Need Help on Question About Inflation

[stevo_dubc]

I recently got into a conversation about inflation being caused by increases in wages. I made the argument that inflation is properly defined as an increase in the money supply, and that price changes are the effect of, not the cause of, monetary inflation.

I thought I constructed a good argument by hitting on the idea that in a barter econonmy there really could not be inflation, because there was no money, so I tried to use that as a demonstration that until an economy has money, and prices are then expressed in that monetary unit, there can be no inflation, only relative price changes.

This is the thread…
http://www.ontheleft.org/forums/index.php?showtopic=28427&st=0&p=269187&fromsearch=1&#entry269187

I thought I had properly demonstrated the concept. I assumed an economy where there were three goods and established their relative prices, and then showed how a rise in the relative price of one good was simply reflected as a drop in the relative price in another good.

Then comes a response that stumps me…
http://www.ontheleft.org/forums/index.php?showtopic=28427&st=0&p=269188&#entry269188

In this post, my correspondent proposes a scenario where all three goods become scarcer, but that they all become scarcer in the same proportion, such that, by happenstance, their relative prices are the same after the scarcity. He asserts that even though the relative prices are the same, this is inflation, since we will have to work longer to get the same amount of apples, bananas, etc.

So I’m asking the real economist here: Where did I go wrong? I suspect that I did not properly distinguish between price changes due to monetary inflation and price changes due to increases in productivity. (I believe this is what my correspondent is getting at.) I suspect I am also setting up an unrealistic scenario in which there are only 3 goods. I think that there always has to be labor involved, and then such absolute changes in prices would always have to be relative to a labor-hour (Again, this seems to be what my correspondent is getting at.)

However, if I include labor as a good, then am I back to his proposition that rising wages are a cause of inflation? I know that I’m close, but am missing an important concept here. Please point a newbie in the right direction.

[Caley_McKibbin]

“[#10342] We could not determine which forum this topic is in.”

[stevo_dubc]

I’m sorry, but I did not realize that the particular sub-forum I referenced is only visible to logged in users. Gosh, that’s annoying. Thanks for trying to help anyway. Maybe if I get some time I’ll copy enough of the thread in question for you guys to take a look.

[billott1]

I would tell him his example assumes properties of the real world that force labor to be the same as money. The real world is not fixed like this relative to goods and labor.

The example assumes the following:

1. All goods are unique to themselves and without substitutes. If people could substitue for the three goods then they would not be as quote “expensive”.

2. All goods are desired in exactly the same way and demanded in the same quantities. This is completely unreal. Different people have vastly different prefences and will want different things in different quantities.

3. I can not store the goods. I guess they are available year round but perishable? Again this is not a real situation.

4. I can not substitute more labor for more of one of the goods. If I could do this then I could build up an excess of one or more goods for trading.

5. All labor output is the same. This is not real. You and I do not have the same value of our labor.

6. The only way to get more of the three goods is through labor. There are other alternatives. I could trade with someone else or someone else could give me the good as a gift.

So it is the restrictions on this world that make it behave with the relationship where labor=value. This is really the heart of the socialist arguments that Menger proved false when he build his theory of prices based upon marginal utility.

So why is money so different? Well because the makers of money in a fiat currency world force people to use their version of money instead of alternatives. So the makers of money, central banks (The Federal Reserve Bank in the USA), use government violence to stop people from substituting other forms of money and use that same violence in forcing people to spend it in different ways. Absent this force people will adopt (More rapidly than people realize) other forms of money as the amount of central bank fiat money increases.

[stevo_dubc]

Sorry about posting a question about a forum thread that nobody could get to. Here is the gist of the discussion. If anyone has any thoughts about where I am going wrong, please let me know.

Chet says…

Can inflation caused by increasing salaries be a significant contributor to inflation. I have know personally a multitude of businesses that failed because the businesses made so much money initially that the owners were overwhelmed and did not put enough money away for taxes. I saw this happen to a lot of new home builders when the boom was going on. Make a lot of money right away, buy a big boat and a few years later all was gone.

