Inflation: The Basics

It would appear that there is some disagreement here at EvC on the nature of inflation. While, in my opinion, this disagreement is about as justified as that between a YEC and a geologist regarding the age of the Earth, it exists nonetheless and so it is probably worth addressing.So far, this disagreement has been derailing a thread started most recently by Phat: Social Unrest?. It started when DBlevins posted the following reply to my statement that paying more for less labor was a championing of 'inflation and economic failure' (Message 10), triggering a volley with myself and Damouse:

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DBlevins in Message 25:

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Everyone 'champions' inflation. No economist champions deflation.

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Damouse made a reply representative of the position of those opposing this view:

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Damouse in Message 63:

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Inflation is not good. Inflation is loss of stability of a monetary system.

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By definition, the rise in price gained by inflation on assets and investments is NOT an increase in value, under ANY shape or form. Inflation devalues money, which increases the number next to your asset, but it doesnt make more or better asset for you.

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To go with this, I gave an example of a non-inflated vs. inflated economy that I think is important-enough to repost here, as it lays out the differences pretty simplistically:

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Jon in Message 70:

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We have an economy: E. Remember, an economy is just a group of folk who trade things. To make their trading easier, they invented money: . Remember, money is just an easy-to-use Standard of Scale that lets folk understand the value of many different things in terms of only one thing. To simplify this example, we focus on only one good in this economy: G. Oh, and people: F.

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Economy: E
Money:
Widgets: G
Folk: F

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Goods are hot items, and everyone wants them; folk will buy Goods so long as they have money for them.

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So, we set up our economy. We have:

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10F
1000G
10,000

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The 10,000 is spread equally over the 10F (100 to each), who, of course, use ALL of it to buy up the 1000G. The price per good: /G = 10,000/1000G = 10/G. We can figure out the REAL VALUE of by comparing it to the # of G that can be bought with it. Since each G costs 10, the value of is calculated as G/ = 1G/10 = 0.10G/, which only tells us that because it costs 10/G, each can only buy 1/10 a G. The REAL VALUE of (as measured in an actual, REAL, goods, G) is 0.10G.

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Behold! A second, almost identical economy: E2!

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This economy is almost exactly the same, except:

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10F
1000G
20,000

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As before, all of is divided over the 10F (200 to each this time), who, as before, use ALL of it to buy up the 1000G. This time, the price per good: /G = 20,000/1000G = 20/G. We can figure out the REAL VALUE of by comparing it to the # of G that can be bought with it. Since each G costs 20, the value of is calculated as G/ = 1G/20 = 0.05G/, which tells us that because it costs 20/G, each can only buy 1/20 a G. The REAL VALUE of (as measured in actual, REAL, goods, G) is 0.05G.

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Now enter Mr. MoneyBags. He wasn't bright enough to convert all his money () to goods (G), so he only has money. In which economy is his money () worth more? In which economy does his money () have more REAL VALUE? Is this the economy that represents Inflation (where the price/good is higher), or the one that does not represent Inflation (lower price/good)?

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In the real world, Mr. MoneyBags is a low-income man on a fixed budget; he doesn't have any goods he can sell, only a fixed income; when the price per goods goes up, the value of his money goes down. Poor Mr. MoneyBags... poor average citizen in an inflation.

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crashfrog has also joined the debate, though, like Damouse, I am inclined to think he is just playing around:

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crashfrog in Message 75:

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More people can have more money and choose to save it, and there is no inflation.

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This is the only thing you're right about. And why is that? Why is it that the government could give everyone a thousand dollars to bury in their backyard and it wouldn't drive up the price of anything but shovels?

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Because inflation is caused by more money chasing the same amount of goods and services. The prices of goods and services are driven up as a result. It's supply and demand. You remember supply and demand, right? When demand increased but supply does not, the prices go up. That's the cause of inflation - more money chasing the same amount of goods and services.

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But that's a good thing. More demand for goods and services puts more people in the business of providing goods and services. Any goods or services that people already have increase in price.

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The primary arguments, then, appear to be:1) Inflation is bad:
a. Inflation decreases the real value of money, and this is bad because anyone today holding money from yesterday has something with less value.2) Inflation is good:
a. Inflation increases the price of goods, and this is indicative of an increase in the value of those goods.
b. Inflation is a representation of an increase in demand, which drives up production and economic growth.Thus, there is some clear disagreement on even the most fundamental aspects of inflation; even the basics cannot be agreed upon.So, let's have a little chat about the basics of inflation.JonEdited by Jon, : -ve +s

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1) Inflation is bad:
a. Inflation decreases the real value of money, and this is bad because anyone today holding money from yesterday has something with less value.

