Inflation, what is it and what causes it and why does it matter?

[EconGuy]

In my experience of economics there are few topics that are simultaneously more misunderstood and at the same time the same people believe they understand it then the concept of inflation and it's causes.

What is inflation?

Simply put, inflation is a rise in prices generally.

What causes inflation?

At the highest level, the cause of inflation is the result a divergence between supply capacity and current level demand.

Why does it matter?

Inflation affects the value of the money that we all use, and it affects the policies that individuals support and are implemented in local, state, and federal governments. Misunderstanding the cause of inflation could result in poor policy support or implementation.

But let's go back to the cause here for a second. My "high-level" description gives an overall explanation, but does little to explain the actual mechanisms. As an analogy, one might ask what causes car accidents, and the response might be something like, "driving too fast under specific conditions." While this might describe car accidents in general, it tells us nothing about what the specific conditions are in any particular instance. Therefore, to really understand inflation, one needs to dig deeper and try to understand as many specific causes as possible in order to best understand inflation at a more detailed level.

The important thing is that the high-level definition should always be consistent with any increasingly specific explanation.

Again, by way of analogy, let's say the specific cause of an accident was texting and driving. If accidents are caused by driving too fast under specific conditions, then looking at a phone while moving is driving too fast under that condition!

How many of you think that it is the creation of money that causes inflation?

This is like saying that speed causes accidents. But wait, didn't I just say that speed causes accidents? No, I said that driving too fast under specific conditions causes accidents. Similarly, money creation by itself does not cause inflation, unless you are trying to define inflation as money creation, in which case you would simply be wrong. Calling money creation inflation is meaningless; it tells us nothing. If you believe that money creation causes inflation, it is fairly simple to disprove that with a simple thought experiment.

If there is 1 apple and $1, then it could be said that the apple is worth $1. But what if there were 2 apples and $2? Still $1 per apple. Here, the effective money supply has increased by 100%, yet the price of apples has stayed exactly the same.

This is, of course, a very simplistic example, but it is one that could exist in the real world. If the overall supply of goods increases at the same rate as money creation, then prices would, all other things being equal, remain the same.

I hope this is helpful! Let me know if you have any other questions.

 

[Revoltingest]

In my experience of economics there are few topics that are simultaneously more misunderstood and at the same time the same people believe they understand it then the concept of inflation and it's causes.

What is inflation?

Simply put, inflation is a rise in prices generally.

Another view is the falling value of
the dollar, ie, currency devaluation.

What causes inflation?

At the highest level, the cause of inflation is the result a divergence between supply capacity and current level demand.

It's complicated.

What Causes Inflation?

What causes inflation? There is no one answer, but like so much of macroeconomics it comes down to a mix of output, money, and expectations. Supply shocks can lower an economy’s potential output, driving up prices. An increase in the money supply can stoke demand, driving up prices. And the...

hbr.org

Why does it matter?

Inflation effects....

"affects"

....the value of the money that we all use and it effects policies that individuals support and are implemented in local, state and federal government. Misunderstanding the cause of inflation could result in poor policy support or implementation.

But let's go back to the cause here for a sec. My "high level" description gives a overall explanation, but does little to explain actual mechanisms. As an analogy, one might asks what causes car accidents and the response might be something like, driving to fast under specific conditions. While this might describe car accidents generally, it tells us nothing about what the conditions are in any specific instance. Thus, to really understand inflation, one needs to dig deeper and try to understand as many specific causes in order to best understand inflation at a more detailed level.

The important thing is that the high level definition should always be consistent with any increasingly specific explanation.

Again, by way of analogy, let's say the specific cause of an accident was texting and driving. If accidents are causes by driving too fact under specific conditions, then looking at a phone while moving, is driving too fast under that condition!

How many of you think that it is the creation of money that causes inflation?

This is like saying speed causes accidents. But wait, didn't I just say that speed causes accidents? No, I said driving too fast under specific conditions causes accidents. Similarly, money creation by itself does not cause inflation, unless you are trying to define inflation as money creation, in which case you'd simply be wrong. Calling money creation inflation is meaningless, it tells us nothing. If you believe that money creation causes inflation, it is fairly simple to disprove that though a simple thought exercise.
If there are1 apple and $1, then it could be said that the apple is worth $1, but what if there were 2 apples and $2? Still $1 per apple. here, the effective oney supply has increased by 100% yet the price of apples stayed exactly the same.

