Introduction to Economics Part 7 - How Inflation Works

What is inflation?  What happens when prices go up?  Is that inflation?  What happens when prices go down?  Is that deflation?

Let's say we have a teddy bear, and the teddy bear costs $20.  What does this mean?  It means that the value of the teddy is twenty times the value of a dollar.  Price is the ratio between the values of two goods, in this case, between the teddy and the currency.  In this case, the ratio is 1:20.

So what happens if the price of the teddy bear changes?  Suppose it goes up to $25.  Has the value of the teddy bear gone up?  Perhaps.  But remember that price is a ratio.  It may not be the value of the teddy that has gone up; it may be the value of the dollar that's gone down.

Economists talk about two different values for goods and services - the nominal value and the real value.

The nominal value is the market price of the good.  The real value is the actual value of the good.  Expressing the real value is difficult, as it is usually expressed in terms of a currency like dollars, which can change.  There is a calculation which takes inflation and deflation into account which determines a resource's real value.  This calculation is beyond the scope of what I want to talk about in this note.  Simply understand that objects have a real value in addition to a nominal value.

Let's say the nominal value of the teddy has gone up.  To determine if this is inflation, we need to see if the real value of the panties has also gone up.  If the real value goes up, then the new price is simply a reflection of the increased demand for teddies.  Perhaps a resource used to make teddies has become scarce.  Perhaps a new use for teddy bears has been found.  Perhaps a notorious teddy thief has pillaged the local Build-a-Bear.  These would all increase the price.  If both the nominal and real values of the teddies decreased, then this price is a reflection of real value.  If new technology results in teddy manufacturing requiring fewer resources and less labor, real teddy prices will drop.

What if this happens economy-wide?  Many economists and politicians describe economy-wide change in prices as inflation.  Is it?

In the last 30 years, computers have improved the efficiency of every single business sector in western civilization.  In every industry, at every level, computers have made it possible to do every job in less time with fewer resources.  All other things being equal, this would result in a drop in all prices.  The economists and politicians mentioned above would call this deflation, but it is not.  The efficiency of the new technology has caused real values of products to decrease.  This is a different phenomenon from deflation.

In the Great Depression, prices across the country dropped without a corresponding drop in real value.  What happened?  Remember that prices are a ratio between the value of a resource and the value of a dollar.  If the real value of the resource is not changing, but the nominal value is, then the value of the dollar must be changing.  Since the prices of the goods and services across the USA dropped, but their real value did not, the value of the dollar must have increased.  This increase in the value of the currency is what we call deflation.

Going back to our teddies - if the price of the teddy bears goes up, but the real value of the teddies does not, then the change in price is due to inflation.

If the price of the teddies goes down without a change in the real value of the teddies, then the cause is deflation.  Since these changing prices are due to changes in the dollar, these changes will be witnessed economy-wide.  The change of economy-wide prices is therefore descriptive of inflation or deflation and not prescriptive.

IS INFLATION NECESSARY?

Some economists claim that inflation is necessary when prices fall in order to maintain price stability.  What effect does this have?  Let's go back to the computer revolution.

As the real prices of various resources fell due to the use of computer technology, capital formerly devoted to those resources could now be spent elsewhere.  This results in economic growth and greater wealth.  What if, in order to maintain price, the government inflates the money supply?  The government prints dollars, exchanges them with banks via the sale of bonds, and thus increases the number of dollars in the economy.  The greater quantity of dollars in circulation decreases the value of each dollar.

Let's say you have $10,000.  After the inflation, you still have $10,000, but this is only the value nominally.  In real value terms, perhaps your dollars only purchase the amount of resources that $9,000 used to purchase.  Without the inflation, you would have had an extra $1,000 to spend, save, donate, or otherwise use.  That amount of value has been taken from you and used by the government, exactly as if you'd been taxed that $1,000.  This is why many economists refer to this as the "inflation tax," as it is the transfer of wealth from the population to the government.

The inflation tax is a particularly regressive tax, because the primary sufferers are the poor, the middle class, and the small businesses, as they are the last to receive the printed money.  The first to receive the printed money have the advantage of spending it at its pre-inflation value.  These groups include the government, the banks, and the politically-connected corporations.  In effect, the inflation tax is a transfer of wealth from the poor and middle class to the rich.  Among the lower classes, those with wages and salaries suffer most of all, as wages and salaries change much more slowly than prices.  To make things even worse, when wages and salaries adjust to inflation, their nominal values increase.  This may put workers into a higher tax bracket, even though their income has, in reality, stayed the same, or even gone down.  This is exactly the same as if the US government started taxing lower wage earners a higher tax rates without ever holding a single vote in Congress.

But it gets even more perverse.  That $1,000 of wealth you lost?  Let's say you really needed it for something, so you're forced to take out a loan to cover the change in price ($1,111).  You are able to take out this loan because the Fed printed money to give to the banks, but you wouldn't need to borrow this money if the Fed had not printed the money in the first place!  Now you're in debt $1,111, which you will have to pay back with interest, when by all rights every penny of that money loaned to you should have been yours to begin with.

From all of this we can easily see that in order to have a robust economy, as well as the greatest benefit for the poor, government should not be striving for price stability, but monetary stability.  Inflation is a tax that increases the gap between the rich and the poor while benefiting politicians and corporations, and the idea that an economy needs inflation to grow or to maintain stability is yet another myth perpetuated by those who benefit from it most.

Thanks for reading!