Sunday, December 27, 2009


The concept of inflation has always bothered me, because none of the theories I learned about it in school made any sense. Then, on the way back from Paris, I came up with a theory of inflation that makes sense, to me at least.

Prices are of course determined by supply and demand. All things being equal, an increase in demand without any change in supply or a decrease in supply without any change in demand will result in an increase in price. And a decrease in demand or an increase in supply will have the opposite effect.

So imagine you have an island, in which 100 people live, work, and trade in dollars. Everybody produces a certain amount, and consumes a certain amount. Everything is stable, nothing changes. Prices stay the same.

Then imagine somebody comes into town with a million dollars he earned back on the continent. He's retiring on the island, so he's not going to work. He's just going to consume. So he buys a house, buys furniture, buys food. But he produces nothing.

The result is that demand increases, but supply stays the same. That, according to the laws of supply and demand, will raise prices for everybody. Inflation.

But here's the key -- the inflation is not caused by an increase in the money supply. If he had used that million dollars to build a new factory, he may very well have increased supply as well ... canceling out his increase in demand. Or if his factory produced even more than he consumed, it could lower produces across the board. The amount of money in the money supply is not significant. The key is the effect his actions have on the supply and demand for products on the island.

Or suppose the government started taxing half the island, and giving that money to the other half of the island, so the other half could consume products, but was no longer required to work. Demand would increase, because the beneficiaries of the wealth transfer would have increased income. Supply would decrease, because those beneficiaries would no longer be required to work for low wages, raising the costs of production. Demand would increase, supply would decrease. Inflation.

Or suppose the government started buying all sorts of stuff -- non-productive stuff -- like cannons and missiles and laser beams. (Remember, just because something is non-productive does not mean it is useless -- defense is important, but it doesn't produce goods that enter the marketplace). The government would finance those purchases with taxes, which would make production more expensive, reducing supply. It would employ people to operate them, drawing labor and increasing labor costs. And of course the government would use raw materials and resources to produce the weaponry, increasing demand. Decreased supply, increased demand. Inflation.

Now it's important to remember that in this model, inflation is not caused by the mere existence of these things. For instance, if our guy moved onto the island and started spending his retirement savings, there would be a step of inflation as the island adjusted to his spending, but then prices would remain stable at the new, higher level. Further inflation would only be caused by FURTHER outpacing of demand by supply.

It's also important to realize that inflation is not caused by an increase in the money supply by itself, but only by the way that money is USED. If our guy came to the island with a million dollars and hid it under a matress, the money supply has increased, but there has been no inflation. If he uses the money to build a factory, there may even be deflation if he lowers prices. It's only if he increases demand without increasing supply that he causes inflation.