Sometimes, the economist in me really hates the news. Wait, that’s all the time. Economics is a complicated and imperfect discipline that is constantly changing. Unfortunately, the mainstream media is mostly interested in what it can feed people to get them to turn on the channel RIGHT NOW, so silly things like “facts” and “accuracy” often go by the wayside.
Now I know that economics isn’t very sexy and there’s a reason why we call it the dismal science.
BUT, there are a few things about economics that are consistently misunderstood in the mainstream media that really make me cringe. So, I give you 3 important things about economics that I think everybody should understand. Enjoy!
1. Economics is the study of scarcity.
It’s not about money, financial markets, or the Fed. It’s simply about how to make the best use of finite resources in a world of infinite wants.
2. Inflation is caused by scarcity
Many believe that the money supply drives inflation. However, inflation is ultimately caused by a shortage of things, either on the supply or demand side. Let me explain:
- Demand-pull inflation: Consumers have extra money and want to buy all the things. Unfortunately, there aren’t enough things because output hasn’t caught up with demand. Producers raise prices because they know they can get more out of the people who have cash burning holes in their pockets.
- Cost-push inflation: The cost of inputs increases because of a shortage in supply and so producers have to increase prices to compensate.
So yes, putting more money into the economy can cause demand-pull inflation, but only if there is a shortage of corresponding output. There are many factors at play – it’s not as simple as more money=inflation.
3. Our banking system is a fractional-reserve banking system – aka the money isn’t really there
Your bank uses the money that you deposit to make loans. This leads to an effect called the “money multiplier” which says that each dollar in deposit leads to multiple dollar increases in GDP. The size of this effect is inversely related to the reserve ratio, or the percentage of their deposits that banks are required to keep ICE. The higher the ratio, the less the effect of the multiplier since banks won’t be able to loan out as much.
This is just a reminder that our financial system is complex. Fortunately we have things like the FDIC now to prevent bank-runs and to ensure that people can access their money if they need to, but it’s still fragile. During the financial crisis, different assets were loaned out in so many different forms to various parties that people started to lose track of who owned what, which was a big part of the meltdown. Michael Lewis’s “The Big Short” does a great job of explaining this in pretty understandable terms. Now I’m not suggesting that you hide all your money under your mattress, but others have done crazier things…
If you’re truly an economic newbie and all of that sounded like I was talking through a garbage disposal, check out Greg Mankiw’s 10 principles of economics for the building blocks. Then watch this video to get a true sense of what they mean.
Does the news drive you crazy, too? What’s the worst misconception you’d like to expel from the world?