assumption is more realistic than the perfectly competitive market assumption. In most cases, markets are not perfectly competitive, especially nowadays more and more markets have become price discriminated markets. The third assumption is that there is no dumping. This assumption ensures that prices are set above cost levels. This is realistic as many countries have anti-dumping regulations to forbid dumping.

Therefore, my previous assumption of how domestic firms and foreign firms split the market is very likely to be true.

How would the change in the labour market change the market?

Yesterday I discussed the quality of labours in the labour market improved comparing with the previous, today I want to discuss how the quality of labours can reshape the market as well as the economy.

More educated labours are more likely to be more productive than those with lower education qualifications; however, it is possible for some labours to be overeducated. The possibility of overeducation implies a waste of private spending as well as public spending. Moreover, it could also lead to a reduction in the supply of the labour market, as people spend more time at schools, and the overall number of employable workers reduces. In addition, due to sheepskin effect, more people want higher levels of education qualification to differentiate themselves from the rest of the population, the supply in the labour market can be decreasing over time. When there is a reduction in the supply of labours, the wage level in the economy is very likely to increase. When the wage level increases in general, the price level in the economy is also likely to increase.

Moreover, the demand in the market may not change though there is an increase in the wage level because the number of employable people reduces in the economy. Meanwhile, the outputs of the economy may also stay the same, as though the productivity of labours is improved by the increased supply of education, the overall number decreases. The demand and the supply both remain the same, so the price level also remains the same.

Overall, the increase in education supply is likely to improve the productivity of labours and reduce the overall labour supply, so the price level in the economy is likely to be unaffected as the supply and demand do not change significantly.

The differences in labour market over time

I discussed why I believed labours with broader knowledge would be more preferred with labours with narrow but specialised skills. My belief is that in the future the demand side will prefer specialisation in order to meet different customers' different preferences and demands but the supply side will prefer generalisation in order to hire labours with broader skills to reduce their costs of using labours when it is cheaper and cheaper to use machinery to replace labours in some basic positions.

Many differences have been made since Adam Smith wrote his famous book, "The Wealth of Nations". Firstly, as I mentioned previously, the labours nowadays are better educated than the labours during Adam Smith's period. People have longer education periods and more knowledge has become available to the general public. Such education environment is much better than the past. Secondly, the costs of receiving the education have been partially passed to individuals rather than employers. In the past, high levels of education were the privilege of the elite classes, employers had to pay the costs of training their employees. Nowadays, employees receive a large part of their training at schools by spending their private costs. Thirdly, though employers still need to train their employees to fit into specific positions, the overall time taken becomes less. Fourthly, the use of machine only requires fixed costs and is playing a larger and larger part in the production and the use labour forces require continuous spending on hiring labour. In some fields, the increase in using machinery can reduce the costs of production, so the employers are more interested in hiring expensive and elite workers which cannot be replaced by machines.

Overall, the quality and characteristics of labours have been changing over the last several centuries due to increase in the population education.

Specialisation in the future

The importance of specialisation was first recognised in Adam Smith's "The Wealth of Nations". In "The Wealth of Nations", Smith explained how specialisation could improve productivity and encourage innovation and increase the overall outputs of the economy or the nation. Nowadays when we re-consider his explanation, some differences are actually happening.

Firstly, specialisation may encourage innovation to some degree; however, in general, specialisation dis-encourage innovation and prevent innovation from taking place. Very deep specialisation does not require workers to have very deep knowledge about their work, they are only asked to repeat some very basic work every day and they may not need to know why they are asked to follow the required process. Under such situation, many of these workers may start to lose some of their knowledge and skills because of their lack of practice. From this point of view, specialisation does not require workers to have rich knowledge and workers with poor knowledge are not likely to create innovation or invention, especially when the technology is developing rapidly nowadays. Secondly, specialisation could lower the costs of production, as companies no longer need to hire expensive skilful and experienced workers. However, when the machinery can be used to replace human workers' positions, the workers hired by companies are required to have knowledge skills that cannot be done by pure machines. These skills are usually complicated and require knowledge from many different fields. Therefore, due to the development of technology and machinery, workers with general knowledge are more preferred than those with a single specialised skill. Moreover, when workers are more productive than previous as they are receiving the better education and people are expected to increase their education time continuously, hiring workers with multiple skills can increase the productivity as they can handle multiple positions and works. Thirdly, over-specialisation could lead to an increase in the complexity of the market. When a market is over-specialised, companies have to access to multiple layers to conduct their productions and have less control of their production when there are too many layers.

