Continuing our island economy fable, this second episode picks up where we left off, diving into inflation and interest rates. If you haven’t read the first part yet, I highly recommend doing so for a full understanding.
Previously, we saw a small island community of 100 people evolve from a simple barter system into a structured society with private property, a government, a currency, and public debt. Now, years have passed, and thanks to a high birth rate, the island’s population has doubled. With more people, new opportunities emerge, and the most visionary residents start businesses.
One islander, inspired by the financial intermediary, decides to become a goods distributor. Instead of everyone searching for products individually, they can now buy everything in one centralized marketplace. Another entrepreneur spots the need for transportation and launches a service to deliver goods to the market. A third innovator starts a firewood factory, arguing that even though people now have to pay for firewood—something that used to be free—it saves them time, allowing them to focus on their specialties and earn more. These new businesses boost productivity, create jobs, and drive economic growth.
Seeing this development, the government seizes the opportunity to collect taxes. Now, in addition to workers and producers, entrepreneurs must also contribute part of their earnings. With fewer resources after taxes, everyone adjusts: workers demand higher wages, producers raise prices, and businesses increase their rates.
As the economy grows, so does tax revenue. The government, justifying its actions as necessary to support a larger population, hires more employees and expands spending—often beyond what’s needed. Soon, expenses outpace tax revenue, creating a budget deficit.
A new administration takes over and needs to find ways to cover costs and pay off past debts. Their solution? Issue more government bonds, taking on new loans to pay off old ones and fund increasing public expenses. As a result, public debt skyrockets.
This starts to impact the economy. Money that could have fueled production is now being redirected to debt payments, slowing down business activity. With the downturn, consumers cut back on spending, seeking cheaper alternatives like buying directly from producers. Retail businesses struggle, layoffs increase, and other sectors, like firewood production, also take a hit. Lower consumption and production lead to a downward economic spiral. Despite the crisis, government spending remains high even as tax revenue falls.
Out of cash and unable to borrow more from citizens, the government comes up with what it thinks is a genius idea: since it controls the currency, it simply prints more money (or, in our island’s case, creates more stones). This allows them to pay off debt and fund expenses. But they overlook a critical issue—production has slowed due to the crisis. More money chasing fewer goods leads to the inevitable: prices skyrocket. If one stone used to buy six bananas, now it buys just one. Inflation surges, crushing people’s purchasing power.
With growing frustration among islanders, the government scrambles to control prices. A seasoned advisor explains that inflation is caused by too much money in circulation and suggests issuing more government bonds to pull cash out of the economy. But to convince people to lend their money, the government needs to make the deal more attractive—by raising interest rates.
The island’s central bank hikes rates, making government bonds more appealing. They soon realize that inflation stems from excess money and that raising interest rates can help control it. But they fail to see the catch: the government is the one paying these higher interest costs. Since tax revenue funds government spending, rising interest rates make public debt even more expensive.
Trapped in this cycle, the government struggles to balance the budget. With the economy still in crisis and tax revenue shrinking, resources aren’t enough to cover expenses. So, they resort to the same old trick—printing more money. But with production still low, inflation spirals even further. To fight it, they raise interest rates again, only to drive public debt even higher.
And so, the island economy finds itself caught in a vicious cycle—one that mirrors the struggles of real-world economies throughout history.