What is the cause of inflation?
Inflation occurs when the amount of money in an economy increases relative to the number of goods in the economy.
Imagine a very simple economy: there are 100 products in total and 100 units of money (100 dollars for example). The average price of a product is then:
[center]100 dollars (the amount of money) / 100 products (the amount of products) =
1 dollar per product. [/center]
Inflation means that you get fewer goods for your dollar, i.e. that things become more expensive. The average price of a product will then for example become $1,50. The inflation then is 50%.
This is only possible if the amount of money in the economy increases relative to the number of goods. As long as the number of goods does not increase more than the money supply does, there will be inflation. This can happen because of changes in the money supply and/or because of changes in the number of goods in the economy (for example a huge natural disaster may destroy a massive number of products causing the same amount of money to chase fewer products) Almost always however inflation occurs primarily because of relatively high increases in the money supply despite increases in the number of products.
To go back to our example, when the average price of a product increases from $1 to $1,50 and the number of goods in the economy stays the same then this can only be so because the amount of money in the economy has increased:
[center](the amount of money) / 100 = 1,50. Therefore, (the amount of money) = 150. [/center]
What is the cause of deflation?
Deflation is caused by a decrease in the money supply relative to the number of goods in the economy.
When economies grow then more and more goods come on the market. When the money supply stays the same or does not increase as fast then deflation will occur. Thus if the money supply stays the same, then deflation is the normal phenomenon in times of economic growth: products become cheaper on average. Since our economies have generally grown over the past 200 years we would expect a long-lasting deflationary period. That this has not been the case is attributable to the increase in the money supply outpacing the increase in the number of goods.
Sometimes, such as in periods of depression, the money supply decreases (in a later section we will see how this is possible) while the number of goods stays the same. In those cases deflation does not indicate economic growth but has as its cause the contraction in the money supply.
But doesn’t inflation have other causes?
Although you may hear a lot of other explanations for inflation, some of which are quite complex, these simply cannot be correct.
Politicians, consumers and unions may blame greedy businesses for inflation because these increase their prices for products and services. These business men in turn may say that they had no choice because the wholesale stores, where they buy their goods from, were the ones who increased their prices, and these wholesale stores in turn may put the blame on the higher prices for natural resources like oil. Employers and politicians may also put the blame for inflation on labor unions whose wage demands are too high thereby increasing the costs of a product of service and causing companies to have to increase their prices.
Another explanation that is commonly heard is that in times of economic growth demand increases thereby causing an increase in prices.
At first sight these explanations sound sensible enough, but upon a second look we realize that they cannot explain inflation because 3 essential factors are overlooked:
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Inflation is an average increase in prices. Save the rare occasion of a huge natural disaster destroying massive amounts of products or the sudden depletion of an important natural resource, this is only possible if the amount of money increases. When for example oil gets more expensive or when greedy companies raise their prices, this only means that these products and services will become more expensive relative to all other products and services in the economy. The average price of all products remains the same.
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on a free market, companies, unions and even oil producers cannot raise their prices without suffering negative consequences because they face competition. When they raise their prices, their competitors can take away their customers by keeping their prices the same and thus by being cheaper than the company that raised its prices. This is how the free market works.
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Inflation cannot be caused by economic growth because the definition of economic growth is that the number and/or quality of goods in an economy increases. When at the same time the amount of money stays the same the average price of a product will decrease and not increase.
Who causes the money supply to increase?
The only institution that is legally allowed to create new money that has to be accepted as a medium of exchange by everybody is the Central Bank, such as the American Federal Reserve or the European Central Bank.
You and I could try to make our own kind of money, the Murray, but likely there will only be very few people who will accept our notes because they in turn would have a lot of difficulty getting other people to accept it, especially because our notes are not backed by anything that also has value as a commodity, like gold has. Governments all over the world have outlawed consumer payments in gold or silver, likely because such money would be a superior competitor to the government created money that is no longer backed by gold.
So pretty much the only money that is used in modern economies is the money that is issued by central banks. When you and I try to copy this money we run the risk of being arrested for counterfeiting. Only the central bank is legally allowed to create this money and thus only the central bank can be the cause of inflation.
By the way, it is remarkable that central banks are often seen as the institutions that fight against inflation, that keeps inflation in check. From what we learned above we can conclude that this is nonsensical.
Why do central banks create new money?
Although central banks formally are often independent institutions, in practice their policy is intended to help governments in achieving their plans.
The 3 main reasons that governments like to see new money created are as follows:
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to increase the income of the government itself without having to raise taxes or borrow more money.
Inflation itself is nothing other than an ingeniously disguised form of taxation. When the central bank creates new money and through a complex process that we will discuss in the next section gives it to the government itself (or to parties that are favored by governments) it simply means that the money of everybody else in society will become worth less, it is like diluting wine with water: there will be more wine but it will be less tasty.
The newly created money can be used by governments to finance wars, pay off debts or pay government salaries without having to raise taxes. Tax raises are often unpopular and so it is convenient for governments to have a mechanism that achieves the same result as taxation, namely increasing the income of the government, but that tends to go largely undetected by the general population.
