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.