Therefore, I believe that workers with multiple skills and rich knowledge of different fields are and will be more preferred than workers with a single specialised skill.

Long term price level change

Yesterday I suggested that some types of rarity could be eased over time, so in the long term, the price levels would face deflationary pressure. However, in the long term, we often see that the price levels are increasing in our real world. During the recent two centuries, the price levels have been skyrocketing; however, during our history, the price levels had not changed significantly for centuries till the industrial revolution according to results found by some studies. 

Here we find a strange phenomenon that the increase in the supply and production and the increase in the overall price levels take place at the same time. The most important reason here is that the sharp increase in the supply and production leads to an increase in the entire world population as more production allows more people to have sufficient goods and services to support their lives. Moreover, when new products are invented, new demands of the population are recognised. Therefore, the increase in the population and the recognization of new demands are the two major drives to increase the price levels.

The population increase rate has been in decline, which means the inflationary pressure coming from the population increase is in its decline as well. However, there are many discoveries and inventions of new demands in the markets. This is creating an increasing proportion of the inflationary pressure in our world economy. However, such drive of inflationary pressure is not stable and usually driven by some historically important innovation or invention. The current boost in the market is still driven by the invention of the Internet, that smartphones, Fintech and many other fields are tightly bonded with the Internet.

Overall, I expect that in the near future, the inflation rate is highly likely to be low till the next influential innovation in our society.

Rarity in the market

Many experts and economists have pointed out that the market price levels are determined by the rarity in the markets. When resources are relatively rarer, their prices are higher. There are many types of rarity according to its causes.

Firstly, some rarity is caused by its natural limitation. For example, the rarity of natural resources are pre-determined by nature, our human beings can do little to improve such situation. Secondly, some rarity is caused by the limitation by the labour force. In some industries, human talent is playing a very important and determinant role in terms of outcomes; therefore, their prices could be high when the resources for extremely skilful labours are limited. However, such rarity may not last very long, as technology can replace humans to provide even more accurate and precise production. Thirdly, rarity can be caused by the market demand. In some market, rarity could be made by the supply side, especially in the luxury product industries. Such rarity can be varied over time as tastes in the markets vary over time. In some markets, rarity is caused by a sharp increase in the demand in the market. A sharp increase in the demand is caused by varies reasons, such as a sharp increase in the population income, or a potential crisis which leads to a sharp increase in the demand. Such rarity is usually temporary, in the long term, such rarity can be eased.

Since having understanding of some causes for rarity in the market, we can see that apart from rarity caused by nature, most causes of rarity are not permanent. This means over time, some of the rarity can moderate itself over time, from this point of view, the price levels in the markets are likely to decline over time when the rarity is being eased over time.

Price level and labour market

Price level and labour market have a very tight correlation. The labour market can determine the cost of production as well as the potential consumption power of the population. When the demand for labour force increases, the wage level is likely to increase, so the cost of production increases; on the other hand, when the wage level increases, the consumers are going to have greater budgets to afford more consumption, when the consumption level increases, the price level in the market is going to increase as well. Therefore, the wage level in the labour market and the price level in the markets are moving towards the same direction. Moreover, when the wage level and the price level both increase, it usually takes place during an economic boom period. This may be a partial reason for why there is an inflation during an economic boom.

However, the difference between the wage level and the income level changes is determined by the productivity in the labour market. When the productivity increases, the extent of the change in the price level is likely to be smaller than the extent of the change in the wage level. When the labours are more productivity, their outputs will increase, so their wage increases are reasonable. In addition, when the outputs increase and the marginal costs of many goods and services are diminishing, the costs of production will maintain at their previous levels or even decrease, as the average spending on labour forces decreases when the scale of production increases.

