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The question came up on comments in Politics.SE:

Situation:

  • A government of a country sets up an unconditional Basic Income Guarantee (defined as monthly payments to EVERY resident, unconditionally, of a certain sum).

    The sum can be roughly estimated as "only enough for a person to survive on" as per Wiki definition.

  • The financing of the program is 100% entirely set up from external, foreign sources - charity donation, or no-strings-attached aid from another government.

Is it a certainty that such an arrangement would be highly inflationary for recipient country, assuming that BIG total financing is a non-trivial compared to recieving country's GDP?


All Wikipedia says on the topic is:

A common concern with Basic Income among the general public is the risk of inflation raising prices and thus undoing its effect. Economists Ed Dolan and Karl Wilderquist say that since the funding for basic income would come from reductions in public spending and/or taxation, there would be no inflationary effect.[citation needed]

... which seems to NOT address foreign-financed BIG at all.

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3 Answers 3

Assume that a big country decides that, from here on, it will distribute for free 1 Kgr of bread to every citizen of a neighbor small country. The bread will be made, transported and distributed with big country resources (raw materials, labor, equipment, wheels, etc). Moreover, big country's representatives will sit around while local citizens eat it.

Will this create inflation? It doesn't seem so.

Now assume that instead, the big country gives for free to the local government electronic funds which the local government transfers to its citizens which in turn transfer it to the bakeries of the big country in order to buy bread and have it delivered (and being watched at, while they eat it). Will this create inflation? It doesn't seem so.

But assume now that the funds are given, always for free and always from the big country, and the citizens of the small country are free to do what they want with them. Will everybody buy bread from abroad? Hmmm, not likely. They may want to go cut their hair with that money. Lots of them. So they rush to all the barber shops and beauty parlors in the country, whose owners start to live this dreadful paradise of every supplier, to be drowning in demand and not have the capacity to fulfill it. And the barbers may think, "hey these people are dying to have their hair cut now. I have two hands and 16 hours a day -They're not enough for all these customers... what if I ask for a little more money per haircut in exchange, say, for a reservation?"

The moral here is that injecting resources into a country may result in excessive demand in local sectors where the productive capacity is not enough to cover the demand, leading to inflation. This is why the ever-sung mantra is "productive investments" rather than "consumption transfers".

If one extends the horizon of course, excessive demand will signal "hey! you, productive resources over there! Come over here! There is more demand than anyone can cover!" -but relocating productive resources takes time, more time than it takes for prices to rise.

(I apologize for the fairy-tale approach, it just came out and for once, I thought "let MathJax lie in peace". But it is perfectly valid scientifically.)

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1  
I wouldn't object to some MathJax as well :) –  DVK Nov 28 at 0:17
    
Even if haircuts go up in price, it's quite possible that the goods that the foreign power sells to get the funds will cause prices to go down in those areas. The net result may still be no inflation. If the foreign power gives its own currency, then it allows the domestic group to buy products and the same thing. This can only be inflationary if people use the foreign money as a replacement for domestic money. That effectively increases the local money supply. –  Brythan Nov 28 at 13:54
    
@Brythan I don't understand the sentence "the goods that the foreign power sells to get the funds will cause prices to go down in those areas". What this had to do with the small-country economy? I didn't model any trade between them (that would have changed the framework into which the OP's question is asked). –  Alecos Papadopoulos Nov 29 at 6:56
    
If there's no trade, then how do you transfer money? If the foreign power can transfer money, there must be some way to trade. Otherwise the foreign power's money would be useless. They need to either be trading currencies (for what?) or using the same currency. I don't see how two countries using the same currency could not have any trade. Even if they don't trade with each other, they'd trade with other countries. –  Brythan Nov 29 at 13:44
    
@Brythan - easy. You give the smaller country dollars. They use dollars to buy oil on international markets (not necessarily from donor country). –  DVK Nov 29 at 13:50

If the foreign country sends goods, then demand for the home currency increases, so the price level falls.

If the foreign country sends currency (which substitutes for the home currency), then demand for the home currency falls, so the price level rises.

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It would be helpful if you elaborated a little. In particular, could you address whether the policy would be "highly inflationary" (or, at least, the degree to which you would expect the price level to rise)? –  Steve S Dec 1 at 3:56

Short Answer:

Probably. For some goods. I guess.

Longer Answer:

Assuming two toy economies and three goods, increasing the supply of good in one economy relative to the supply of goods of the other two classes will decrease its trade value relative to them.

Prior to the transfer (at $t_0$) they'd look like:

$$E_1(t_0)=\{a_1x,\ b_1y,\ c_1z\}$$ $$E_2(t_0)=\{a_2x,\ b_2y,\ c_2z\}$$

with basic prices of $x$ in $E_2$ as:

$$p_x(y)=\frac{a_2}{b_2},\ \ p_x(z)=\frac{a_2}{c_2}$$

in that it if we started with $a_1=4,$ $b_1=8,$ and $c_1=16,$ then one unit of $x$ would cost either $2y$ or $4z$ in $E_1$.

