Inflation is a term used with consistent regularity in the business and finance media, as well as by politicians and bankers, who would all have us believe that there essentially is no inflation. This would obviously have to mean that all the people I talk to around the world, in the UK, USA, Germany, Ireland, Australia, etc. would have to be wrong about their perceptions of rising prices month in and month out.

But how many people have actually stopped and thought about what inflation actually is and how it is caused. Many people I talk to simply state the modern "definition" of inflation as being a rise in prices. So, let's take a look at the subject in a little more detail.

The Basics Of Inflation

In order to really understand inflation you have to start with the idea that prices of goods are defined by the economic law of supply and demand. If more people demand a certain product, but the producers are unable to quickly come up with the additional produce, then prices for that particular item will go up. The very opposite happens if consumers suddenly demand less of a product, but producers are still offering the same amount for sale. Supply and demand affects pretty much everything in the economic world, just like gravity affects the world of physics, and it is no different when it comes to inflation

Keeping this in mind let us imagine an economy where the money supply is fixed at a certain level. What I mean by this is that the total amount of money in the hands of people and organisations is a fixed amount and does not change at all. Now imagine that in this economy there was suddenly a higher demand for a certain product, but the supply stayed the same. This would mean that prices would have to rise as demand is higher than supply; essentially, more money is chasing the same amount of goods. But because more money is now chasing one particular product, there is less money that can be spent on other products, meaning lower demand for other products, as the amount of money in supply is still fixed.

As an example consider a very small island economy that has \$100 in money supply and the only thing being traded in any given week is one cow and one sheep at a current price of \$60 and \$40 respectively. If the person selling the sheep suddenly charged \$45 for the sheep because there was more demand, then there would be only \$55 left to be traded for the cow. This means that with a fixed money supply the price of one set of goods can only go up if the price of a set of other goods goes down.

What this all comes down to is that in an economy with a fixed money supply, the price of all goods cannot go up together, and that the overall price level has to stay the same.

European Central bank

How Can The Overall Price Change?

The only way that the overall price of all goods can go up or down is by manipulation of the money supply. If you add more money to an economic system, but the level of production stays the same, then all that happens is that overall prices go up. So, when people say that inflation is the increase in the overall price level, they are actually referring to the effect of inflation. Inflation itself is an increase in the money supply, which is why Milton Friedman famously said that "inflation is always and everywhere a monetary phenomenon.".

What always gets me is when you hear central bankers from around the world talking about their mandates to keep inflation at a certain "low" level. But as we have seen, it is the very actions of central banks, by manipulating the supply of money, which drives the level of prices in the first place. For central banks to say that their main focus is to hold inflation low is like a whiskey distiller saying their main purpose is to reduce the amount of alcohol consumption, or a fire fighter setting a fire in order to put it out.

So Why The Confusion?

All this leads to the question of why do there seem to be different definitions that add to confusion? To understand this we need to look at who supplies information about price inflation and who benefits from this information. In the various countries around the world, it is usually the government's statistical offices in conjunction with central banks that work on calculating and publishing the level of price increases, which is how they define inflation.

It just so happens that both governments and central banks are generally the most vocal proponents of printing more money in order to "help the economy recover". At the same time they are adamant that price inflation is low, or even declining. Confusion over inflation is most certainly the result of governments actively pursuing inflationary monetary policies, while distancing themselves from the affects on prices, and even understating the affects.

But why would they do this? Why tell the public that more money is needed and that it will have no effect on the price level? To answer this we need to take a look at who benefits the most from inflationary monetary policies.

Who Benefits From Inflation?

So far we have stated that when newly created money is pumped into the economy the level of prices goes up. If everyone would be given \$100,000 tomorrow morning, we would not be any richer as the price of everything would simply go up. However, the first people to notice that they have the extra money would be the ones that would gain, as they would start buying before overall demand has gone crazy. Those that sleep in until the afternoon would have missed out completely. This means that the further up the monetary food chain you are the more you gain from the new money being put into circulation.

That is why newly created money is not just given to the general public; it is either given to banks at an extremely low interest rate or used to buy government bonds off the open market. What the banks usually would do is lend it out, but in times of economic distress and uncertainty they want to pile it into the safest possible place. And where would that be? Generally government bonds are seen as the safest place to park cash. The reason for this is that if there is ever any problem of repaying the bonds, governments can always have more money printed. The conclusion here is that the two entities that benefit the most from newly created money are banks and governments, as banks are given really cheap money that they automatically get a guaranteed return on by handing it over to governments, and governments can borrow money for their spending plans. The two are completely intertwined and proverbially in bed together.

Who Loses Out Through Inflation?

By the time the money filters through banks and governments and ends up in our hands, the purchasing power of the money has gone down, as prices have gone up; we essentially get no benefit and are left with higher prices. And to add insult to injury, the tax payer also has to pay more out of their diminished income to pay back the loans.

Governments, on the other hand, are able to borrow lots of new money, spend it at current prices and then in the future repay the debt with less valuable money. This makes inflation beneficial to debtors at the expense of creditors, as creditors will eventually receive less valuable money back in repayment. And this is why governments are so much in favour of inflation, because they are among the biggest debtors in the world and have the most to gain from a depreciating currency. It is also because of this fact that politicians are so adamant that deflation, the opposite of inflation, is such a detrimental thing.

Is Deflation Really A Bad Thing?

Would you really be upset if you went to do your shopping today and noticed that for the same things you bought last month you are now paying less? At what stretch of the imagination does this harm the average citizen and especially the poor?

Of course politicians have an answer to this. In their warped world they claim that if prices were falling then people would not buy anything in anticipation of lower prices and the economy would collapse. These claims, however, are fictitious and totally devious in nature, as they simply cannot be backed up with any observations in economic reality. Take computers, cell phones and flat screen TVs as prime examples. The prices for these items used to be so high that only the very rich could afford them. I remember seeing a 40 inch flat screen TV with a five figure price tag not even ten years ago; today you can pick them up for less than four figure sums. If price deflation would really result in people not buying things, then nobody would be buying phones, or laptops, or iPads or fancy TV screens. But reality is that as prices go down, more and more people are able to afford them and sales go through the roof.

Another poltical argument is that falling prices cause problems for producers of goods, as they can no longer produce stuff profitably and end up losing money. This is also a total non-argument, as when overall prices fall, then prices of the input costs and raw materials also go down. For a company producing something, it is the margin between production costs and selling price that matters, not the sale price on its own. To look at one without the other is disingenuous at best, but I would call it deceptive.

Conclusion

The bottom line is that when people talk about inflation in conjunction with price increases, they are actually talking about the effects of inflation, and hopefully you are now equipped enough to correct them.

Image Credits: kumbarovDerFussi