Globalisation and the price level

Globalisation can definitely reshape prices in markets that globalisation can re-determine the supply and demand in markets across the world. Globalisation emerges many markets across countries into several world markets then the overall demand and supply may not change significantly, but the individual demands and supplies in separated countries do change and tend to narrow the price differences across regions and countries. Under such circumstance, the price levels in the developing world increase as the previous prices were lower than the average world price levels, the price levels in the developed world decreased as the previous prices were higher than the average world price levels.

However, globalisation may have impacts on the world overall price levels. Globalisation can help to enlarge the production scale, leading to a possible improvement of productivity. The costs of production reduce under globalisation so the supply curve can shift upwards, the prices can drop. On the other hands, globalisation can increase the overall demand. New products are introduced to new markets and the people can find out their new demands when they see new products in their markets. When both the supply and the demand increase, the price change is determined by the extends of changes in supply and demand. However, as I expect the supply increases more significantly than the demand changes, therefore a decrease in the price level appears under globalisation and we can see that our world economy experienced a period of low inflation and high economic growth from late last century to early this century.

Such price level change is near its end, as the further price level change will be led by the change in trade barriers across countries that when the barriers are high, the prices will increase and when the barriers are disappearing, the prices will drop.

Will the ageing population influence the price level in the economy?

The increase rate of the world population is in decline and the world economy is facing the issue of an ageing population. When there is an ageing population, there will be more retired people than work forces in the population.

When we assume there is no productivity improvement in the economy, it becomes a big problem that the outputs will decrease when there is an ageing population. Therefore, improving productivity is the most prior thing to deal with the ageing population. I do not think this is a very difficult task, as the speed of replacing some positions by machinery is constrained to the employment rate. When the ageing population appears, the overall working force in the population will decrease, there are fewer people that need to be offered jobs to lower the unemployment rate, so the speed of replacing positions by machinery can accelerate. Therefore, I think the production level in the future will not decrease.

Moreover, we also need to concern the difference between consumption powers of the working forces and the retired population. The permanent income hypothesis suggests that people will spend their money at a level which is equal to their expected long-term average income. If the hypothesis is true, the ageing population will have no impacts on the population's consumer powers, as people have stable consumer power over their lifetime. However, some assumptions in the permanent income hypothesis are not realistic, therefore, the permanent income hypothesis may not be true in the real world. People do not have an accurate estimation about their future incomes and they are more likely to overestimate their future incomes; under such circumstance, their consumptions will decrease when they realise their incomes are below their previous estimated levels. When this happens, the ageing population could cause a decline in the average consumption among the population.

Overall, when the supply level maintains or even increases and the demand/consumption level decreases, the price level under an ageing population economy will decrease.

Why can the demand side and the supply side be treated differently by the financial market?

Yesterday I said that the demand side and the supply side could be treated differently by the financial market, today I want to talk about why the demand side and the supply side can be treated differently by the financial market.

The basic reason is the supply side and the demand side have different levels of risk. The majority of the demand side borrowers are individuals and their main purpose for borrow is to buy some consumer goods and services, which do not produce further incomes in the future. Moreover, most of these goods and services have depreciating value trends. In addition, individuals do not produce secure income increases and the value creation ability of individuals is not as strong as the ability of many companies. On the other hand, although some companies may not have sufficient cash to pay back their loans, they have many assets that can provide more security for their creditors. In addition, the amounts of the loans taken by companies are much greater than the amounts of the loans taken by individuals. Making several small loans is not as preferred as making a big loan to banks, as making several small loans need more work and has higher costs.

Overall, as lending to companies is less risky and more cost efficient, the banks and financial institutions are more willing to lend to companies rather than individuals. Therefore, the supply side is easier to borrow loans. When the supply side has access to more financial support, they can expand their supply, this can potentially increase the market supply and lower the price level. However, sometimes, as companies avoid to enter price competitions, the market supply can change to a relatively insignificant degree.

