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A Parable of Two Countries

December 21, 2011

Imagine there are two countries, A and C. Every year, C buys 5% of the money in A using goods and stores that money in a vault. Country A’s central bank offsets the lost money by printing an additional 5%, leaving the level of spending and inflation unchanged. However, after a decade, C has amassed a huge pile of A’s fiat currency (50% of the domestic supply). If C tries to spend it all at once, there will be massive inflation in A, and the level of consumption will drop in A. If prices are flexible, the money supply would increase by 50% and so would spending and prices.

Note that in this case, the biggest loser is C. When they were accruing A’s money, there was deflationary pressure on A’s currency, meaning A was getting a lot of goods for a little bit of money. If C tries to spend their huge pile of money all at once, they will have to pay massively inflated prices. However, such a move would still induce monetary instability in A, unless the central bankers were really good at their jobs (they are not).

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