This is, of course, a frightening simplistic example, but it's one that could exist in the real world. If the overall supply of goods increases at the same rate as money creation, then prices would, all other things being equal, prices would remain the same.

A real estate professional's thought about inflation....
Let's consider a hypothetical scenario that plays out
somewhat realistically. Compare 2 houses.

In 1950 the house would require the income from
30 years to pay off a loan to buy the house.
In 1980 the same house would be triple the
price, but would still require the income from 30
years to pay off the loan to buy it.

If the 1950 house buyer sold the house in 1980,
the price would be triple, resulting in a profit
that is double the 1950 purchase price.
The seller pays capital gains tax on this profit.

Is the 1980 house worth more than the 1950
house in economic value?
Or is the 1980 dollar worth only 1/3 of the 1950
dollar?
In the latter view, government is taxing us on
phantom gain, ie, there's no real economic gain,
only a gain in the number of dollars required to
buy 1950 homes in 1980. This is a sneaky for
government to exact income taxes on dollars
that really aren't income.
Capital gains tax should be adjusted for inflation.

 

[Pete in Panama]

Another view is the falling value of
the dollar, ie, currency devaluation...

That's my take too. Supply/demand don't matter. If the currency is devalued we got inflation. Simple.

...Capital gains tax should be adjusted for inflation.

Perhaps, but Capgains is such a hot button issue that the rates depend a lot more on the political winds than any policy wonk preference.

 

[EconGuy]

Another view is the falling value of
the dollar, ie, currency devaluation.

While technically correct, referring to inflation an increase in prices is more accurate and intuitive.

Why?

Simple, if we look at the spending power of money we can see that money actually can be worth more over time in some instances. Thus the buying power of the dollar isn't reduced in all instances. For example this old graphic I happened to have saved.

Now to be clear, I'm not saying your wrong, just pointing out that if the buying power of money is the definition of inflation, how come it goes farther in some instances? Now you should rightly point out that money would have gone even farther if inflation hadn't set in, but my point is, calling inflation an increase in the general price level is more intuitive and therefore has better explanatory power.

But you say toe-ma toe, I say toe-mah-toe. Whatever.

It's complicated.

Yeah, I don't do homework assignments. If there's a point you want to make from the article you posted, or you think it bolsters a point you want to make, and then cite it and invite me to read it, that's cool, but unless you want to make a specific point please make it. I don't need to read an article to know that econ is complicated.

"affects"

Yeah, truth be known, I didn't even realize I had posted this yet, I wasn't done with it so I didn't proof it, but thank you for the correction.

Is the 1980 house worth more than the 1950
house in economic value?
Or is the 1980 dollar worth only 1/3 of the 1950
dollar?

Well your only looking at cost side.

You could say the same about the income side.

in 1950 the average income for a family was $3300, but in 1980 it was $21,000, or $44,000 and $48,000 respectfully when adjusting for inflation.

But in nominal terms (that you used) incomes from 1950-1980 increased 6 times while the value of the home increased 3. Even in real terms the average family of 4 had more money in 1980 than 1950.

Thus, again viewing inflation as a decrease in the buying power of a dollar isn't very meaningful unless you know how money dollars people make between given times.

This is again why measuring inflation in terms of prices is more meaningful to the average person because the extra step of understanding how much more money make today compared to the past is a step that isn't required. People simply consider their incomes relative to their costs. If costs outpace increase in wages (another very intuitive measure) than people fell inflation and might ask for a raise or look for a new job, or increase their skills to make more money etc.....

In the latter view, government is taxing us on
phantom gain, ie, there's no real economic gain,
only a gain in the number of dollars required to
buy 1950 homes in 1980.

That's called "unrealized gain" and people, especially the wealthy, leverage unrealized gains all the time and earn money on those gains quite often.

For example if interest rates are at 4%, but an investor thinks they can earn 7% on an investment, it makes more sense to borrow the money at 4% and leave investment income unrealized (and therefore not have to pay taxes on it). If the investment pays 7%, then the investor makes a net gain of 3% be taking the loan and paying interest, plus avoiding having to turn assets into cash and paying capital gains taxes. In fact, if your investment went south and only paid 2% meaning a net 2% was paid on the loan, that's still less than the capital gains tax.

Capital gains tax should be adjusted for inflation.

See above.

Respectfully,

EG

 

[EconGuy]

That's my take too. Supply/demand don't matter. If the currency is devalued we got inflation. Simple.