What are the possible actions of the financial market that influence the market price level?

Yesterday I argued that the existence of the financial market does not influence the market price level; today I want to talk about if it is possible for the financial market to take certain actions to influence the market price level.

Firstly, the financial market could have different attitudes towards the demand side and the supply side; when the two sides are treated differently, their gains from the financial market will be different and their changes do not move in parallel, so the market price level will change.

Secondly, the financial market could send signals to the market that influence the market price level. The financial market also provides credit ratings and checking, and even economic forecast services, based on the services, the market price can amend according to these forecasts and estimates.

Thirdly, the financial market has its own interests, as it is operating to maximise its own profits. The financial market will try to absorb some profits from the ordinary market to pay for its contribution for the economy.

Fourthly, all individuals are taking actions to maximise their own profits. Therefore, it is possible to exist conflicts of interests in the financial market. When there is a conflict of interests, the market may behave problematically and some price changes can occur.

Overall, the existence of the financial market does not directly influence the market price level; however, as the financial market is part of the economy and some of its activities can influence the overall price level.

Does the existance of the financial market have impacts on the price levels?

The existence of the financial market helps our to borrow from the future to pay for more goods and services at the current time, or save for now and spend more in the future. Therefore, it can shift our budget constraints outwards. When we have larger budget constraints, we are able to spend more at some point of our time.

From a basic financial market, there are only two time periods, when we expand our timeline to infinite, at each time point, more outputs will be generated at each time period. In addition, an infinite leverage is theoretically possible if some party in the financial market is willing to take an infinite risk. Therefore, when the financial market is willing to take more risks, the supply side in the ordinary market can use the financial market leverage their capitals to a greater degree and indirectly increase their other production factors.

When the supply side is able to gain more production factors, they can help to supply more to the market. Under such circumstance, when the supply shifts upward, the price level tends to decrease. Therefore, when the financial market is willing to take more risks, the price levels are likely to drop.

However, the demand side also has access to the financial market. They can boost their demand. So when both the supply side and the demand side increase, the price levels will not change. However, the supply and the demand do not necessarily move in parallel; therefore, the market can experience some degree of price change. When the demand increases more than the supply, the price levels will increase, and vice versa.

Overall, the existence of the financial market does not have significant impacts on the price levels in the ordinary markets.

Invention and innovation may contribute to inflation

Nowadays the increase rate in the world population tends to decrease. When the productivity increases forever, it is possible that there is an excess of supply, as almost all products have diminishing marginal utilities and people only tend consume below certain levels. When there is an excess of supply, the average price level will decrease. However, I do not see this will eventually happen to our world because of the invention and innovation and I think invention and innovation will contribute to supporting the current price levels and even increasing the price levels partially.

We, consumers, only know our preferences about the existing products; however, we do not know the utilities and preferences about the non-existing products. And innovation and invention can create products which have not existed in the market yet. Some of these products may become substitutes for the existing products; however, it is possible that some form entirely new products can be invented. Once an entirely new product is invented, it can create an upward shift of the demand in the whole economy and some productive factors will be redistributed to this new sector and the supply in other sectors will remain at their previous levels without being increased by the improved productivity.

When the supply in other sectors remain at their previous levels, as the supply and the demand do not change, the price level will not change. On the other, when a new market appears in the economy, the supply side usually has the market power in the beginning; therefore, the price level in this sector tends to be higher than if the market becomes more mature.

Therefore, I think innovation and invention can prevent the price level from dropping due to improved productivity and open new markets in the economy which have relatively high price levels.

Fashion and taste competition may help to reduce prices

Consumers do not have perfect information of companies’ costs of production, they compare the prices of the products they prefer with their historical prices and their substitutes’ prices to judge if the prices are “reasonable”. Moreover, a product has different utilities to different people, as people have different preferences and individual characteristics. However, people can influence each other and under others’ influence, people’s beliefs of products’ utilities can change from time to time.

