Inflation Question

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csstudent's picture
csstudent
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Inflation Question

First let me say that I just finished watching all of the videos and learned a tremendous amount.  They helped clear up a lot of concepts that were very murky for me that I had been wondering about.

 I have one question about inflation though.  I understand the concept that an increased money suppy devalues the dollar and gives what we perceive as rising prices.  However, doesn't supply and demand of items play into this as well?  For example, let's say that inflation runs rampant sometime in the next year or two and it costs 10 or 20 dollars per gallon of gas.  When gas was recently up to 4 dollars per gallon, I changed my lifestyle to reduce our families demand for gas. For example, I started walking to work and riding the bus more frequently.  If everybody did this, the demand for gas would go down and wouldn't the cost per gallon drop as well regardless of  how much money was floating around?

 Thanks again for the great job you have done. 

wdstk46's picture
wdstk46
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Re: Inflation Question

If only prices rose but wages didn't, you would be quite correct.  If you have a real inflation, though, with the general price level rising continuously, you need to have wages rising with it otherwise there is no demand to drive the price level higher.  Note that I am talking about the aggregate.  Individual industries and professions can find themselves on the wrong side of the curve and unable to afford the new, higher prices.  They may fail.  This is just one of the distortions an inflation can cause.

The case you state was not one of inflation, however.  The spike in gasoline and other commodities was isolated to a specific sector.  In other sectors, prices were falling rapidly.  Oil prices went up but wages didn't.  Demand dropped sharply.  That is pulling the price of oil down, as you surmised it would.  If/when all the newly minted money now sitting in the FRB reserves hits the economy, we will see a general price/wage spiral.  That may be a bit longer than most people suspect, I think.

 Jim

csstudent's picture
csstudent
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Re: Inflation Question

Jim,

 Thank you very much for your response.  I have one additional question based on it.

 The question I have is based on this sentence in your response: "If/when all the newly minted money now sitting in the FRB reserves hits the economy, we will see a general price/wage spiral."  One thing I've never understood about inflation is if my wages keep up with inflation, why is that bad.  Let's say we see inflation at 50% in a year.  If I get a 50% pay raise that year, is there a real problem?  If I don't and most other people don't get that kind of pay raise, the demand just wouldn't be there to drive prices up that much.  To me it seems like if most people have their wages keeping up with inflation it shouldn't be a big deal and if people's wages don't keep up, then the demand drops off and prices will fall back down.  

As I mentioned in my original post, I understand the general theory that printing money devalues the dollar and we see that with prices.  I just feel that I'm missing something when I try to relate this to basic supply and demand.

 Thanks. 

wdstk46's picture
wdstk46
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Re: Inflation Question

A great question.  Actually if wages generally kept up with prices then it really wouldn't make any difference.  If you look back over the last 100 years you can see that prices rose massively but wages, in general, kept up.  If the economy is actually growing productively at the same time, you can even get "real" wage growth.  That why things are still in one piece, more or less.

The problem is two-fold.  One is that inflation distorts the economy badly.  What the government pulls out of the general market has to affect some sectors.  Manufacturing and service industries that might have been viable without the government distortion become unprofitable and fail.  Other industries are created that might never have arisen as there is no real demand from the citizens.  It becomes slightly chaotic.  

The other part of the problem is that, as Chis pointed out, inflation, once that choice is made, must be exponential and eventually the economy can't keep up with the change in money supply and the distorting effects.  The economy and the currency will fail.  In the end, this is inevitable.

I hope that helps a bit.

 

Jim 

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Lemonyellowschwin
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Re: Inflation Question

csstudent,

 I think you are basically correct that, theoretically, if wages precisely kept up with inflation (and if wages keeping up with inflation were the only issue) everything would be copasetic so long as the wages could be spent immediately on whatever the worker needed.

In real life, societies are supposed to save money to use later.  And people and companies and governments make deals with one another that are designed to last for a long time.  Saving money and shuffling it about and making long term economic contracts are sort of the glue that holds everything together.