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If this is the only criticism of inflation, then it is a rather poor indictment at least for modest levels of inflation. After all, the way to counteract the decreasing value of a dollar due to inflation is simply not to put money in your mattress. Either spend the money or invest it, and both options generate wealth for you or others.We don't want people doing the equivalent of putting money in their mattress.

First, let me quote the message in its entirety for sake of having everything in one thread:

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DBlevins in Message 79 of Social Unrest?:

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To ease congestion I thought I would combine my response to Jon.

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Post 74

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I assumed this was the case when I replied to you earlier. You never addressed the issue.

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I never addressed the issue because I never said I was talking about during the war, but afterward. Your question didn't seem relevant to my statement about the economy, unless you could be more clear about why you bring up the economy during the war versus the economy after.

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Certainly wasn't money spent on condoms...

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Flippant but perhaps I deserved that. M increased, but what happened to the economy?

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No, they COST more; their VALUE does not change.

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Jeebus. I'm not sure if we are talking around each other or you are purposely being obtuse.

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Do the checks increase or decrease the amount of money in circulation? In our example, does it move us from E1 to E2, or from E2 to E1?

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It depends on what they do with it, wouldn't you say .

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Let's get back to the real world. We expect that if the economy is working properly, an increase in monetary supply will cause inflation, but it will also likely cause an increase in productivity, which has the effect of eventually suppressing inflationary pressures. Of course any large shock due to pricing caused by supply and demand pressures or any shock induced by monetary policies can induce either hyperinflation (bad) or stagflation (bad) but if everything works and there are no shocks then most economists would agree that having that little bit of inflation is a good thing.

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Small condolence, since the money left over is now worth less than yesterday.

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Not if your purchasing power has not been significantly affected, which would be the case when productivity has increased. You're telling me that you would rather pay 6% interest on your house than you would 4%?

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Now on to post 78

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It is less.

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But this is off-topic, really. We should start an inflation thread.

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Not necessarily. While I agree that prima facie it would appear to be the case that my dollars are worth less, that would be the case IF everything else cost more as well. It might even lead to inflation if this happened in significant portions, but this is a one time occurence where the value of the dollar remains the same, it is the subjective value of the pencil that has increased. If you can buy more things because you sold that pencil for more, the dollars value with respect to your purchasing power has basically remained the same.

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Now, I will reply to it: Interestingly, I never made any comments about the economy during the war; Damouse did, though, and perhaps your reply was meant for those comments. My question was:

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Jon in Message 61:

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A return to the prosperity of the post-war and pre-reagan economy.

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Huh? What caused post-war prosperity?

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I had been assuming WWII, but you replied to me by talking about the 90's, and so I thought maybe I had guessed the wrong war. Since we now understand that it was WWII you were talking about, I think a reply to my question is in order. Indeed; but to keep it from having an impact on the amount of money in circulation, we'd have to prevent every single person who receives a check from spending any of that money. This is unlikely, and so these government checks are undoubtedly going to impact the amount of money in circulation. With that cleared up, perhaps now you can answer the question: What is the impact of these government checks on the amount of money in circulation?Productivity where? If my earnings do not increase, then I have the same amount of money; unless you can keep my income rising with inflation, then the overall effect is a decrease in purchasing power. You're not accounting for the affect of the labor pool. No; your dollars are worth less than the dollars of the person who only paid $100 for the same pencil. Value of money is determined by the amount of goods/services it can buy, using a simple equation: Goods/Money. In this case, the $100 has more value than your $135, since less money is used to buy the same good (p = pencil):1p/$100 = 0.010p/$
1p/$135 ≈ 0.007p/$That real value of money is not the number next to the $ sign. It is not the amount of goods/services for which it 'might' be exchanged. It is the amount of goods/services for which it can be and is exchanged. You are using 'value' in two different ways here, which I think is the cause of fault in most of your argument. Can you separate them before we continue?Jon

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Tough. This is exactly what the poor do with almost all of their moneyand they have no choice. The physical assets they do have are not saleable, as their life and/or livelihood is upon them dependent.Most people are poor. The majority of people are negatively affected by inflation.Jon