Some products have certain virtual utilities, for example, some paintings are believed to be suitable for collection. Fashion or taste builds many products’ utilities. And taste and fashion can be spread across people, and the prices for taste and fashion can vary according to people's demands. However, once in a sector, there is only one mainstream taste, the price for this taste can be extremely high, as the taste becomes a monopoly in the market. 

If we can have many different tastes in a sector, the prices for these tastes can be different, as the tastes can be differentiated as well, just like products. Tastes can be differentiated according to different social classes or age groups. The groups with relatively low consumption power will receive cheaper tastes.

Therefore, although introducing more taste and fashion does not directly reduce the prices, they can help to increase the introduction of cheaper brands of products.

consumer surplus

I talked about how differentiation can lift the market average price level up as more of consumer surplus will be replaced to be supplier surplus. This implies one phenomenon that once a company is able to access more information about its clients, more consumer surplus will be taken by the supply side. Under such circumstance, the demand side will not have any complaints about this phenomenon, as all the consumers are willing to pay the prices for their preferred products. Such process of occupying the consumer surplus will continue as products will be more differentiated and specialised.

Is there any factor that can improve the consumer surplus nowadays? There are actually several factors; however, to be honest, these factors are generally weak. Firstly, the better communication can help consumers to form some form of union to gain some market power to fight against the supply side. Secondly, consumers now have better information, so they are less likely to be exploited by the supply side. Thirdly, better communication between the supply side and the demand side may change the relationship between the supply side and the demand side. Some small companies can gain consumers by establishing a good relationship with their clients. The consumers can gain more gains beyond the utility of the product but also other things, for example, better services and friendship with the company. Fourthly, location does not matter so much, nowadays people can shop from almost all around the world; therefore, they are possible to get cheaper prices from overseas.

Overall, these factors may help consumers to regain some of their surpluses but they are relatively weak and the price will continue to rise due to the market differentiation.

Price taker or price maker?

The first economic concept I learnt is the price is determined by the market supply and demand and both the supply side and the demand side are price takers when the market is perfectly competitive. However, I always wonder how realistic the term “price taker” exists in the real world.

Many people who do not learn any economics commonly think that the supply side including companies and producers is setting the prices for their customers, and most customers are price takers. This is not surprising, in every Apple’s product announcement event, we can see the Apple CEO announces the prices the company sets for their new iPhones and other new products. In supermarkets, we see the price labels and feel we do not have the power to influence the prices. Therefore, it is not surprising our customers at most time feel they are price takers and feel the supply side sets the prices for them.

I do agree with them that I also feel that companies are commonly price makers and customers are price takers. This is because I think nowadays many markets are not perfectly competitive and companies are able to differentiate their products from their competitors and gain enough market powers to set prices. Of course, companies do not have the full power to set prices, as they still need to concern the maximum prices their customers are willing to pay.

I think nowadays, companies intend to split all the potential customers in one market into different categories in terms of different price levels they are willing to accept. Under such circumstance, the output in the market is the same as the output in a perfectly competitive market; however, all the consumer surplus will be transferred to the supply surplus under a perfect differentiation circumstance.  Such phenomenon can increase the costs of their customers and increase the price levels on average.

Therefore, when the market is more specialised and differentiated, the average price level will increases.

International supply in an economy

Yesterday I talked about how the domestic inflation rate is determined by the international production and supply. Today I want to discuss further the international supply in an individual economy. In a normal perfectly competitive market, the supply curve is usually modelled as an upward sloping curve, as when the price increases, the supply will increase. When it comes to the supply in an economy from the entire world, this supply law is also correct. Once in one country, the price level increases, more goods and services will be imported into this country, as companies can make more revenues and profits.

