The Economy and You #10: What Is Inflation?
Typically, when you ask someone what inflation is, they respond it is the rise in prices that makes my money worth less. In most respects, this description can be considered fairly accurate. Inflation is the increase in overall price level of goods and services in our economy.
It is important to note that not all price increases constitutes inflation. Prices of individual goods and services are determined by the supply and demand of the free market. When prices of some goods rise while others fall, these are relative price changes. Inflation occurs when there is an increase in the overall price level. Therefore, a price increase of a specific good or service you buy does not indicate inflation.
Economists measure the overall price level by looking at all or a large number of goods and services in the economy. There are two measures generally used to measure overall price levels. The GDP Deflator measures the cost of goods and services produced in the economy relative to purchasing power. This differs from the Consumer Price Index (CPI), in that the GDP Deflator is not based on a fixed basket of goods and services. I will talk more about the Consumer Price Index in later articles.
Because inflation is the increase in the overall level of prices, it is linked to money. Some say, “Inflation is too many dollars chasing too few goods.” To better explain how this works, imagine a world that only has two goods: oranges picked from orange trees, and paper money printed by the government. In a year where there is a drought and oranges are scarce, we’d expect to see the price of oranges rise, as there will be quite a few dollars chasing very few oranges. Conversely, if there’s a record crop or oranges, we’d expect to see the price of oranges fall, as orange sellers will need to reduce their prices in order to sell all of their inventories.
Just as the supply of oranges can rise or fall, so can the supply of money. If the government decides to print a lot of money, then dollars will become plentiful relative to oranges, just as in the drought situation. Thus inflation is caused by the amount of dollars rising relative to the amount of oranges.
Therefore, inflation is caused by a combination of four factors:
- the money supply goes up
- the supply of other goods goes down
- the demand for money goes down
- the demand for other goods goes up
Still, there is more to inflation. There is “price inflation and monetary inflation. Price inflation is when prices rise and it takes more money to buy the same item. Monetary inflation is when the money supply has increased which usually results in price inflation.
Money inflation is often seen as the government printing money (economics students may want to look up the related topic of seigniorage or inflation tax). While theU.S.may not just print more money when needed, the federal government has tools available to increase the money supply.
So to conclude, when the government increases the money supply faster than the quantity of goods increases we have inflation. Interestingly, as the supply of goods and services increase, the money supply has to increase as well or else price will actually decline.
In my next article I will examine the widely used inflation index, the consumer price index (CPI), and how it is calculated and why there are different CPI estimates.