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What is Inflation?

From my book on the Great Financial Crisis, remembering that it was written in the form of a conversation:


Prices change for an item (or service or labor) for three principal reasons (I am going to ignore the roles of taxes, duties, and other governmental effects):

1. Supply or demand for the item or service changes

2. The amount of money changes – this is inflation in the fundamental use of the word

3. The value of the dollar changes


The concept of supply and demand is fairly straightforward. Let’s say there were 10 apples and people only wanted six, then supply would be greater than demand, and in order to get rid of the apples, the grocer would lower the price. Or there is one house with two interested buyers. Supply is less than demand and the seller will be able to get a good price by having the two buyers compete. You do not have a high school diploma and are unskilled. There are thousands of people like you, so that the supply will be higher than the demand, resulting in a relatively low salary. There is only one Tiger Woods, and a lot of people want to see him do his thing and to listen to what he has to say – maybe fewer these days, but still a lot of people. Tiger will make a lot of money.


That’s the way it works with everything, all the time, in the economy – cars, iPhones, houses, your salary, dry cleaning. The market sets the price through supply and demand.


Money is simply a medium of exchange – a simple way to convert labor into iPhones or a hamburger dinner. I work, I get money for my work, I buy a hamburger for money.


If the supply of money is constant and all the goods and services in the world are constant, the overall price of everything cannot change. If the price of something goes up, and the money supply is constant, then the price of something else has to go down, keeping the overall price level constant.


Let’s say the entire world consisted of $100, 10 apples and 5 pears. Supply and demand would result in some allocation of the money between the apples and the pears – let’s say $8 per apple and $4 per pear.


Assume a chef appears on Oprah and recommends an apple recipe. Everybody wants apples. Since there are only 10 apples, the price shoots up to $12. Since there is only $100 in the world, the price of pears would have to decrease to $1. But overall, prices have not changed – apples went up; pears went down; overall unchanged.


If there were an apple tree disease and the number of apples dropped by half, then, all things being equal, the price of apples would go to $16 and the price of pears would stay the same.


Changes in supply and demand do not strictly result in overall inflation because somewhere, price increases balance price decreases. However, since we refer to any increase in price as inflation, this can all be confusing. Whenever I discuss price increases I will clarify which type of price increase I am talking about.


Very quickly, let’s discuss why salaries generally don’t go down.


Let’s say that the aggregate salaries of all the people in the world is $1 million, and that all those people are producing goods and services. One day, for whatever reason – maybe people have purchased all of some of the goods, say tennis shoes, they need – demand goes down by 20%. Ignoring all kinds of complications, demand for people would go down 20%, and, just like in the case of the pears, the price of people – their salaries – would go down, say, 20%. That’s the way the market works.


Only, we are not pears and we take salary reductions personally. Politically, it just almost cannot be done.


But the law of supply and demand is an iron law, so that saying “it can’t be done” is like saying we want gravity to stop.


The (very) simple answer is that unemployment increases to 20%. We have decided to have a society in which unemployment of the few is generally preferred to continually changing wages for the many.


Moving right along, we get to the heart of the matter - inflation. Continuing our previous apples-and-pears example, one day the government increases the supply of money to $200 – it just prints more money. Assuming that there are no savings, what happens to prices? Since the supply of apples and pears did not change and the demand for apples and pears did not change, prices would just double, strictly because there was more money.


That is inflation – increasing amounts of money chasing the same amount of goods and services.


All governments inflate all the time, if they have the chance. Once the money supply is unconstrained by the gold standard, the government is free to print as much money as it can get away with. To give you an idea of how much the government has inflated, goods and services costing $1 in 1934 when FDR came into office, would today cost $17.90. Put another way, a dollar today would have had the same purchasing power as less than $0.06 in 1934.


The only way to accurately look at numbers denominated in dollars over a long period of time is to adjust them for inflation, which I will do as we go along. (There is a good argument to be made that the government has fiddled with the official measures of inflation to make them appear lower than they are. I will not get into that discussion, and will use official numbers when presenting after-inflation amounts. Beware, however, that numbers over the past few decades are probably worse than presented.)


My government does this? I thought the Fed was supposed to stop inflation.


Get over it. You got over the tooth fairy and Santa Claus; get over believing that your government does not have its own agendas and one of them is inflation.


















Figure 4 - Estimated Consumer Price Index, 1800-2009


Think about it for a second. The Federal Reserve was created in 1913, and a dollar today will buy what 4 cents would have purchased in 1913. Either they are incredibly incompetent, or incredibly stupid, or …


They really aren’t serious about inflation.


Atta boy. I’ll make a cynic of you, yet.