That doesn't make any sense, you can't have devaluation of a currency unless you measure the value (extrinsic) of a currency against something of real value (intrinsic) like goods and services, otherwise how would you know your money is devalued in the first place?

 

[Revoltingest]

That's my take too. Supply/demand don't matter. If the currency is devalued we got inflation. Simple.

I see both both causes, ie, currency devaluation & scarcity vs demand.
The latter depends upon the specific product.
I recall some government minion on NPR stating that they intend to
have inflation. As I recall, it was in the 4% / year range.

 

[Revoltingest]

Well your only looking at cost side.

"you're"
No, I considered both in that scenario.
Same number of years working for wages
to fully amortize the loan.
Note the usefulness of comparing economic
value to dollar value, & how the latter decreases
over time.

Yeah, I don't do homework assignments.

I gave you none.
Reference links are there to use or not.

I've nothing to add.

 

[Heyo]

That doesn't make any sense, you can't have devaluation of a currency unless you measure the value (extrinsic) of a currency against something of real value (intrinsic) like goods and services, otherwise how would you know your money is devalued in the first place?

It does make sense on a macroeconomic scale. Devaluation of currency is lost buying power on the global market. I.e. prices go up for imports. Depending on the connectedness of the local economy consumers feel that kind of inflation more or less.
Therefore your definition is more comprehensive.

 

[Pete in Panama]

That doesn't make any sense, you can't have devaluation of a currency unless you measure the value (extrinsic) of a currency against something of real value (intrinsic) like goods and services, otherwise how would you know your money is devalued in the first place?

Money is first created by a government that issues a currency and proclaims that the currency can be redeemed for a commodity at a set exchange or a basket of goods for that exchange. In the case of the dollar, the U.S. gov't used the Fed to control the value of the dollar so it can buy a market basket of commonly purchased goods --as rated by the Consumer Price Index.

Whenever the gov't changes that amount of exchange rate of money to goods it's called inflation/deflation.

 

[Pete in Panama]

I see both both causes, ie, currency devaluation & scarcity vs demand.
The latter depends upon the specific product.
I recall some government minion on NPR stating that they intend to
have inflation. As I recall, it was in the 4% / year range.

You're right, if the gov't sets the value of the dollar as being equal to say, a set amount of gold, and the market price of that commodity falls, we get inflation regardless of government edict.

My understanding is that the Fed wants inflation to be around one or two percent. It's healthier for the economy when they reach that goal.

 

[Revoltingest]

You're right, if the gov't sets the value of the dollar as being equal to say, a set amount of gold, and the market price of that commodity falls, we get inflation regardless of government edict.

Government ties the dollar to the price of gold?
Have a source for this?

My understanding is that the Fed wants inflation to be around one or two percent. It's healthier for the economy when they reach that goal.

Why do you believe 2% yearly currency
devaluation is healthier than 0%?

 

[Heyo]

Money is first created by a government that issues a currency and proclaims that the currency can be redeemed for a commodity at a set exchange or a basket of goods for that exchange. In the case of the dollar, the U.S. gov't used the Fed to control the value of the dollar so it can buy a market basket of commonly purchased goods --as rated by the Consumer Price Index.

Whenever the gov't changes that amount of exchange rate of money to goods it's called inflation/deflation.

That's a very naïve view of things, especially for the dollar. The US doesn't issues the dollar, the Fed does. The Fed, despite having "federal" in its name, is as federal as FedEx is. It's a consortium of privately owned banks who's board of directors gets appointed by the PotUS.
The US then lends money from the Fed at interest (which is currently at 0%). So, the US doesn't set the value of the dollar nor does it control it.
The Fed doesn't control the value of the dollar either. They can steer a little through dissemination and by setting interest rates but the dollar is the world reserve currency. I.e. there are so many dollars in circulation or stored in the accounts of other countries that no single entity is able to control it, it is controlled by the global market.

 

[Pete in Panama]

Government ties the dollar to the price of gold?
Have a source for this?

You're asking me if I have a link for "if" the gov't ties it such? Gov'ts all over the world did just that for a long time.

Why do you believe 2% yearly currency
devaluation is healthier than 0%?

0% might be nice if it were possible, but in real life prices fluctuate. The risk of aiming for zero is that half the time you'll have deflation. We don't want that. Deflation destroys virtually all businesses by upping the cost of loan paybacks --like what happened in the 1930's.