In hyperinflation, it all goes to pot.  What happens to the person who worked her whole life to save a million dollars for retirement, when her million dollars no longer buys "a loaf of bread?"  You've seen the famous picture of the woman burning the German bills in her stove because it was cheaper to heat her house with currency than to buy wood.  Imagine those bills as someone's life savings.

Inflation wreaks havoc on the economy . . . there is no incentive to save or produce, only to consume. . . everyone's savings becomes worth less . . . long term creditors of all sorts are left hanging in hyperinflation, because they only have the right to be paid off in depreciating dollars.  Economic planning and investment becomes very difficult. .  . saving money becomes counterproductive . . .it completely messes everything up.

Welcome to the site, btw.

mred's picture
mred
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Re: Inflation Question

http://mises.org/story/2525

csstudent's picture
csstudent
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Re: Inflation Question

Just wanted to thank everybody for their responses.  It's starting to sink in although I have to be honest, I'm still not 100% convinced that there is a correlation between price inflation and the money supply.  It seems a bit like physics which is what my background is in - there are some areas where the math is 100% correct but it is still difficult to believe or understand the the results.

csstudent's picture
csstudent
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Re: Inflation Question

I hate to be dense about this but I need to ask a few other questions about this because I just can't seem to agree that monetary inflation implies there will be price inflation.

I just rewatched chapter 16 of the Crash Course dealing with asset bubbles.  He states "A bubble exists when asset price inflation rises beyond what incomes can sustain."  We clearly saw this with the housing market in the US.

Let's say that Zimbabwe Ben cranks up the printing presses and floods the US economy with trillions of dollars.  According to the arguments in this chapter, that would lead to price inflation.  Let's further assume that it costs $50 to buy a loaf of bread today and that next month it costs $100 for that same loaf of bread.  If my income doesn't go up that month, then I need to either cut spending somewhere else, put it on a credit card or not buy it.  If I look at these options, cutting spending somewhere else will drive the demand down for other products and therefore drive down their prices.  I don't have a credit card but if I did, running up debt will eventually lead to problems with my families budget.  Finally, if I don't buy the loaf of bread because I can't afford it then demand will drop and prices should then drop.  So, wouldn't the price of a loaf of bread crash just like house prices have crashed?

Thanks. 

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Re: Inflation Question

Two things can cause prices to rise.  One is to create an industry cartel, like OPEC, which is gov't enforced to regulate production volume or set hard prices on things.  Such price fixing never works and typically fail due to black-market activity if there are other supplies to be had and sold.  The other thing is monetary Inflation with money velocity.   The central bank can print all the money it wants but if it's stuck in a mattress it doesn't do anything.  You need the money to start flowing out into the economy and start changing hands for it to start bidding up prices.  The faster people exchange money the more it bids up prices for goods/services.  The larger the available money supply the more it will support higher levels of money velocity.

In your example you are not a benificary of the inflation because your wages did not increase.  You are one of those who have your wealth stolen from you because things cost more for you and you can only buy less of them.  However, say I'm Ben Bernanke and I print a fresh $1 million and give it to the construction industry.  Same as printing it to lend out.  These people get the new money first.  They get to spend it to buy ashphalt (made from oil), Concrete, Steel., etc.. and they bid up the prices on all those commodities to do construction work.  The price gets bid up because say you are simultaneously building a house and want to buy concrete and ashphalt at the same time.  You both compete to buy the commodity that has a limited supply.  The New demand for skilled construction workers means that they likely had to leave other construction jobs and therefore the new company had to offer higher wages to hire them.  THerefore the construction workers get the higher pay and benefit from the new gov't money.  The guy that operates the cement truck gets more money too because they were able to charge more for the cement.  All while you had no pay raise but had to pay more for the same goods.  Your wealth is therefore transfered to those working in construction.

Now say instead of printing money to give it to the construction company it was borrowed out of savings.  Because your money was lent to the construction company that means you were not able to build your house this year.  THat means you didn't compete against the construction company to buy the concrete & ashphalt.  Therefore the cost of those commodities did not rise.  The construction co. pays you back your wealth plus interest and next year you have even more money to build your house at the same price as yesterday.