The Fed’s targeted rate of inflation is 2% per year. A usual reaction to that target is, that’s really low. However, at 2% per year, prices will essentially double in about 35 years. That means that during your lifetime, at 2% inflation, prices would more than quadruple.


Tell me, oh cynic, why do they do this?


Governments do this for several reasons.


The first is the time-honored task of paying debt with devalued dollars. If you owe a lot of money, like our government does, then you want to devalue the currency so that you eventually pay back fewer real dollars – in terms of purchasing power – than you borrowed. An attempt to get something for nothing that works surprisingly well … for a while.


Another is that they are more afraid of deflation than inflation, so that they bias the economy toward inflation to give some cushion against deflation.


Another is to make you feel better. Back to that cost of living raise. You work hard, you think you deserve something whether you do or not. And, lo and behold, up pops a cost of living raise to make you feel better. What really happens is that your income went up to offset increased costs, but for some reason you still feel better. Contented voters vote for incumbents.


A scam?


Yep, a scam. But an effective one. And one in which you are compliant.


However, you might contemplate the following quote by Keynes: “Lenin is said to have declared that the best way to destroy the Capitalistic System was to debauch the currency. . . Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million can diagnose.”


We are in the midst of one of the grandest debauchings of our currency in our history.


What, then, is deflation?


If inflation is too much money chasing goods and services, then deflation is …


Too little money chasing goods and services. But I don’t see how that can happen. Just print more money, right? That’s one of the reasons you said we went off the gold standard in the first place.


I love it when you pay attention.


I will give you a simple answer for now, and then make it a little more complicated when I discuss the implications of some of Obama’s policies on the prospects for future inflation (hint, it is potentially very ugly – but not for a while).


Deflation can occur when everybody decides not to spend money, as happened during the Great Depression and as began to happen in 2008.


Going back to supply and demand, if demand falls drastically, as happens in a recession or depression, and supply stays the same, price has to come down. Deflation occurs. If supply decreases to meet demand, if businesses cut back because no one is buying what they have to offer, that means that more people lose their jobs as manufacturers slow down, and demand decreases further, creating a negative, reinforcing spiral downward.


Printing money does not help because I don’t want to spend money no matter how much money the government is printing. I am scared, or I lost my job, or I am going to pay down my debt, or I am going to save, but for whatever the reason, I do not want to spend. If enough people do not want to spend, prices will come down. This is what famous British economist John Maynard Keynes, who was influential in creating policies to combat the Great Depression, called the “liquidity trap.” Basically, it does not matter how much money there is if no one is spending it.


Got it, thanks. You never talked about the third source of price increases.


Ok. Up until now, we have looked at simple cases of price increases within simple, closed societies. However, the world we live in is globalized (as was the world in 1929, by the way), and much of what we buy comes from overseas – from countries that have currencies other than the dollar. We are exchanging green pieces of paper for big screen TVs and foie gras. On the other side of the transaction, people are exchanging their big screens and foie gras for green pieces of paper. They have to decide what that green piece of paper is worth, since it is no longer convertible into gold.


The dollar is like an IOU from the United States. It is like lending $1 to your brother-in-law and receiving an IOU from him. What is his IOU worth? If he is honest, hard working, has an education and a job, and the economy is going well and is expected to go well in the future, that IOU from your brother-in-law is probably worth what it says it is worth – a dollar. If he is a gambler, or an idler, or a drug addict, you might as well throw the IOU away. If he is a recovering drug addict, who is trying to get his life together, you might pick a number that is greater than zero, but less than one.


A foreigner who holds a dollar is in exactly the same position as you are with the IOU from your brother-in-law. He will value that dollar based on the integrity, policies, and prospects of the United States.


Let’s say a big screen costs $2,000. For some reason or other, the US government decides to implement sober, responsible economic policies and the prospects for the US, compared to today, get better. The foreigner increases his view of the value of the dollar, and is now willing to sell you a big screen TV for $1,900.


Or, say that for some reason or other, the US government decides to implement economically foolish polices and the prospects for the US, compared to today, get worse. The foreigner becomes concerned and decreases his view of the value of the dollar and now demands $2,100 for the big screen TV.


That’s how changes in the international value of the dollar can cause prices to increase or decrease.


And, by the way, the value of the dollar will be one of the biggest determinants of our future wealth, and one of the most important subjects I will be discussing later.


In the meantime, prices go up and down for three principal reasons, each of which can be going in either direction at any given time:


1. Changes in supply and demand

2. Inflation or deflation – changes in the money supply relative to the amount of goods and services

3. Changes in the international value of the dollar

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