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I like your intent here, but I'm afraid your complex style and in media res dealie-o are going to throw some people off and potentially murk things up for you.So I'm going to start with an even gayer fake economy and walk through the repercussions. I don't know if this will really help much, but whatever, my heart is in the right place?So imagine an island economy, with coconuts for goods and something for money. We can imagine them as shells that the chief has signed, but for convenience I will call them dollars. We begin with a hundred coconuts and a hundred dollars. Thus, each coconut is now worth about one dollar, subject to minor variations around the island due to free trade.The merchant Mbonga however, learns to make coconut pies. These pies are delicious and desirable and popular, they are worth more to the buyer than a coconut. Let's say Mbonga is charging two dollars a pie, and can make two pies from one coconut. Thus far he has made 5 pies for sale, and also eaten one as a nice publicity stunt. *licks lips*At this point he has invested 3 dollars and stands to make about 10, he is making a profit based on the value he has added through his work, and the economy is growing where he is due to increased productivity. But with the money supply at a fixed amount, any such growth must be reflected by an equal amount of shrinkage. When Mbonga goes to buy more coconuts to make even more pies, they will only cost about ninety cents each, and their price will continue to decrease as new productivity creates new desirable goods. Perhaps Phil will invent coconut wine, perhaps Natalia will develop a market for stained coconut masks. As long as the market remains free and the money supply remains fixed, all new production will decrease the price of existing goods.At this point, wise old Rosenfelt and his cronies notice, that the actual buying power of the money is increasing. Instead of doing work to improve goods to make a profit, all they need to do is hoard money! At this point the cash represents a better investment, what could buy you two coconuts today is likely to be able to buy you 4 tomorrow, just be patient.This has the effect of taking money out of circulation, which only increases the problem. The less money is available, the more desperate the sellers become. These coconuts dont last forever, you know. The people who might be taking care of the trees and doing the bottom level work of production are starving off, and the economy is collapsing. The great depression has arrived, and while a dollar is worth a lot, no one has a dollar.The obvious solution is for the chief to sign more shells and get them moving in the economy. More dollars means the buying power of the individual dollar goes down again and it is no longer advantageous to hoard them. This is what is called inflation, and far from being a bad thing, it is the only thing that keeps a large interconnected economy from collapsing in on itself.The main problem with just printing money though, especially once the economy is already collapsed, is that the new money is quickly considered worthless. So a couple of witch doctors are called upon to do various "find the pea" and "three card monte" tricks to get the money into circulation without undermining public confidence. Generally they pretend to loan it back and forth to one another a few times in order to establish a fiat value for it. Their names are Federal and Reserve.

well they should put their money in a bank and find one that gives more intrest than the inflation "takes away"the bank keeps the money in motion and they get more of it than it's lost valuea healthy inflation is a good thing around 1-3% the guy that posted above explained it very well.

Both of these arguments can be true: These positions are not mutually exclusive. Inflation can be both "good" and decrease the real value of money. Sure, that sounds bad, but hardly anybody is sitting on big piles of money. Primarily, people are using their money to buy things, or else they're loaning it to people who are using it to buy things.More demand for goods and services is an indisputable good thing. Seriously, there just can't be any dispute about the merits of demand, can there? Therefore to the extent that inflation represents an increase in demand for goods and services - which it almost always does - it's a "good thing", to at least the first order of approximation.

Quite correct. Poor people are sitting on small piles of money, the value of which decreases with inflation. Rich people hold their wealth in capitaltangible stuff. So, yes, no big piles of money out there. I know; I separated them because they appeared to be representative of the two 'pro-inflation' arguments being made in the other thread. Each of you, however, had mixed the two parts a little, but I thought it worth mentioning the difference. Depends; are there means to meet that demand? Who will meet that demand? See above; the assumption that an increase in demand is inherently a good thing is quite simplistic and, dare I say, nave.Jon

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No, you've misunderstood me. What I meant was that

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Inflation decreases the real value of money, and this is bad because anyone today holding money from yesterday has something with less value.

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and

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a. Inflation increases the price of goods, and this is indicative of an increase in the value of those goods.
b. Inflation is a representation of an increase in demand, which drives up production and economic growth.

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aren't mutually exclusive or contradictory. It can be a good thing that the value of sitting on piles of money decreases. I think you'll find that poor people aren't sitting on any piles of money. (This is an example on your part of how many people who talk about economics don't seem to evince any understanding of how things actually work in the real world. See: all the economists who can't understand why people stand on escalators and mount staircases.) What the poor are sitting on, primarily, is the value of their labor - which increases during inflation, because the poor disproportionately have jobs making things and providing services, the value of which increases during inflation - and a fair bit of debt, which inflation also effectively decreases (they don't adjust the principle of your mortgage or car loan for inflation.) In a recession? All the people who are currently out of work. All the goods currently languishing unsold in warehouses. All the shuttered factories. Inflation is good when you're experiencing a shortfall in demand, because more money chasing the same amount of goods creates demand for more goods. See: US economy, 2008-present. Hardly any more naive than saying "inflation is bad", which, as you'll recall, was the conclusion of the post of yours I replied to. Is the truth more complicated? Obviously there's an extreme of inflation that is no good at all. But healthy economies are recognized by their possession of a certain degree of inflation. Indeed, if it weren't for inflation, the natural growth of population would leave us all bankrupt and starving, as more and more people had to compete for less and less money. Inflation is how we introduce extra money for all the new people to have.So, for the most part, it simply can't be argued that some inflation is a good thing. That is why, universally, economists recognize good economies by a good rate of inflation and bad ones by a rate that is either too low or way too high. Even the economists you like, Jon.

