What Causes Inflation
Before we start, I just want to say that a short blog post is not the easiest way to convey what, at times, can be a difficult economic phenomena , but as always I will do my best. Like any good writer, I will give away the answer at the start. The culprit that causes inflation is printing money, short and sweet. Thats it. Honestly, thats it. If the central bank prints more money then prices go up, pretty much guaranteed. Pretty much.
Well lets start our journey towards economic literacy by explaining why. Consider this example. I am typing this blog on a mac. Let’s say that we live in a fake economy called businessland. In businessland, the total amount of money in existence is €100. What is the most amount possible that someone can pay for my mac? Well the answer is €100. All the money buys all the goods, so if there is only one mac produced and there is only €100 then the mac costs €100.
What if the central Bank printed more money? Let’s say another €100. What happens then? Well, all the money buys all the goods, so all the money (€200) buys all the goods (1 mac). What has happened? More money was printed and prices rose. Is this always the case? No, but more on that later.
Let’s ask another question, what would happen to inflation if the government got it’s hands on €90 and burned it? Well, I hope you would agree that there would be less money and now the money supply would be €10. What is the price of the mac now? Again, all the money buys all the goods. There is only €10 in existence and so the price falls to €10 as that is the highest amount that anyone could possibly pay. What has happened? The money supply fell and so did prices. Is this always the case, when money supply falls so do prices? Not always. In all of our examples, what has not changed? The answer is the mac. There has only been one mac produced in every one of these situations. What happens if we look at each of the above examples and instead of changing the money supply, we changed the level of production.
Again, we are in the economy of businessland. The money supply is €100 and the total level of production is one mac. How much does this mac cost? The answer is €100. Why? Well, all the money buys all the goods so €100 buys one mac.
Now let us say that the money supply stays the same but the number of macs produced, increased to four. How much does each one cost now? Well, all the money buys all the goods, so the price of each mac is €25. Why? Well, each mac is identical and therefore its value or price is the same. So it is €100/4 = €25. What was the net result of an increase in production. The answer, a reduction in prices or deflation.
Now, lets suppose that next year, the money supply stays the same but the production of macs falls to 2. What is the price of each mac. Again, all the money buys all the goods. €100/2 = €50. What has happened to the price of all goods produced in businessland after the quantity of goods and services produced fell? The answer, inflation. Prices rose.
So, hopefully now we see that prices have a tendency to rise following an increase in the money supply. Anecdotally, the reason is that people have more euros to hand over for goods and services. They bid up the price. And, hopefully now you realised that prices have a tendency to fall when production is increased as they need to lower price to sell of the extra stuff.
For the very astute students among you, a question may be coming to mind. Is there a way that we can combine the two effects of printing money and increased production to predict the final figure for inflation? The answer is yes. Before we do that, lets see if you can work out yourself, from a few simple examples, what the inflation rate might be.
Scenario 1: Production doubles and the money supply doubles
Scenario 2: Production halves and the money supply halves
Scenario 3: Production halves and the money supply doubles
Scenario 4: Production doubles and the money supply halves
Looking at the above scenarios independently, I hope you might be able to extract what the effect on prices (inflation) might be.
Scenario 1: If production doubles, that means that the effect that this has on prices is to reduce them. The reason is that the money supply is being spread over a greater range of goods. If the money supply were to remain the same and the quantity if goods and services produced were to double, we would expect prices to half. The problem is that the money supply has not stayed the same. If the money supply has doubled and the quantity of goods and services stayed the same we would expect prices to double. Again, these two effect have not acted in isolation. The increase in the money supply causes prices to double. The increase in production causes prices to half, so the effects cancel each other out and we would expect nob change in prices.
So when I said that printing money alone causes inflation, I am not entirely right, we need to take into account the change in the level of production.
In the above example, the money supply doubled and prices did not change. It caused no inflation.
Scenario 2: If production halves we would expect prices to double as the same quantity of money is chasing fewer goods and services. However, the quantity of money in the economy has also halved. If that happens we would expect prices to half as there is less money able to be paid for goods and services. Again, these two effect cancel each other out and this leaves the price level unchanged. That means inflation is again zero.
Scenario 3: If production halves, we expect prices to double as the same quantity of money is chasing half the amount of stuff. If the money supply doubles, we would expect prices to double as twice the quantity of money is chasing the same amount of goods. Again neither of these effects are acting in isolation. The halving of production causes prices to double and the doubling of the money supply causes prices to double so when we combine those effects we get a 400% inflation rate.
Scenario 4: Production doubles. That means that prices half as there is twice as much stuff to buy and the quantity supply halves causing a halving of the price level. Both of these combined means that the price level falls by 75%.
For those mathematicians among you there is a formula called “The Quantity Theory of Money”, for measuring the expected rate of inflation. It is as follows.
% Change in the Price Level (Inflation) = % Change in Money Supply - % Change in Production (National Income)
This means that inflation will occur if the percentage increase in money is greater than the GDP growth rate.