What causes inflation?

SolitaryRoad.com

Website owner:  James Miller

[ Home ] [ Up ] [ Info ] [ Mail ]

Inflation. A general increase in prices and fall in the purchasing value of money.

The rate of inflation is computed by calculating the change in the cost of some selected “basket” of goods and services over a period of a year. See On inflation, the rate of inflation, and the erosion of the dollar

What causes inflation? This question is directly tied to the question: What causes the price of a good or service to increase?

Q. What causes the price of a good or service to increase?

A. I can think of two things that can cause this:

1. The Law of Supply and Demand. 1) If the demand goes up for a good or service and the supply remains constant, the price will go up. 2) If demand drops and the supply remains constant the price will drop. 3) If the supply increases and the demand remains constant the price will drop. 4) If the supply drops and the demand remains constant, the price will go up.

2. One of the components in the price of a good or service increases. The price of any good or service will have many components that contribute to its final price. Example. Labor component, cost of constituent materials, transportation costs, wholesale and retail markups, overhead costs, etc. An increase in the prevailing cost of gasoline, for example, will generally affect the price of goods because it is a component of the transportation cost.

Many economists contend that government money printing causes inflation. I have never been able to confirm that this must necessarily happen by any chain of logic. However, in many, many countries down through the ages, going back to ancient times, desperate governments in need of money have attempted to fill their coffers either by just printing money if they were using paper currency or lowering the amount of gold or silver in their coins if their money was gold or silver coin. The practice generally ends in inflation, often super inflation. It happened in Germany after World War I, Zimbabwe, and many other countries. In Germany and Zimbabwe the currencies became worthless.

The following comes from Basic Economics by Thomas Sowell, p. 224 -226:

As we have already noted, doubling a nation’s money supply will not double its wealth but will more likely lead to higher prices for everything. Prices in general rise for the same reason that prices of particular goods and services rise — namely that there is more demanded than supplied at a particular price. When people have more money, they tend to spend more. Without a corresponding increase in the volume of output, the prices of existing output simply rises because the quantity demanded exceeds the quantity supplied.

Whatever the money consists of — whether sea shells, gold, or paper — more of it in the national economy means higher prices. This relationship between the total amount of money and the general price level has been seen for centuries. When Alexander the Great began spending the captured treasures of the Persians, prices rose in Greece. Similarly, when the Spaniards removed vast amounts of gold from their colonies in the Western Hemisphere, price levels rose not only in Spain, but across Europe. The Spaniards used much of their wealth to buy imports from other European countries, sending their gold to those countries to pay for these purchases, thereby adding to the total money supply across the continent.

None of this is hard to understand. Complications and confusion come in when we start thinking about such things as the “intrinsic value” of money or believe that gold somehow “backs up” our money or in some mysterious way gives it value.

For much of history, gold has been used as money by many countries. Sometimes the gold has been used directly in coins or (for large purchases) in nuggets, gold bars or other forms. Even more convenient for carrying around were pieces of paper money printed by the government that were redeemable in gold whenever you wanted it. It was not only more convenient to carry around paper money, it was safer than carrying large sums of money as metal that jingled in your pockets or was conspicuous in bags, attracting the attention of criminals.

The big problem with money created by the government is that those who run the government always face the temptation to create more money and spend it. Whether among ancient kings or modern politicians, this has happened again and again over the centuries, leading to inflation and the many economic and social problems that flow from inflation. For this reason, many countries have preferred using gold, silver, or some material that is inherently limited in supply, as money. It is a way of depriving governments of the power to expand the money supply to inflationary levels.

Gold has long been considered ideal for this purpose, since there is a limited supply of gold in the world. When paper money is convertible into gold whenever the individual chooses to do so, then the money is said to be “backed up” by gold. This expression is misleading only if we imagine that the value of the gold is somehow transferred to the paper money, when in fact the gold simply limits the amount of paper money that can be issued.

The American dollar was once redeemable in gold on demand, but that was ended in 1933. Since then we have simply had paper money, limited in supply only by what officials thought they could or could not get away with politically. To give some idea of the cumulative effects of inflation, a one-hundred-dollar bill in 1998 would buy less than a twenty-dollar bill bought in the 1960's. Among other things, this means that people who saved money in the 1960s has four-fifths of its value silently stolen from them over the next three decades.