After the transfer (let's say of good $x$ of quantity $a_t$ at $t_1$, they'd look like:

$$E_1(t_1)=\{(a_1-a_t)x,\ b_1y,\ c_1z\}$$ $$E_2(t_1)=\{(a_2+a_t)x,\ b_2y,\ c_2z\}$$

consequently in the recipient country ($E_2$), the price of good $y$ in terms of $x$ would have declined to $\frac{b_2}{a_2+a_t}$. But, with a rational expectation of future gifts of good $x$, the value of $x$ in $E_2$ should also be diminished (or price of a good in terms of $x$ increased) by the NPV of the perpetuity times the probability of default at each payment, though we'll skip quantifying that for now (and merely assume it's positive and non-zero), and simply say that at $t_1$ in $E_2$ the price of $y$ in terms of $x$ is:

$$p_x(y)>\frac{a_2+a_t}{b_2}>\frac{a_2}{b_2}$$

and the price of $z$ in terms of $x$ is now:

$$p_x(z)>\frac{a_2+a_t}{c_2}>\frac{a_2}{c_2}$$

So as long as $x$ is currency, under the classical regime, any increase in the quantity of $x$ will decrease it's relative value in terms of the other commodities in the economy.

Still Longer Answer

This simplistic explanation over looks a few key factors, and can be expanded on by including basic international trade.

If $z$ is a fungible, non-perishable, and easily transported, and both economies have relatively free trade, then we have another story.

In that case, members of $E_1$ and $E_2$ would presumably have access to all the $z$ in each other's markets, so the price of $z$ in terms of $x$ would be globally set, and remain unchanged, since in the aggregate, the supply of $x$ has remained unchanged.

An Elaboration on Regulatory Dynamics

Further complicating this, however, would be any regulatory trade inefficiencies, like tariffs. Let's say $E_1$ has a tariff on the export of $z$ of $q\%$, then prices of $z$ are likely to rise in both $E_1$ and $E_2$ as the supply of $x$ has decreased in $E_1$. Since the ratios of $z:y$ should also remain unchanged if $y$ is not traded in this example, then prices of $y$ in terms of $x$ would also have to increase.

One would assume that given that their relative scarcity ($\frac{b}{c}$) hasn't changed from $t_0$ to $t_1$ (before and after the transfer), the ratio of their prices hasn't, or more formally:

$$p_{x_{t_0}}(y):p_{x_{t_0}}(z) = p_{x_{t_1}}(y):p_{x_{t_1}}(z)$$

should hold for both $E_1$ and $E_2$

Transportation and Storage Costs

Of course most consumer spending is on consumable goods (funny how they got that name), which are generally neither free to ship, undifferentiated, or truly non-perishable. In fact, in aid recipient nations, the percent of GDP that is spent on household consumption is often larger than the total GDP, precisely because of foreign aid, although speculative debt buying in developing markets has historically also been something of a problem (See Carbuagh International Economics [citation needed]).

What this means, is that there would be a price gradient sloping upward away from the border into $E_2$ and downward into the territory of $E_1$. The magnitude of the slope would of course be proportional to the ratio of $a_t$ to $a_1$ in $E_1$ and $a_2$ in $E_2$

Ricardo and Comparative Advantage

Given the relative production rates of goods $y$ and $z$ in the different economies, the prices in real currency might fluctuate away from even the trade influenced prices, as the relative supply of these goods changed inside their respective economies. Further, the country most efficient at producing one or the other of these goods would probably specialize, thereby reducing the price of that good at home in terms of $x$, and increasing the price of the other.

Inflation

Of course the Monetary Base can also increase in either economy, as represented by a growth in the quantity of $x$, further confounding the relationship of $a_t$ to the function $P_x()$. That is, assuming of course both countries are currency issuers as opposed to being part of a larger monetary bloc like the EU.

Currency Issue

Of course if our toy economies are not issuers of their own currency, or are part of some more restrictive monetary bloc, they may not have the ability to control inflation as easily.

Banking Regulation

Of course $MB$ represents only a fraction of $M_0$, which is itself only a fraction of the total Money Supply ($M$), which in our toy economies would be the respective values of $a$. Consequently, an injection of hard capital into $MB$ could have a wildly disproportionate affect on $M$. Since classic inflation is linked to $M$ through the equation of exchange, or

$$M * V = P * Q$$

Differing Local Preferences vis-a-vis Utility Functions and Environmental factors

We touched briefly on logistics earlier, but haven't really dealt with the fine-grained details of differing marginal utility. For simplicity's sake, we can use the example of ice. If we were to assume on of the goods (let's say $y$) were ice, and the recipient economy was a desert, and the donor a frozen tundra, then you could see how purchasing more ice than could be consumed between stimulus payments (in $x$) would not be beneficial.

This would mean the recipient economy would not likely see a large increase in the price of ice, unless there were adequate technology to mitigate the risk of spoilage, although that would still increase the cost of preservation, which would put downward pressure on demand.

However, if the roles were reversed, and they could just leave it sitting outside, then there would be.

Other confounding factors

And of course:

  • Economies usually have more than two goods and a currency.
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