Essay One – Inflation – Part Three
Inflation, deflation, economic crisis and so on, getting to the bottom of meanings.
Inflation – Part three
Inflation, deflation, economic crisis and so on, getting to the bottom of meanings.
Inflation – Part three
Sherry writes:
I think we are getting somewhere!
You’ve zeroed in on the key question, I believe: why is there an inflation risk while the outlook remains so grim?
Inflation is a (sustained) increase in the equilibrium price of goods and services.
The price results from the interaction between two completely independent sides of the market: the demanders and the suppliers. Think of money (or a debit card, whatever form money takes) as an enabler of demand — it makes transactions easier, quicker, and thus more transactions result. The higher the supply of money, the more enhanced the underlying demand for goods and services (by consumers, business, and government).
So more money, higher demand. Higher demand, higher prices. Higher prices, higher inflation.
Now, what if, quite independent of the money supply, businesses and industry were competing and expanding and
becoming more and more efficient, producing more goods with better technology and fewer inputs?
This would increase the available supply of goods and services in the economy, and would reduce the equilibrium prices of those goods and services.
Now let the two sides of the economy, the demand side and the supply side, co-exist and interact. And think of their interaction as a video rather than as a snapshot. If the demand is increasing at a faster rate than supply, prices rise. If supply increases at a faster rate than demand, prices fall. With the current rate of increase of the monetary base by the Fed, and the current chill in industrial production, price increases are more likely than not.
I quibble with the aside about the banks and speculation, and point #1 above on how money is created needs some tweeking….but we can deal with those in another post if you like!
Sherry
Paul responds:
Thanks Sherry, I think I’m nearly there. Let me try and reflect back what you said to confirm my understanding.
- More money in the system tends to make it easier for all segments of society to consume. That increased demand tends to raise prices.
- Despite much weaker demand, you see the twin outcomes of reduced production and ‘easier’ money tending towards higher inflation than we have at present.
- That does not necessarily mean that hyperinflation (what is meant by that?) is in store.
- The phase we are in at present is a contraction in both output and demand hence price stabilisation and, in some cases, price declines. These declines will soon (?) find new equilibriums at which point inflation has the opportunity to appear due to the tremendous amounts of printed money in the system.
- Deflation is a risk if a vicious circle of more unemployment, less demand, less production, more layoffs and so on becomes embedded. Governments are fundamentally very scared of this scenario, hence the policies of increasing the money supply.
Sherry’s response:
Yes, by George, I think we’ve got it!
First, I don’t think we are headed for hyperinflation (which is just excessive inflation), because that requires a much higher degree of uncertainty about the behavior of consumers, business, and government than I think is basically possible for the U.S. economy right now.
I would agree that supply and demand are contracting. And because prices have been fairly stable, that tells us that these two (unobservable) factors in the economy have been contracting at about the same rate. If demand contracts faster than supply for a sustained period, we will have deflation. Price changes — both increases and decreases — always result from the rate of change in supply relative to demand.

- Supply and Demand
Deflation is indeed a scary prospect if it is demand-driven because then it is associated with a fall in output, more people out of work, idle factories, and the fear that accompanies all of that.
If prices fall because of massive improvements in the rate of productivity growth, however, we would see increases in output and employment, and that would be a good thing.
In fact, that should be the goal of government policy, in my view: reduce the real costs of production by reducing business taxes, fees, regulations, and paperwork. We would see an immediate and sustained increase in U.S. output, a fall in prices, and a drop in unemployment. The “Golden Bullet” it’s called.
Our current Fed Chairman, Mr. Ben Bernake, does seem to be much more concerned with deflation than inflation, which is consistent with his easy monetary policy over the last several months.
I worry that Mr. Bernake is overly confident in his ability to contain inflation should it arise. The administration’s concern over a rise in unemployment likewise explains the historic expansionary government spending we are currently witnessing.
Fiscal policy, which we’ve assumed constant in the above dialogue about inflation, may be a good topic for future discussions!
Sherry
This concludes the first essay. Comments most welcome.
Are we talking ‘growth’ as in more and more money being lent to the US Treasury Department from the [ever increasing] sale of US Treasury Bonds?


and then be able to make best decisions with a minimum of risk to our wealth.
Wonderful article and comments! There seems to be some confusion on the facts surrounding the relationship between the Fed’s actions, the demand for and supply of U.S. bonds, and the interest rate. First, the Fed buys U.S. treasuries all the time, and they are only part of the world demand for U.S. instruments. Their plan to buy an additional $300billion in Treasuries within a relatively short window did represent a notable increase relative to their usual purchases, and was intended to raise the price which lowers the yield or equilibrium interest rate on those bonds, assuming these purchases continue to represent a net increase in world demand for U.S. bonds (which requires a fairly stable supply), and assuming inflation expectations remain flat.
There’s the rub: IF the Fed creates money (deposits, reserves) when it purchases these bonds, inflationary pressures do enter the picture. And increased inflation means higher interest rates. Inflation does require a sustained increase in the supply of money relative to underlying productivity of the economy. If money supply simply “keeps up” with productivity, we’d have zero inflation. If there is insufficient money (or liquidity or credit), deflation kicks in — which I believe is the real concern of the Fed under Bernake. There is ample evidence that Bernake is fairly cavalier about inflation, and perhaps overly confident about his ability to counteract inflationary pressures in fairly short order without much volatility in the markets. It’s deflation he wants to avoid at almost all costs.
I wonder if anyone can help me find any reference in the press of the Fed Res bulletins or minutes that clearly state that the Fed is going to create deposits in order to fund their purchase of the $300billion in Treasuries? I’ve looked and cannot find it. It’s important because this is what links the Fed’s purchase of bonds to any concerns about inflation — a source of a great deal of the confusion on this topic. To the extent the Fed uses anything else, like some of the AIG and Maiden Lane assets that they’ve recently purchased (a result of Paulson and Geithner’s borderline-constitutional blurring of the roles of the Treasury and the Fed), to buy some or all of these bonds, the money supply doesn’t increase and inflation worries abate.
There’s an in-depth, nuts ‘n bolts discussion of Inflation on http://www.LearningfromDogs.com that you all might like to see, linked in to my blog at http://www.SherryJarrell.com.