 

[Revoltingest]

You're asking me if I have a link for "if" the gov't ties it such? Gov'ts all over the world did just that for a long time.

0% might be nice if it were possible, but in real life prices fluctuate. The risk of aiming for zero is that half the time you'll have deflation. We don't want that. Deflation destroys virtually all businesses by upping the cost of loan paybacks --like what happened in the 1930's.

USA went off the gold standard by 1971.
Since then, the price of gold fluctuates
based upon demand for it.

 

[Pete in Panama]

That's a very naïve view of things, especially for the dollar. The US doesn't issues the dollar, the Fed does.

huh, are you saying that the Fed is not part of the U.S. gov't?

The Fed, despite having "federal" in its name, is as federal as FedEx is. It's a consortium of privately owned banks who's board of directors gets appointed by the PotUS.

Are u aware that all the empoyees of the FED are U.S. gov't employees under the OPM?

The US then lends money from the Fed at interest (which is currently at 0%). So, the US doesn't set the value of the dollar nor does it control it.

Can we agree that the Fed's management is appointed by the president and confirmed by congress?

The Fed doesn't control the value of the dollar either. They can steer a little through dissemination and by setting interest rates but the dollar is the world reserve currency. I.e. there are so many dollars in circulation or stored in the accounts of other countries that no single entity is able to control it, it is controlled by the global market.

It's true that most dollars are created by foreign banks outside of the Fed's jurisdiction. At the same time the Fed has enormous control over the U.S. economy (which is about 30% of the world's economy). It's what happens w/ the dollar in the U.S. that matters to the U.S. gov't anyway.

 

[Revoltingest]

It's true that most dollars are created by foreign banks outside of the Fed's jurisdiction.

Source?

 

[Pete in Panama]

Source?

Read it some magazine a while ago & I can't remember the exact source. Just did a search on Eurodollars and petrodollars and it gets even murkier. The problem is that conditions are constantly changing, add to that is the fact that money volume w/o significant velocity means nothing. I understand that crypto currencies are affecting the numbers.

W/ the Fed we got good numbers on dollars within U.S. justrisdictions and outside the U.S. we get a lot of conflicting reports. So go ahead and say I'm wrong if u want, you got that privilege anyway no matter what source I post.

 

[Heyo]

huh, are you saying that the Fed is not part of the U.S. gov't?

"The Federal Reserve Act created a system of private and public entities. There were to be at least eight and no more than twelve private regional Federal Reserve banks. Twelve were established, and each had various branches, a board of directors, and district boundaries. The Federal Reserve Board, consisting of seven members, was created as the governing body of the Fed. Each member is appointed by the U.S. president and confirmed by the U.S. Senate." - Federal Reserve Act - Wikipedia
The Fed is a conglomerate of privately owned banks with a board of directors appointed by the Prez.

Can we agree that the Fed's management is appointed by the president and confirmed by congress?

Yea, I already said so.

It's true that most dollars are created by foreign banks outside of the Fed's jurisdiction.

I'm not sure that's true but as some countries use the dollar as a shadow currency, there sure is some book money in circulation that isn't created by US banks.

At the same time the Fed has enormous control over the U.S. economy (which is about 30% of the world's economy). It's what happens w/ the dollar in the U.S. that matters to the U.S. gov't anyway.

The Fed has only as much power as the world economy allows it to have. If they go crazy, the rest of the world may decide to drop the $ as a reserve currency and OPEC would drop the petro $. It would be disastrous for the $ and the US economy - but then and only then would the Fed control the $.

 

[Twilight Hue]

Read it some magazine a while ago & I can't remember the exact source. Just did a search on Eurodollars and petrodollars and it gets even murkier. The problem is that conditions are constantly changing, add to that is the fact that money volume w/o significant velocity means nothing. I understand that crypto currencies are affecting the numbers.

W/ the Fed we got good numbers on dollars within U.S. justrisdictions and outside the U.S. we get a lot of conflicting reports. So go ahead and say I'm wrong if u want, you got that privilege anyway no matter what source I post.

I think the variation of currency is the problem as there is no world standard for one single currency.

Worse is cryptic currency now is about as shady as it gets.

 

[EconGuy]

Devaluation of currency is lost buying power on the global market.

Setting aside that claim for just a sec, you're using the words "buying power", buying what? The point here is that intuitively money's value is always tied to something in the real world.