Sobering as such inflation may be in the United States, it pales alongside levels of inflation reached in some other countries. “Double-digit inflation” during a year in the United States creates political alarms, but various countries in Latin America and Eastern Europe have had periods when the annual rate of inflation was in four digits.

_____________________________________________________________________________

Q. What happens when the money supply is expanded?

An increase in the supply of money works both through lowering interest rates, which spurs investment, and through putting more money in the hands of consumers, making them feel wealthier, and thus stimulating spending. Business firms respond to increased sales by ordering more raw materials and increasing production.

www.econlib.org

Money Supply. The U.S. money supply comprises currency—dollar bills and coins issued by the Federal Reserve System and the U.S. Treasury—and various kinds of deposits held by the public at commercial banks and other depository institutions such as thrifts and credit unions. On June 30, 2004, the money supply, measured as the sum of currency and checking account deposits, totaled $1,333 billion. Including some types of savings deposits, the money supply totaled $6,275 billion. An even broader measure totaled $9,275 billion.

These measures correspond to three definitions of money that the Federal Reserve uses: M1, a narrow measure of money’s function as a medium of exchange; M2, a broader measure that also reflects money’s function as a store of value; and M3, a still broader measure that covers items that many regard as close substitutes for money.

The definition of money has varied. For centuries, physical commodities, most commonly silver or gold, served as money. Later, when paper money and checkable deposits were introduced, they were convertible into commodity money. The abandonment of convertibility of money into a commodity since August 15, 1971, when President Richard M. Nixon discontinued converting U.S. dollars into gold at $35 per ounce, has made the monies of the United States and other countries into fiat money—money that national monetary authorities have the power to issue without legal constraints.

Money Supply

By Anna J. Schwartz

What Is the Money Supply?

www.econlib.org

When the Fed increases the money supply faster than the economy is growing, inflation occurs. In this situation, the increase in money circulating in an economy is higher than the increase in goods produced. There is now more money chasing not as many goods in this economy.

Investopedia.com

_____________________________________________________________________________

I am have not been able to convince myself that this last assertion is always true. I note that the US Federal Reserve injected a huge amount of money into the economy via a sequence of “Quantitative Easings” after the crisis of 2007 - 2008 without giving rise to inflation.

In the last year, since the 2020 - 2021 period of the great Covid crisis, countries around the world have experienced a lot of inflation. Why? During the Covid crisis a huge number of businesses in countries around the world were forcibly shut down and a great many businesses simply went out of business. Many others were simply greatly hampered in their operations. There was a huge amount of economic damage done in all this, great economic carnage. And a lot of damage was done to supply chains specifically. It is not surprising that all of this economic and supply chain damage would cause many shortages. Shortages of products cause prices to rise. That means inflation. Also the Ukraine War that started last February has caused shortages of gasoline and natural gas in Europe and increased prices of gasoline.

Governments also printed a lot of money during the Covid crisis so that might have contributed.

In response to this inflation our Federal Reserve has been aggressively increasing interest rates in the last several months. I am not just sure how this action will bring down inflation. It would act to put a hamper on business. I am not sure how making things difficult for business will bring down inflation. I would think that making things hard for business would create greater shortages and even higher prices and thus greater inflation.

I posed the following question for a Google search: Why does increasing interest rates reduce inflation? The answer that I got was: Because higher interest rates mean higher borrowing costs, people will eventually start spending less. The demand for goods and services will then drop, which will cause inflation to fall.

This will be true to some extent. To understand how it works you must understand how it comes about. Some people with credit cards carry all of the credit card debt that they are able to handle (and pay outrageous interest rates in doing it) and, after paying their rent and other monthly expenses, have nothing left over and save nothing. They live life all maxed out with regard to credit cards. Then when interest rates go up the interest rates on their credit cards goes up, their credit card outgo thus also goes up, and so they have less money to spend. Other people like myself are savers and always have some money left over at the end of each month that they put in savings (I have always paid my credit card balances off in full at the end of each month and have never paid any credit card interest). The degree of the above effect depends on what portion of the society lives all maxed out on credit cards in this way and save nothing versus people like myself who do not. For people like myself, higher interest rates only mean more income from savings. Higher interest rates have no impact on how much they spend.

10 Nov 2022