“What is it Arjun?” asked the cabbie.
“When I lend, I do not create money, I only monetize credit. That much I could understand. But was this credit just sitting there for me to monetize it? Is there no cost to it?”
“Indeed, there is. Did you observe what was happening in the real economy when you lent money?”
“I did, of course. The entrepreneurs who borrowed money from me set up industries.”
“What does ‘set up industries’ mean?”
“One of them, built a factory, for example.”
“Did he have to hire labour to construct the factory?”
“And where did the labourers come from? Were they sitting idle earlier?”
“Of course not. We are a primitive village. The Model villagers cannot afford to be unemployed. They were doing something else.”
“Producing something else?”
“What happened to the production of whatever they were producing?”
“And what happened to the price of whatever they were producing?”
“So Arjun, you see what happens. Investment does come out of thin air. The resources that are diverted to building factories for future consumption inevitably come from resources that are producing widgets for current consumption. How much of a hit to current consumption The Model villagers can take is determined by how much inflation your investments cause.
If there is too much inflation, it means that The Model Villagers really. really want their stuff. In that case, factory owners can offer higher wages to attract labour back from the factory builders.
On the other hand, if prices do not rise by much, it means that the villagers can do without some of the marginal things that the current round of factory building caused. ”
“Ah, now I see.”
“Good. If you understand inflation, now we can try to understand interest. For the two are linked.”