However, the slope of the supply curve also matters. When the slope is relatively flatter, it implies the price change in one economy can be more moderate; if the slope is relatively sharp and steep, the price change in the economy is more violent. The international total production is distributed based on wealth distribution that wealthier countries get more proportions of the production and poorer countries get smaller proportions of the production. Once the production and supply are determined by the outputs of the economy, the supply curve is definitely not a straight upward sloping line. Moreover, to the imports from overseas, the prices are usually pre-determined, as the imports generally have extra costs including transport costs, tariffs, that make them have higher costs of supply. Therefore, the price is pre-determined, and the imports will see the pre-determined price and choose their levels of supply. Under such circumstance, the supply from other parts of the world chooses its supply level while seeing the demand in the economy.

Overall, I think the total supply from the whole in an economy is close to a flat line, that the imports from the other parts world will enter the market after the domestic supply and the level will be equal to the shortage of the domestic demand, and as long as the price is above the cost of supply, the imports will be willing to occupy the gap between the domestic supply and the domestic demand.

Inflation and CPI

Inflation is commonly measured by CPI that measures the price changes of certain goods and services over time. However, to many of the members of the population consumes a lot more goods and services than those contained in the CPI calculation basket. Therefore, it does not necessarily reflect the changes in the price levels in our economies. Moreover, especially in some large countries, prices can vary in different areas due to the geographic distribution differences. In many economic activities including government policies, financial market activities, the inflation rate has been one of the most important factors to be considered; therefore, a more accurate inflation calculation model should be created.

Many governments have put into many efforts into improving the inflation rate calculation model. They put different weights on different goods and services to represent their weights in normal people's consumption. In addition, they amend the goods and services contained in the CPI basket to update people's consumption behaviour change over time. However, such calculation probably works better in the public sector than the private sectors. The CPI can reflect the ordinary people's living costs. In the private costs, the price changes in the sectors can change differently from the CPI changes. Therefore, when they are making their business decisions or consumption decisions, they should adopt their inflation in their individual sectors.

Moreover, my opinion is that the inflation calculation should be based on a general model that models the entire economy as a single market, and the inflation rate is the price change in this economy. The demand is the entire population income; however, the supply in this single market should take into account all supply goods that contain the supply from overseas. So under this circumstance, the inflation rate is based on the domestic incomes and the international economic outputs.

To accumulate individual consumptions

When calculating the inflation rate, the goods and services contained in the market basket for CPI calculation are common goods and services; therefore, when the demands for these goods and services increase, the prices will increase. However, different goods and services have different elasticities of demand, so I do not see a way to find a general equation to model all the goods and services’ demand according to our income changes by accumulating individual specific demands for different goods and services.

However, as the goods and services contained in the CPI are almost necessities to everyone. When the necessities do have a ceiling of the demand, up to a certain level, the demand for the necessities does not increase significantly despite the increase in people’s incomes. Therefore, we are possible to find a model to model the general elasticity of the demand for the combination of these goods and services in the CPI basket, and once we find the elasticity of the demand, we are able to model the general demand for the goods and services in the entire economy.

The problem here is that it may not be able to accurately model the price changes in the entire economy, as this model needs all individual data or at least a randomly selected sample. Moreover, in the CPI basket, different goods and services have different weights, this adds more complication in our model. In addition, when we consider the inflation rate in the economy, we need to consider multiple factors and different economies and people have different demands for different goods and services. In some wealthy economies, people no longer need necessities, they have better substitues for the necessities, for example, they consume better meat and food. Under such circumstance, not only the quantities change but also the types of goods and services change when people’s incomes change.

Therefore, modelling a general demand for the combination of necessities is a way to model individual elasticities of demand in general, but it is not a very accurate way to do so.

Inflation and price

Inflation rate is usually measured by CPI, which is to measure changes in the price level of market basket of consumer goods and services purchased by households. Therefore, it is reasonable to accumulate individual consumption and production, these microeconomic factors to model the inflation rate, which is a macroeconomic concept. Nowadays, accumulating microeconomic models to model the macroeconomic issues has become very common and popular.

To accumulate individual consumptions to model the total demand in the economy, I think we need an equation that contains the consumption as the dependent variable, and wealth, goods’ elasticities of demand and other relevant factors as the independent variables. And the total supply should include the individual costs of production, other productive factors.