I reply…

Not that you asked, but here’s my opinion:

Inflation is the result of an increase in the supply of money. Increases in prices are an effect rather than a cause of inflation.

Money is a good, like any other, with a price. The thing about money is that, while the prices of other goods are reckoned in the monetary unit, the price of the monetary unit is reckoned in every other good in the market. Economics tells us that an increase in supply causes a drop in the price, so an increase in the quantity of money results in a drop in the price of money, which means that the relative price of all other goods increases proportionately.

If you don’t believe that inflation is uniquely a monetary phenomenon, consider a barter economy. For simplicity’s sake, imagine that there are only 3 goods in the economy: apples, bananas, and cherries. Let’s further assume that the prices of these goods are as follows:

1 apple = 2 bananas = 4 cherries.
The other prices are easy to work out…
1 banana = 1/2 apple = 2 cherries
1 cherry = 1/4 apple = 1/2 banana

(Please correct my math, if necessary.)

Please describe what inflation would look like in this economy and how it would come about.

Only when money is introduced is there a possible situation where inflation can occur, and it is always caused by an increase in the money supply.

Chet says…

Inflation in barter economy. Cherry trees are hit by a disease and there are less cherries. Now it requires more apples or bananas for the same amount of cherries.

I am looking for causes of inflation that are skipped over. The biggest cause of inflation I think is from supply and demand of wages. Health care, COLA, everything that increases the price of a product that does not increase the worth of a product. As the housing boom was going on people took advantage of the dynamics to take more money for themselves above what the initial value was. There is no stopping people from taking more money not from value added but from demand of theor services. NBA players get more money for their performance not from value of their performance but from ability to withhold their services.

So it appears that inflation comes from greed or from inflated value of self worth. Not value added but price demanded. I guess that is free market. The recent skyrocketing of higher incomes does not come from value added but from ability to demand. I feel there is no end without calamity.

I say…

This is inflation? The price of cherries rises and the prices of apples and bananas falls. How is that inflation? Only one price rose, but two fell.

Actually, that reminds me. I forgot to ask you: How do you define inflation?

Chet says…

Inflation means to me when an item costs more but the item is the same. Gallon of milk goes up in price but the milk is still the same identical poduct.

If it takes more apples or bananas to get the same to get the same amount of cherries isn’t that inflation?

I say…

But then what of the prices of apples and bananas, their prices have gone down. Let’s look at the original prices, and then the prices after the cherry crisis. Here are the original prices:

1 apple = 2 bananas = 4 cherries.
1 banana = 1/2 apple = 2 cherries
1 cherry = 1/4 apple = 1/2 banana

Let’s say that after the crisis the prices are as follows:

1 apples = 2 bananas = 1/2 cherry
1 banana = 1/2/ apple = 1/4 cherry
1 cherry = 2 apples = 4 bananas

As you mentioned before, due to the shortage of cherries, their price has gone up. A cherry used to be priced at 1/4 apple or 1/2 banana, but now it is priced at 2 apples or 4 bananas. On the flip side, while an apple used to have a price of 4 cherries, its price has dropped to 1/2 cherries. Likewise with bananas, which have dropped in price from 2 cherries to 1/4 cherries.

If we use your definition of inflation, this example would have our simple economy experiencing both inflation (cherries are up) and deflation (apples and bananas are down) at the same time.

What we have seen here is simply the phenomenon of relative prices. The price of each good is related to the price of all other goods. As the price of one rises, the prices of the others fall in proportion. This is the very reason I brought up the barter example. It demonstrates that all price increases must be relative. The price of good X always rises or falls not in isolation, but in relation to other prices.

However, when most people speak of inflation, they don’t mean a change in relative prices. They are referring to an across the board increase in prices - the general price level is going up. But as we’ve already demonstrated, in order for prices of some goods to rise, the prices of other goods must necessarily fall. So I’ll ask you $64,000 question: If, in an inflationary economy, prices are continually rising, what good’s price must be falling? And what would cause the price of this good to fall relative to all other goods?