As prices rise rapidly people start to spend their money quicker.  Money velocity goes up to drive up prices.  It's tuesday before a long weekend in summer and you know gasoline will be expensive on Friday before leaving town.  You anticipate this so you go buy on Tuesday because on Wednesday everyone will be trying to buy gas, which drives the price up by Thursday.

 

csstudent's picture
csstudent
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Re: Inflation Question

bearing:

Thanks for that explanation.  It seems like what you are saying is that for inflation or hyperinflation to kick in you need an increase in the money supply and an increase in the velocity of money.  Is that correct?

Thanks. 

SamLinder's picture
SamLinder
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Re: Inflation Question

csstudent,

The simplest explanation I ever heard for inflation and deflation is as follows:

Inflation: Too much money chasing too few goods. (Everybody has money so they compete for the available goods and rapidly drive up the price.)

Defalation: Too little money chasing too many goods. (Hardly anyone has any money, so no one is competing for the available goods so the price drops.)

bearing01's picture
bearing01
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Re: Inflation Question

Yes you are correct.   And a bigger supply of money (inflated money supply) permits / supports greater levels of money velocity.

Hyper-inflation really has to do with how rapidly the costs of goods are rising and how fast the printing press is running to support the ever-increasing demand for money.   If people demand more money to buy things today, because prices are rising, then the loans have to get larger in sum and/or people spend larger quantities of money to bid up prices and spend their money.  This places more demand/desire for the need for money so you can spend it.  This would naturally drive interest rates up - but if the Federal Reserve prints more money then the interest rates will remain low.  The rising prices would turn into a death spiral.  However, If the printing press was turned off then interest rates would rise and greater sums of money would be more difficult to obtain.  it will immedately arrest further inflation.  You would not get hyper-inflation.   Once people realize prices aren't going up anymore and that the money is again a store of value they won't feel the urgency to spend their money.  

Hyper-inflation like that of Weimar Germany after WWI or Argentina is basically just running the printing press until the money death spiral continues until you need trillions of dollars to buy bread.  Until it is basically worthless.

Note however, if the money supply is not inflating / expanding that if the price of one or two items go up due to a shortage then this really isn't inflation.  For example.  Say if we start to run out of Oil and the price of gasoline goes to $10/gallon.  Yes gas will be expensive and so will other things like groceries - that rely on trucks to transport it.  If the money supply is not inflatied then people won't have more money to spend on both gasoline and groceries and other things.  If people want to buy shoes they will have to conserve the amount of gasoline they buy to save their money for shoes.  If fewer people buy shoes because they have to buy gasoline instead, then the price of shoes may become depressed while gasoline and food remain expensive.  Overall the economy does not see a general price rise.  Prices only rise in those areas related to Oil.  Shoe factories will see no profits in shoes, reduce their production and/or instead retool to make something in greater demand like electric cars.  When electric cars are created to compete with oil the demand and price for oil will come down again, and so will the price of groceries.  However, say the money supply was expanded when the price of oil went up (due to shortage).  Then people would have access  to more money (credit) to buy both the gasoline and the shoes.  The price of shoes would not fall as in the first scenario - no need to re-tool the shoe factory.  People would conserve less and continue to have the ability and demand for oil.  Fewer people will be attempting to make electric cars.  This would be a general price rise/inflation because of expanding money supply.

Therefore, overall price inflation is not strictly due to a shortage of a good or supply/demand.  But rather it is a result of more money chasing the same number of goods.  When the created money is used to make a factory and produce it is the net overall increase in money compared to the availability of all the goods that cause prices to rise.

SamLinder's picture
SamLinder
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Re: Inflation Question

Then there's always Stagflation: http://en.wikipedia.org/wiki/Stagflation

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Re: Inflation Question

Your problem is that you assume as money supply increase, or prices increase, that supply is steady or the same. Clearly, fewer people will purchase goods, but as fewer people are buying goods, more and more people are getting laid off. 500,000 new and unemployed individuals in January alone. As millions are laid off, supply will DROP.  Companies are going out of business, downsizing and producing less.

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