The problem in this way of modelling is that we have to take account of all factors that determine the different individuals’ consumption decisions and form a general formulate which is suitable for the majority of the population. In addition, we have to ensure that the sums of the factors that are included in the general formula are measurable or at least estimable. On the other hand, the general formula for the supply side should have the similar quality.

Price interaction

Prices can interact across different markets. We all know that the demand of a good increases when the price of its complementary good decreases, and the demand for a good increases when the price of its substitute increases. Basic economics teaches us to use the cross elasticity of demand to distinguish the relationship between goods (services).

Nowadays, almost all goods and services can be related together. For example, food price can be tightly related to the price of some financial products. The pricing of financial products is based on their financial companies’ economic models, in any economic model, inflation is an impossibly omitted factor, and food price is one of many determinants of inflation; therefore, food price is related to the price of financial products. Moreover, based on our individual preferences, it is not hard to find the reason that why every good is related.

Our consumption decision is based on two factors: budget constraint and personal preference. Any good or service consumes some proportion of the budget and difference utilities can be gained from different combinations of goods and services. Therefore, once our budget is pre-determined, to maximise our preference or achieve a certain level of utility, any change in consumption of one good or service must result in changes in consumption of other goods and services.

Therefore, all prices interact, some might show relatively weaker correlations than the others, this is because the interaction involves more complicated factors.

Excess capacity

Yesterday I talked about how a bad inflation is caused by a lack of sufficient productive factors, today I want to discuss the issue of excess capacity in the economy. Excess capacity can be caused by various reasons, and often can lead to a reduction in the price level. Excess capacity rarely takes place on a large scale and causes a deflation in the economy, as in general, people often prefer more than less. Excess capacity takes place when a specific good or service no longer meets the market demand and requirement.

For example, last century, quartz watches were invented and rapidly took over the majority of the market which had been owned by the mechanic watches, this is because watches were seen as the tools to track precise time at the time, and quartz watches met the market requirement better than mechanic watches. Many Swiss watchmakers went bankruptcy during that period. There is another example, the Chinese coal and steel industries have been marked as industries with excess capacity. I think this issue is only partially caused by an unthoughtful investment in the industries, the main reason for it is the Chinese market demands better qualities of coal and steel, which can meet the environmentally friendly standards, the needs of high-tech industries (for the aerospace industry, the car industry and other industries). Moreover, the poor quality steel and coal have no advantage to win any market share in the global market, which means the excess supply of steel and coal cannot be exported to other countries.

Therefore, based on the above two examples, I think that the excess capacity is not only caused by an increase in investment and production, it is also caused by a shift of the market “taste”. 

How to distinguish between a good inflation and a bad inflation

Inflation can be put into two categories based on its causes: demand-pull inflation, cost-push inflation. However, this does not necessarily help to distinguish between a good inflation and a bad inflation. Usually, we distinguish based on the degree of volatility, we see a moderate inflation as a good inflation and a volatile inflation (hyperinflation) as a bad inflation.

I think we should find a way to distinguish a bad inflation and a good inflation based on its causes, in order to prevent further damage from a bad inflation when we can see a sign of it.

Both demand-pull inflation and cost-push inflation can be a bad inflation; however, we usually see that cost-push inflation is rather a bad inflation, as we expect a healthy economy tends to lower the costs of production due to the improvement of efficiency of resource allocation.

I see bad inflations always happen when the supply side loses its ability to meet the demand side due to the lack of production factors. Therefore, some cost-push inflations can be eased automatically by improving efficiency and productivity, when production factors are available, so they are not long term problems that need us to worry too much. On the other hands, many catastrophic hyperinflations are caused by the lack of production factors. For example, Germany after the first World War suffered a period of hyperinflation because many factories were destroyed and many men were killed in the War and Germany lost sufficient production factors to meet the domestic demand during its post-war period. Such inflation problem often requires a structural reform and help from the outside world.

Overall, we do not need to worry too much about inflation due to higher demand, higher costs due to bad management or inefficiency, the inflation that we need to worry is the one caused by the lack of production factors. 