I wonder, is demand linked to the size of population by any "known" relationship? Obviously more people means needing more stuff, but what exactly if any is the link.If as crash says, inflation is necessary to keep the amount of money available fair to the number of people alive to use it (inflation required to match demand) does that mean countries/economies with decreasing populations should have a significantly lower or inverted rate of inflation to account for the lower number of people?

If you had read my previous posts, you would have seen that you've taken my 'INFLATION IS BAD' comment out of context. I also said:

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Jon in Message 17:

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When inflation occurs, deflation is the quickest fix.

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Is the system inflated or deflated? If you believe it inflated, then you should adopt my solution above. If you believe it deflated, then an alternate solution is required. If you believe it inflated, but continue charging more and more for the same output each successive day, then the system will fail.

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Before pretending to have a grasp on your opponent's position, you should first bother understanding itin full. Out of work where? Factories where? Demand from whom? Whose labor? There is a problem with your theory; it doesn't account for certain things. Can you spot what those things are? The questions above were designed to help you with that. Value ≠ Money. Is 1 hour of work still worth the same amount of bread?JonEdited by Jon, : Begin Editing...Edited by Jon, : End Editing...Edited by Jon, : No reason given.

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Out of work everywhere. No economy has full employment. Factories everywhere. No economy is perfectly efficient. Demand from all the people with more money, obviously. The labor of people who make goods and provide services, obviously. The questions above are stupid, predicated on your failure to understand how things work in the real world. Money is precisely how we measure value, just as "units of length" is precisely how we measure distance. You can no more pretend that they're completely unrelated things than you can pretend that your height is unrelated to the number of inches between your feet and your head.

I'm sorry, I may not be understanding correctly. You seem to be saying that there are circumstances in which what you are calling "deflation" (an overall increase in the buying power of existing currency) could ever be good. This would be incorrect, for reasons I have already tried to demonstrate.This "deflation" is self-perpetuating, it becomes depression, and the normal 19th century fix, large-scale war, is no longer considered a viable solution since the develop of chemical and nuclear weapons. Inflation, on the other hand, is self-correcting. This doesn't mean recessions are good, by any means. But recessions will eventually go away on their own, they don't require an economic reboot (read: martial law, authoritarian measures, rapid population reduction) the way that depressions do.The reason we don't try to keep inflation as close to zero as we can is because normal market fluctuations could drop it below zero and from that point forward the economony would essentially become unrecoverable. The reason it is going so badly now is because the circulation of money has increased drastically in the past few years. Essentially, in free market terms, prices need to double. But because of the low and "fixed" income victims you are concerned for, governments have found it necessary to intervene and slow down these rising prices, generally still through indirect means in the west however.Regardless of means though, this protectionism has the effect of impeding the free market, which is represented as a decrease in normal productivity. As a result, businesses are holding their breath, unemployment is rising, and various monopolies are begging the question for a living as a way of blocking up legislative processes.

Declining populations have quite a few things to be worried about, from an economic point of view. As population rates decline, the demographic profile starts to shift toward the grayer or older part of the spectrum, which puts an added burden on the ecomony:less input to pension and entitlement systems and more withdrawals, which will cause a shift to those still in the workforce paying higher premiums.Increased pressures on the healthcare system.Less creativity and adaptability within the workforce.decline in markets leading to less investments adversely affecting economic growth.Effectively lower savings rates. The above is by all means not a comprehensive list, and there can be argued that there are positive aspects to a declining population (Ex. A decrease in energy consumption) but I am not sure you could say that declining birthrates would have much impact on inflation rates.

Deflation is the last resort of a severly impacted economy. Mainstream economies will first resort to disinflationary policies. I can't believe that you are advocating a total restructuring of an economies currency, a la Zimbabwe, in order to correct an inflated system.You are totally out of your rockers here!Don't confuse disinflation with deflation!