Chet says…

You are referring to a zero some economic system where there is a fixed supply of money and as the prices of some items go up it is mirrored by a drop in consumption. In our economy the zero sum mirrors some people having more money and some people having less money. We are in the phenomenon of prices going up and a large segment of buyers has been taken out of the market. Unemployment compensation has subsidized staples.

I personally don’t see prices going down. I think instead of prices going down you see businesses going out of business.

I say…

How would an economist in a barter economy determine the inflation rate of the economy?

Chet says…

Take your system and assign a unit for the current exchange rate for the three products. If takes more apples to get cherries then it is apples + x apples = cherries. The x is the inflation rate. So if it used to take one apple to get four cherries and now it takes one and a half apples to get four cherries it takes half as many more apples or 50% more apples for the same amount of cherries.
An inflation rate of 50%.

I say…

So we can price each good in terms of the others, like so:

When reckoned in apples, bananas cost 1/2 apple, and cherries cost 1/4 apple.
When reckoned in bananas, apples cost 2 bananas, and cherries cost 1/2 a banana.
When reckoned in cherries, apples cost 4 cherries and bananas cost 2 cherries.

So now we can not the differences in the relative prices after the cherry disaster:

When reckoned in apples, bananas cost 1/2 apple (no change), and cherries cost 2 apples (and 800% increase).
When reckoned in bananas, apples cost 2 bananas (no change), and cherries cost 4 bananas (an 800% increase).
When reckoned in cherries, apples cost 1/2 a cherry (an 800% decrease) and bananas cost 1/4 of a cherry (an 800% decrease).

Just to circle back to my original proposition, I claim that inflation is exclusively a monetary phenomenon and that without the introduction of money into an economy there can be no inflation, only relative changes in the prices of various goods.

As you can see above, the changes in relative price due to the cherry shortage can be observed in three ways, depending upon which good one decides to use as money. When apples or bananas are used as money, the change in the price of cherries is observable as a rise in an individual price while the price of other goods remains unchanged. Only when we use cherries as money do we see an across-the-board price change in all goods, in this a reduction.

Inflation is not the change in price of any one good, or group of goods. Inflation is a change in the price of the good that is used as money (in this case cherries). When the good used as money changes its price (through a change in supply) this is reflected as an across-the-board-change in the prices of all other goods. This is why I assert that inflation is an exclusively monetary phenomenon.

Sorry if I’m boring everyone here, but there’s a lot of misinformation about exactly what inflation is and what are its causes. Inflation is across-the-board changes in prices due to a reduction in value of money, generally caused by an increase in supply.

If I’m beating a dead horse, just let me know and I’ll drop it.

This following quote is the part that particularly stumps me as I said before. In the scenario he describes below, relative prices all remain the same, but they are indeed all scarcer, so they must in absolute terms be more expensive. There must obviously be some 4th factor that does not change relative to the three goods - possibly labor?

Chet says…

If there is a drought that effects all products equally and they stay at 1 apple = 2 bananas = 4 cherries and then irrigation ditches have to be built and it takes twice as long to get the same amount on products. The the dynamics become observable. The amount produced over a period of time. So now we have introduced a variable into the equation and we have product produced over a period of time. The price of the commodities related to each other stay the same but the consumer consumer will have to work longer to get the same amount of product. That is inflation with no price change. Same goods requiring more time to acquire. Or inflation.

I suppose that this can be analogized to work and power equations.
Power = the amount of " work " done over a period of " time". The interesting variable is demand. If it takes a lot of time to produce a product then need over want becomes the factor that influences demand. The taste of the fruits now becomes subordinate to the nutritional value of the foods.

I’d appreciate any feedback on my position as well. Please point out if I have it wrong.

[Catalan]

I can’t read the entire exchange right now, but this stands out (Chet’s response):

Inflation in barter economy. Cherry trees are hit by a disease and there are less cherries. Now it requires more apples or bananas for the same amount of cherries.

