Home > Economics > Inflation – Part 1

Inflation – Part 1

Before I get into too much detail on how the government spends and why it should (or shouldn’t), I think it’s best that I cover inflation. I will divide this up into 2 posts. This first post will be more of an overview that will introduce the reader to the various topics concerning inflation.  Part two will be a more in depth look at causes and effects and will include more discussion of how government policies work (or don’t work).

Introduction

Current political and economic discussions about with fears of the national debt and large national deficits. As I discussed in my previous post, these fears are irrational to the extent that there is no solvency concern for the U.S. or any other government which has sovereign control of its own currency. It can never “run out of money” as some many politicians would like you to believe. While there might still be some people who refuse to admit this fact, I think most people will readily agree that, in reality, the government has an infinite supply of its own money. However, most people (especially the conservatives and libertarians) quickly jump on the hyper-inflation bandwagon. The thought process goes like this, “OK fine, in theory government has unlimited supply of money, but in reality, if government keeps ‘printing money’ we will eventually see inflation and if the spend too much we’ll get hyper-inflation like Zimbabwe or Wiemar Germany.”

Over the next couple of posts, I’m going to discuss inflation, including its causes and effects, and will attempt to convince you of  a few key points.

  1. Contrary to popular belief that all inflation is bad, a low steady rate of inflation is actually a good thing.
  2. Increases in the money supply will not automatically lead to inflation.
What is Inflation?

Investopedia defines inflation as  “The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.” The important factor here is that we are looking at the  “general” level of goods and not just a couple of items. This is important as the price of a single item could be driven by demand or supply shocks.

Most people use the CPI (consumer price index) as the standard measure of inflation. It is the official measurement of the US Government and when someone quotes you the rate of inflation, the CPI is what they are talking about. However, just like any other national economic measurement (such as unemployment or GDP) what is included in the basket of goods measured by the CPI is up for debate. Do we include gas prices? What about housing? Daycare? You get the point. However, what is in the measurement is something I’m ignoring for now so that I can discuss the broader topic.

Causes of Inflation?

Since inflation is really just an increase in prices, the answer to the question of what causes inflation is basically just a question of what causes prices to increase. Any good economics 101 student can tell you it’s just a matter of supply and demand.

Inflation coming from the demand side is called “demand-pull” inflation. This is an increase in price level driven by increased consumer demand. As more people “demand” a product, the supplier can charge a higher price. An increase in the money supply or decreases in unemployment fall into this type of inflation because they increase demand for consumer goods at a level price point.

Inflation coming from the supply side is called “cost-push” inflation. Inflation of this type is generally caused by increases to input costs which lead suppliers to have to charge a higher price for their finished goods. The biggest driver of “cost-push” inflation is the price of oil, which is set (for the most part) by an oligopoly of Middle Eastern nations. Because oil is a major factor in transportation cost, oil prices tend to drive the prices of most other goods. Another example of this type of inflation is a supply shock. If all of a sudden, there is a whole lot less of something, we see the price rise. For example, if a hurricane destroyed 30% of the world’s banana supply, you would expect banana prices to rise.

These two types of inflation can occur simultaneously (called stagflation), however they most often partially offset each other. Increases in prices from cost-push inflation, create lower demand (since the price is now higher) which can lead to a small lowering of prices to try to stay competitive. Similarly, if demand increases, a firm could raise prices, but most likely will just increase production (if possible) so they don’t lose business to a competitor. I will discuss more about this in part 2.

Is Inflation Good or Bad?

Inflation is neither good nor bad as long as it affects all prices equally. If the price of goods rise, I am ambivalent as long as my wages rise by the same amount. If an iPod cost $200 and I earn $10/hour it is functionally equivalent to an iPod costing $400 and me earning $20/hour. My purchasing power has not changed. I still have to work 20 hours to afford an IPod, however, we have seen inflation of 100%.

The problem arises when we have consumer product inflation (like iPods) without a corresponding increase in income. This causes purchasing power to decrease.  If an iPod goes up to $400, but I still only make $10/hr, I now have to work 40 hours to afford one. This declining of purchasing power is what most people are talking about when they talk about inflation. This is bad for people on fixed incomes like retirees and also bad for lenders who have typically set a fixed interest rate.

Inflation is good for those people whose wages can increase, but who have fixed rate debt. Continuing the iPod example, if I borrowed $200 to buy an iPod before the inflation and my wages went from $10/hr to $20/hr, I now only have to work 10 hours to pay back my loan (plus some interest).

We typically view inflation as bad because most of us are in the first category. Your typical worker’s wage only gets increased once a year and is set by the company they work for. The rate of the rise typically lags behind the inflation rate. This causes their real income to decline. However, wages do eventually increase and any debt that they have (like a mortgage) is not easier to pay off.

Now you are probably asking, “so if inflation is mostly bad for most people why do we want some if it?” For one it encourages spending. It is more beneficial for me to buy something today, if I know it will cost more in the future. In this sense, mild inflation helps to increase demand, which helps the economy as a whole. Without inflation, we would always be on the border of deflation. Deflation is perhaps worse than inflation in that it decreases aggregate demand, which, similar to Keynes’ paradox of thrift, leads to recessions and depressions.

Another reason for a small level of inflation is that it allows the central bank to play with monetary policy (although we will eventually debate the usefulness of monetary policy) If there were 0% inflation, interest rates would get closer to 0% potentially leading to a liquidity trap and the Fed wouldn’t have the room it needs to adjust interest rates.

To summarize, while inflation is bad, deflation can be an even bigger problem. It’s best to target a low level of inflation (ideally in the 1%-2% range). This helps encourage purchases, which drive the economy as well as allows some policy space for the Fed to act to prevent deflation.

Conclusion (of part 1)

Hopefully I’ve convinced you of point #1.In the next post, I’ll discuss government spending and how that affects the money supply. I’ll also talk about other things that increase or decrease the money supply, particularly bank loans. Then I’ll talk about how the money supply affects inflation.

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