Inflation, Money Supply, and Interest Rates: Learningfromdogs, part 3

Essay One – Inflation – Part Three

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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.

1. More money in the system tends to make it easier for all segments of society to consume. That increased demand tends to raise prices.
2. Despite much weaker demand, you see the twin outcomes of reduced production and ‘easier’ money tending towards higher inflation than we have at present.
3. That does not necessarily mean that hyperinflation (what is meant by that?) is in store.
4. 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.
5. 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 Bernanke, 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. Bernanke 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.