Globalisation of inflation

Inflation can also be globalised just like many other things via the forex market as well as the international trading network. Inflation is a phenomenon of price changing, and the price is determined by supply and demand in the market.

Different countries have different inflation rates because the demand related to the element measuring the inflation is domestic demand. Each country has its unique demand, so when the demands for goods are different in different countries, the price levels in these countries will also be different; therefore, the inflation rates in different countries are different. However, many countries have similar inflation trends, this is because the supply for all countries is relatively similar.

Nowadays, we have an international trading network so all goods and services can be supplied by the entire world. In addition, the international trading network tends to make prices of the same goods and services have similar prices everywhere around the world. When some places have got higher prices for some goods and (or) services, more such goods and (or) services will be supplied into these places and lower the local prices. However, due to our different trading policies, supply is not exactly the same everywhere, some countries have higher transport costs or higher tariffs, the supply will be lowered than somewhere with cheaper transport costs or lower tariffs.

Overall, under the current circumstance, globalisation tends to distribute the inflation pressure across the world, and all countries which have access to the global market have similar inflation trends.

The inflation and the growth

The Bank of Japan keeps its monetary policy on hold to keep inflation moving toward the 2.0% target. The Bank of England also sets its inflation target at 2.0%, and other central banks also have similar targets. Previously I have explained why inflation is important for governments, today I want to discuss how inflation relates to economic growth.

Inflation usually implies an increase in the prices in the domestic markets on average; however, when a country actually measures its domestic inflation, it only measures the change in the average prices of a basket of several selected goods and services, as it is impossible to measure all price changes all cross the economy. Therefore, sometimes some price decreases are not observed in our inflation sample.

Growth does not necessarily lead to an inflation; however, sometimes an inflation can lead to an economic growth. Inflation can redistribute the resources in the economy. Inflation signals price increases in some sectors of the economy. Once price increases usually imply increases in demand, so the market is likely to react to the increases in demand and increase the supply. Such process can help to improve the efficiency of the resource distribution. Once the resources are distributed more efficiently, the economy will grow.

I explained the reason for why an economic growth does not necessarily lead to an inflation previously, so I will only give a simple example to explain this question again. We usually think the price for smart phones has a slowly increasing trend; however, that is not true. Apple’s iPhone is a famous smartphone, once the new version of iPhone usually has a slightly higher price than its previous version. However, when we look at the inflation, we do not see this as a price increase. Once the new version is released, the price of the older version decreases, so it is a price decrease (deflation).

Overall, I believe, inflation causes an economic inflation as inflation implies a shortage of supply in the economy that pushes the supply as well as the production in the economy, thus leading to an economic growth.

Under what situation the government will be no longer able to control the inflation rate?

The government has fiscal tools and monetary tools to control the domestic inflation rate; however, sometimes it may not be able to use such tools to influence the domestic inflation. Inflation implies the currency is being devalued. As a currency is backed by its government, when its government’s credit is questioned by the international market or large financial institutions, the value of the currency will also be badly damaged.

Inflation also means the currency is devalued against goods and services. When there is a shortage in the supply side, the currency will be oversupplied to the market, when the equilibrium of the demand and supply for money changes, the values will change, and the currency is devalued and there is an inflation in the economy. Therefore, when an economy lacks sufficient supply and production of goods and services, the government cannot control the value of its currency.

In addition, the inflation can get out of the government’s hands especially nowadays because of the economy’s trade with other countries. Countries are trading with each other and countries do not need to produce everything by themselves now. However, once one country has an important resource that it has to depend on imports but the supply from imports decreases for some reason (natural disaster caused decrease in production in other countries, political reason such as sanctions), the currency will depreciate in the forex market, and as it is an important resource for the domestic economy, the prices of goods and services that relate to this resource in the domestic markets will increase sharply and lead to inflation.

These are the several situations where the government lacks of tools to lower the inflation, and all these reasons tight relate to one important reason that the economy does not have the ability to generate sufficient production.