The price of cherries relative to bananas and apples rose, but the price of bananas and apples relatively to cherries fell. So, yes, if the marginal utility of something increases due to a decrease in supply, and therefore causes an increase in the price of that good, the price of other goods would necessarily fall relative to that good.

So, when modeled in an economy with money and indirect exchange, an increase in demand or a fall in supply of Good X may cause the price of Good X to rise, but now knowing that more money is being bidded towards Good X we know that the price of Good Y will fall, because demand (modeled by the amount of money bidded towards that good) has fallen. So, there is no general price inflation.

[Smiling_Dave]

The definition of inflation used to be “an increase in the money supply.” A consequence of this “monetary inflation” is “price inflation”.

But once the definition of inflation has shifted, and now means rising prices, sure, there are two other ways that prices can rise besides monetary inflation.

One is a decrease in the supply of goods. By the law of supply and demand, the less there is of a good, the higher its price will be. When a catastrophe hits the island and wipes out half of all the fruits, then there has been a decrease in supply of all of them, raising the price of each one.

If only one of the goods had been reduced in supply, its price would have risen, the price of the others would not have been affected neccesarily. If people still want as much the now more expensive good [say apples], then they will buy less of the others [after all, the dont have more money just because there are less apples]. If the content themselves with buying less apples, but buy just as many of the other fruits, the price of the other fruits will not change, because neither their supply nor their demand has changed.

The other thing that changes the price of goods is a change in demand. Even if the amount of money on the island stays the same, and even if the amount of fruit stays the same, prices could change if demand changes. Meaning if people want [and can afford to pay for] more apples one day, perhaps because they read in a book that an apple a day keeps the doctor away, or for any other reason whatsoever, then by the law of supply and demand the price of apples will go up.

So summing up for a moment, 3 things can make the price of a good go up. More money printed, lower supply and higher demand.

Now there is BIG BIG difference between the first reason prices go up [money printing], and the other two. The first big difference is that it is AVOIDABLE. Don’t print more money and prices will not go up. But decreases in supply and decreases in demand cannot be avoided. There is what there is, and people want what they want.

The second big difference is that printing money makes the price of EVERYTHING go up. It puts more paper money in some peoples hands, mainly the ones who print it, so that the prcie will go up of whatever they are buying, because they have increased demand for it that would not have existed otherwise. [Remember, demand means you want it and have the money to pay for it]. As the new money trickles throught the economy, passing through more and more hands, the new people increase the demand for what they want. Eventually demand for everything has increased, pretty much, and so prices of everything have increased. But an increase in supply or a decrease in demand only increases the price of the thing whose supply ordemand has changed. After all, there cannot be an increase in the price of everything, because demand for other things [which includes ability to pay ] has not changed. people do nto have more money, beacuse no neew money has been printed. So if they buy more of product X, they will have to buy less of everything else, reducing prices of everything else.

Put another way, since money printing makes the price of everything go up, then those who dont get the new money, or get it after everyone else got it before them, have their purchasing power decreased. So that money printing is a way of taking purchasing power away from the average man and giving it to the printers of the money.

But changes in supply and demand, though they may make one thing more expensive [the thing whose supply or demand has changed], they will make the other things [whose supply and demand have not changed] cheaper.

Now when one group gets a pay raise, where is the money to pay them more coming from? If it is coming from newly printed money, then sure that will raise prices for everyone, as above. If it coming out of the pocket of their employer or of the consumers, then whoever is paying for it loses money. Thus whatever demand he used to create from having that money now disappears, because he no longer has the money. So that the increasing demand the guys with raises create is offset by decrease in demand of whoever is paying them.

So that prices do not change from increased wages to one group. It just makes them richer at someone elses expense. Of course if you give the whole country a raise, then that can only be paid for by printing money, which of course will raise prices.

[Consultant]

So, there is no general price inflation.

Wrong. There is overall still less production, hence higher prices. You are right though that the general price increase is lower than the price increase in the good that had the big hit in production levels.