Wednesday, May 12, 2010

Real Value vs Nominal Cost vs Relative Cost

Hi All, 

Welcome once again. We renamed it as “Common Man's hub of Economics” as it is now going to too many people. Initially it was just sort of debate between few friends so “Gangal School of Economics” was name, which was ok then but now it needs to be changed. I have changed it in all the posts.

Anyways, let’s see difference between “Real Value vs Nominal Cost vs Relative Cost”.

Real Value 

Well we all probably will agree that Single smallest and most valuable thing in whole world is “Koh-I-Noor” Diamond. Question is why. And simple answer is it’s “rare”. So “What is rare is valuable there should be no doubt about it”. What about gold well that’s also valuable why is again because you can not increase it’s Supply at any rate. Whole process of gold extraction is pretty tough and max supply that we get per year is 2000- 2500 Tons. Due to very high density 19.3 if you make a cube of it, it can fit in medium size Room. Yes that’s it. We cannot produce more gold than that per year. "It has been estimated that all gold ever refined would form a single cube 20 m (66 ft) on a side (equivalent to 8000 m3)". In other words it’s rare as well hence not as high as diamond but still gold is precious. What about Silver, same story again rare but not rare as gold so in value less than gold but still it’s a precious metal.

Nominal Cost.

Well this is bit complex. Nominal Cost has many aspects to it. Let’s take an example of a Father who earned 20,000 and spend 10,000 per month (4 Rs School fees, 1000 Rs max for groceries). Now if his son earns 1,00,000 per month and spends 70,000 per month (5000 School Fees, 40000 Home EMI and so on) despite “Numbers” son has weaker economy. In other words it’s just time that has inflated these numbers and son is in “illusion of wealth” whereas he will face all same challenges during his retirement that his father faced. At the same time if he earns 20,000 and even if saves 12,000 his economy is still weak. And this is because the “Value of 12000 Rs saved now as compared to value of 10,000 Rs his father saved (During his time) is low dramatically.

This is typically known as currency depreciation and is caused by inflation (Increase in Money supply, Printing of money to fund government deficits that we discussed for some time now.)

Relative Cost

This is tougher to understand. It’s basically Einstein’s theory of relativity that becomes applicable even in economics.

Well, if you see graphs below you can understand that even great peak of Dow of 2006-7 when measured in gold it was a complete bear market. Think more and more about it. This can be understood with better clarity by looking at graphs below.

Dow Jones in Nominal Terms. from 1900 till 2010
at 25000 on x Axis there is 1971 on 40000 there is 2010.

Dow Jones when measured in Gold

So bottom-line is we are in world where everything is going up in nominal terms and down in real terms and as I see we have left no path for U turn. Obviously this system is unsustainable so let’s wait and watch and enjoy till it breaks or repairs in hard way :) 

P.S: Gold crossed all time high today making new all time high. Since beginning of this forum i.e since many Months now, I have been mentioning importance of gold and silver in upcoming time. I hope we all including me will be able to make it this time before it makes new all time high. 

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