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the government wants to favor certain groups in society such as banks or government contractors, at the expense of all other people: when the central bank creates new money it can lend to the banks and the first customers they in turn lend the money to for a low rate have an advantage relative to all other people in society.
The central bank can also create emergency credit for banks that otherwise would go bankrupt: because they can borrow credit at a very low rate they can save their business. Central banks thus subsidize failing banks by lowering the value of your money.
Something similar is the case when the central bank creates emergency credit that banks can borrow and then lend out at a low rate to big companies that are having financial problems. This happened recently when both the Fed and the ECB created new money that banks lent out to major stock companies. What then happens is basically a subsidy from everybody else in society to big Wall Street companies and stock brokers.
Another way in which governments can favor certain groups is by spending the money on projects such as wars for which large companies such as Haliburton get contracting work. These companies thus also profit indirectly from newly created money.
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Some economic theories like that of Keynes state that governments can control, direct and stimulate the economy on a macro-level by changing the supply of money (mostly increasing, but also sometimes decreasing it)
How do central banks create new money?
In the old days central banks would simply print new money and distribute it, but nowadays the money creation process is a lot more complex: the control that the central bank has over the reserves of regular banks is the central mechanism for money creation.
Central banks can create new money by controlling the reserves of regular banks. Banks need to have reserves in order to give people who have lent their money to the bank their money back. But banks no longer have all the money that their customers have lent them in reserve. They have used a large portion of that money to invest with or lend to others. This we call fractional reserve banking. Banks only have a fraction of the reserves that they have been entrusted with. So if people have lent 10 million dollars to the bank, they may only have 1 million dollars in reserve. Central banks have made this odd and fraudulent practice possible and it in turn can use this fact to control the money supply. This happens in 4 ways:
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It is easy to see that fractional reserve banking is a potentially volatile situation: if customers of a bank were to try to get their money back from the bank en masse the bank would be instantly bankrupt and a lot of people would lose their money. In order to avoid such bank runs and subsequent bankruptcies the central bank will help banks that are in trouble by for example giving them cheap credit so that they can add to their reserves at low costs.
Central banking thus makes fractional reserve banking possible and as a result banks can make profits by lending out money that they are supposed to keep safe for its customers. This means that the banks create new money that they are lending out because at the same time they pretend that they have that money on the accounts of their customers. They use it in a double way.
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the central bank also determines the level of reserves that banks must have. The central bank can legally require banks to have a certain minimum level of reserves. When central banks then ease this requirement banks can lend out more money with the same level of reserves, thereby increasing the money supply. Central banks can also cause a decrease in the money supply by tightening the reserve conditions for banks: if they have to have a ratio of 2:10 instead of 1:10 banks have to decrease their lending out of money by 50 percent, thereby causing the money supply to decrease.
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the central bank can add to the reserves of banks by buying goods such as government bonds from banks directly or indirectly. The central bank then simply creates new money and transfers that to the seller in question. When the central bank buys directly from a bank the bank in question simply gets the new money on its account thereby increasing its reserves. When the central bank buys a good from a private party that private party will receive his money from the central bank on his account at a private bank, thereby also increasing the reserves of said bank. Moreover, because the bank is allowed by the central bank to lend out several times the size of its reserves the money supply increases by several times the size of the received payment.
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the central bank can also add to the reserves of banks by lending money to them at artificially low interest rates. Whenever the interest rate that the central bank charges is lower than the market rate (the rate than banks charge each other for example) then this means that banks will borrow more money than they would otherwise. The extra money originates at the central bank. And like before, the banks can in turn lend out several times the amount of money that they borrowed from the central bank and so the money supply in the economy increases at several times the size of the borrowed money. When you read in the newspapers or hear on the news about interest rates that are being cut or raised it is this inflationary process that they are talking about.
What are the consequences of inflation?
—A friend of mine is writing this last section, but here are some preliminary remarks—
The main consequences of inflation stem from the fact that new money is never spread all over the economy equally and simultaneously, but is injected at some points (the banking system for example) and time passes before it has rippled over the economy and prices adjust to the new money supply.
If we all were to wake up tomorrow finding out that the central bank put 2 new 0s on each credit account, debt, bank note, coin and so on (thus turning $1 into $100) this would be a case of inflation, because the purchasing power of a single dollar would have decreased greatly. But at the same time since we now each have an equivalent increase in our money supply this would actually not be harmful, just pointless.
But this is not how new money enters the economy. Instead some parties get their hands on the new money first when that money everywhere else in the economy is still worth as much as before (and they also get it at a discount rate). Only as more and more transactions are made with this new money will price levels in the overall economy adjust and will consumers, businesses and other find out that their old money is now worth less because the money supply has been diluted.
So what in fact takes place is a redistribution of wealth from everybody who has money to those who get the new money and those who owe others money (since now they have to pay back relatively less). Moreover, because it takes time for prices to adjust economic calculation is hindered. Finally, because the price mechanisms of money (interest rates) is disturbed by artificially cheap new money (low interest rates) there will be an imbalance between supply and demand for money resulting in among other things the business cycle.