What Causes Inflation?

What Causes Inflation?

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    Alvexo - Inflation

    Jeremy asks us on Twitter: what causes inflation?

    Well, Jeremy, I remember the first time I played Monopoly and was handed all those cute bills of 500, 100 and 50 pound or dollar bills. They seemed so much more than that paltry pocket money my parents were giving me every week to buy ice cream. Why, with that kind of money I could go out and buy … a car?

    Only I couldn’t.

    The money wasn’t even worth the paper it was printed on.

    Suddenly, I knew how the Germans felt in 1923 when 4 trillion marks were worth one dollar, or the Argentinians in the 1980s, when terror, corruption and hyperinflation were a rife feature of everyday life.

    Years later, trying to live off a fixed salary and thoroughly disenchanted with Monopoly’s board-game currency, I had finally amassed a certain amount of savings and wondered where best I could store it without it losing value and perhaps even earning from it some extra income. Clearly, zero-interest bank programs were out; and I couldn’t afford to meaningfully invest in regular shares and wait decades to see if I’d guessed right. I decided to find out what the relationship between trading forex and inflation was, so I did some reading (it’s something I often find I have no choice but to do).

    Apparently, the root cause of inflation is governments, or rather whoever does the money printing for central governments – i.e. central banks. Also, there is a difference between causing inflation and controlling it. Let’s begin with the former.

    What we need to remember, at this juncture, is that what a country is worth – its total assets minus its financial obligations – is a more-or-less measurable value. And in order to enable commerce between people, entities and the country itself with its trading partners, some of that net worth is represented by currency, whose value that government is supposed to guarantee.

    When there isn’t enough of it (money) the government simply has more (again – money) printed. Unfortunately, ‘more bills’ doesn’t mean the country suddenly got richer; it simply means each bill is worth less than it used to be.

    The Chinese (as usual) were the first to figure out this little scam. It only took them 300 years from the moment they introduced the concept of paper money (10th Century, more or less) until they realized that they had printed their way into hyper-inflation (that’s where inflation is so high that it can double prices on a daily basis and people simply abandon the currency in favor of gold, goats and other valuable assets).

    The simplest approach to inflation states that inflation is a direct result of increased money supply – print more money; it’s worth less; producers want to maintain the value of their product; prices rise; money is now worth even less; people need more money; that’s inflation. Adherents to this approach (such as Milton Friedman) are called ‘monetarists’.

    Nowadays, economists believe that inflation is both good and bad; and in order to justify that duality, they have created rather complex models to explain why inflation occurs. There are quantity and quality theories for money and production, first formulated by Adam Smith and David Hume, and the Keynsian approach that ascribes visible inflation to the self-expression of economic pressures through prices. Keynsians even believe that simply printing money does not cause in itself inflation, since the demand to print money comes, not from governments, but from commercial banks making demands upon central banks for additional credit.

    Let’s start with the simplest form of inflation – the one we all know about. That’s where a person unable to cope with rising prices asks for a raise. The boss gives it to him/her, but then raises the prices of whatever his/her company is selling in order to cover the cost of the raise. The aforementioned employee is now back where he/she was before his/her threat of a strike, more money in his/her pocket but with the same amount of (now more expensive) tomatoes in his/her shopping bag. Nobody has printed any money yet, until someone in the government cafeteria asks for a tomato sandwich, which is prohibitively expensive so they print more money sending everybody back to square one. The ensuing vicious circle is referred to as ‘hangover inflation’.

    ‘Cost-push inflation’ is the result of more expensive production costs, which a manufacturer then passes on to the consumer.

    Finally, ‘demand-pull inflation’ is the result of increased spending – primarily by governments. This is the kind of inflation that generates economic growth, thanks to excess demand and investment stimulation. One way to create excess demand (that’s when the entire or aggregate demand is more than what the economy can supply) is to print money at a rate that is faster than the speed at which an economy is actually growing. The money is worth less; people have more of it; and there’s less to do with it.

    Now, we all know that inflation, employment and gross domestic product (that’s how much stuff a country makes) are closely related, rising and falling more or less in tandem. However, over the years, it has been found that rising employment will only increase inflation in the short-term. Not only that, but ‘rational expectations’ theorists believe that investors and other interested parties will try to anticipate a central bank’s activities and create their own self-fulfilling prophesies, based on a central bank’s credibility and relative softness/toughness of policy expectations.

    And so, given that the causes of inflation are many and manifold, there is a need to control the beast, and that – again – is the job of governments and central banks that determine fiscal and – more importantly – monetary policy, respectively. Clearly, by controlling the amount of money printed and the benchmark interest rate, central banks are the ones best situated to control inflation. By raising interest rates, less people will make loans and there will be less need for money, thus lowering inflation. The idea is to keep levels at a point in which people are taking loans, spending and stimulating the economy towards growth but, on the other hand, not losing impetus due to inflation that is hard to keep up with. Controlling taxation and government spending is also a means of controlling inflation, as are wage and price controls (a characteristic of war-tie economies), but some might say that that’s putting the carriage before the horse.

     

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