Inflation Cause and Effect
I often receive letters from students, that demonstrate a fuzzy understanding of inflation and its causes. Unfortunately, I often get the same type letters from teachers and business people too!
It seems that people often confuse the cause of inflation with the effect of inflation and unfortunately the dictionary isn’t much help. As you can see in my article What is the Real Definition of Inflation? the modern definition of inflation is
“A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money…”
In other words according to this definition inflation is things getting more expensive.
But that is really the effect of inflation not inflation itself. The American Heritage® Dictionary of the English Language, Fourth Edition, Copyright © 2000 Published by Houghton Mifflin Company goes on to say:
…caused by an increase in available currency and credit beyond the proportion of available goods and services.
In other words, the common usage of the word inflation is the effect that people see. When they see prices in their local stores going up they call it inflation.
But what is being inflated? Obviously prices are being inflated. So this is actually “price inflation”.
Price inflation is a result of “monetary inflation”.
Or “monetary inflation” is the cause of “price inflation”.
So what is “monetary inflation” and where does it come from?
“Monetary inflation” is basically the government figuratively cranking up the printing presses and increasing the money supply.
In the old days that was how we got inflation. The government would actually print more dollars. But today the government has much more advanced methods of increasing the money supply. Remember, “monetary inflation” is the “increase in the amount of currency in circulation”.
But how do we define currency in circulation? Is it just the cash in our pockets? Or does it include the money in our checking accounts? How about our savings accounts? What about Money Market accounts, CD’s, and time deposits?
“The Federal Reserve tracks and publishes the money supply measured three different ways– M1, M2, and M3.
These three money supply measures track slightly different views of the money supply with M1 being the most liquid and M3 including giant deposits held by foreign banks. And M2 being somewhere in between i.e. basically Cash, Checking and Savings accounts.
Interestingly, the FED decided to stop tracking M3 effective March 23, 2006 for some mysterious reason. See the article on M3 Money Supply for what they could be hiding.
But back to the question of the cause of inflation. Basically when the government increases the money supply faster than the quantity of goods increases we have inflation. Interestingly as the supply of goods increase the money supply has to increase or else prices actually go down.
Many people mistakenly believe that prices rise because businesses are “greedy”. This is not the case in a free enterprise system. Because of competition the businesses that succeed are those that provide the highest quality goods for the lowest price. So a business can’t just arbitrarily raise its prices anytime it wants to. If it does, before long all of its customers will be buying from someone else.
But if each dollar is worth less because the supply of dollars has increased, all business are forced to raise prices just to get the same value for their products.
For further information on how increasing or decreasing the money supply affects prices see our article on Deflation.
thank you for this very detailed analysis of inflation!!…it really means a lot to economists in the making like me…..thank you!!
This strikes me as a contemporary explanation of inflation. There was inflation when the dollar was backed by silver.
Eric,
Actually, that proves the point. The price inflation that occurred when Silver was the defacto currency of the land was the result of massive silver discoveries and increased mine production which resulted in an increased money supply. There were also periods of gradual deflation (falling prices) as the increase in goods and services increased faster than the money supply. So over the long term they balanced out.
The advantage of “hard money” (i.e. backed by gold and/or silver) is that it takes the control of the money supply out of the hands of the government and gives it to private industry (when mining becomes more profitable more is produced). Without being able to print whenever they want the government can’t spend on worthless projects. It also reduces the likelihood of war since governments can’t wage war if they don’t have the money (and they can’t just print more if they feel like going to war).
It would be helpful if everyone understood that money is just a medium of exchange. The supply of money does not cause inflation. Need proof? Look at the past 8 years, with money supply the greatest it has ever been and the economy continues to struggle to keep deflation in check. The supply and demand determine the inflation rate. Prices do go up as demand increases but that is only indicative of a growing economy and as long as the supply can be provided within the cost unit it will not cause inflation.
Cliff, Actually even though the FED pumped up the money supply a great deal of wealth was erased in 2008 (in stock and Real Estate) values and so much of the FED’s printing just replaced what had evaporated. Also, see our articles on Velocity of Money and how that affects inflation.
Inflation comes when there is a persistent rise in the general price level..and the general price implies an average of commodities price. Especially in Africa we are suffering a lot because we normally use hard currency when we want to purchase goods from our neibouring states but when the doller rate goes high all the goods price will go up . I am South Sudan student studying in Uganda.
Very good article and response to the above question.
“But if each dollar is worth less because the supply of dollars has increased, all business are forced to raise prices just to get the same value for their products.”
This is always stated as if this cause-effect relationship should be self-evident. Clearly it’s not. It’s stated as if everyone can SEE how much money is in circulation at any given time. If I were to create cash out of whole cloth, I would be able to exchange it for goods and services. I would even be able to take the cash to an investment bank and use it to “earn” more money. (Tabling for the moment the whole question of how this practice could be called “earning”) the question is: who tells the marketplace that the money is worth less than it was yesterday? When and where and how often do they do it? And why does the marketplace believe them?
Good point. That is exactly why there is a lag of 18 months to 2 years before the economy catches on that there is more money. The early spenders (the government) get to spend it at the old value before people realize that there is more money floating around. The next logical question is, “How do they figure it out?” and in a sense they don’t they just know that they personally have a bit more available (perhaps they got a cost of living raise). Lenders are willing to loan more, Suppliers sell more stuff (initially to the government) and they hire more people, buy more products and generally spread the money around a bit. Eventually this “excess” cash is freely sloshing around and people are willing (or forced) to bid up prices. From the supply side suppliers must charge more because their costs have gone up, so they must raise prices.
No one sits around and says let’s see there is “X” number of dollars in circulation and “Y” units of Gross Domestic Product so the average item should cost “Z”. That number would be meaningless anyway, because what is an “average item”? The market is compilation of everyone’s income and expenses with everyone acting in their own best interest. The end result is a gradual shift in the overall balance… initially exerting very small forces on prices. But if it continues for too long the perception becomes a self fulfilling prophecy as people expect prices to rise they build that into their costs. This continues until a contraction in the money supply forces that perception to change. Eventually people realize that their personal supply of dollars is drying up, at which point they can’t bid prices up anymore and they shop for bargains, are willing to accept lower wages and cut back on unnecessary purchases. Suppliers respond by having sales, liquidating excess unsold inventory and laying off workers. So at any given time the economy is in flux as everyone is weighing their personal income against their expenses trying to decide if they have too little money and need to be frugal or a little extra that they can spend lavishly.
That’s an interesting issue about the worth of our money, because since coming off the gold standard, cash has no intrinsic value other than what the ‘market’ says it has. They’ve even reduced the amount of silver used in nickels, dimes, and quarters, as well as reducing the amount of copper used in penneys. If one strings all of these exceedingly bad decisions together, one would think that someone is trying to destroy the U.S. economy on purpose.