Friday, September 25, 2015

Inflation: What is it?

There is a common theme for the definition of inflation. This theme usually states that inflation is defined as "rising prices in goods and services". With that definition, economists, financial experts, and others, always advise their clients to "hedge against inflation". So, in short, they are concerned about the spending power of their client's money. Back to the definition of inflation: Is this really the definition? Is it precise?

Let us take the common definition again: "Inflation is the phenomenon of rising prices in goods and services." However, let us suppose that a gas station is short in its inventory on gas. They normally anticipate the delivery truck to come once per week, yet this week, the truck does not arrive. In this case, assuming the demand is the same, or it's increasing, the gas store owner will raise the price. Is this inflation? 
Yes, prices have increased, and yes, prices have been inflated. But, the prices are being inflated due to the law of supply and demand. This makes the common definition of inflation imprecise. 

What is Inflation?

The more precise definition is based on this example. Suppose the central bank increases the money supply or money stock. Those first in line to receive the money can acquire goods and services before others can pick up those same goods and services. In doing this action, the first recipients drive up demand, thus driving up the prices of those said goods and services. It should be noted that demand was not increased until the money supply or stock was increases. Therefore, the rise in prices occur as a result of the increase in the money supply.  So, is inflation really the result of an increase in prices, or is it simply a result of the increase in the money supply?  It can be concluded that inflation simply is the increase in the money supply, deflation is the decrease in the money supply. The results of these actions cause an increase in prices or a decrease, respectively.

Price level and Price Stability

Two terms that are tossed around by mainstream economists are: Price Level and Price stability. These terms are typically used with the notion of Inflation. Starting with Price level, many economists attempt to produce math functions that can and demonstrate the price level. As one ponders this concept, there are questions that have answers that usurp the logic of this "price level" concept. What is the actual "price level"? How is it determined? Why should it be at this stated level?

Human beings are actors in the marketplace in a constant pursuit of "happiness". And, in that pursuit, voluntary exchange takes place. At times, there are items that the actors value more than others, since all actors are restrained to make choices with scarce resources. If a vast majority of actors in the marketplace prefer to purchase Item (A), in contrast to Item (B), then the price of item (A) will rise, and subsequently, the price of Item (B) will drop. In short, with this example, there are two price levels!  At this point, economists will aggregate all the items, and determine the price level. This exercise is risible simply because all of the items are not homogeneous in nature. And, the actors all "value" those items different, as value is subjective. This makes the notion of price level highly fallacious.

The concept of Price Stability is equally as fallacious as the notion of obtaining a Price level. The actors in the marketplace all are seeking their respective goals and happiness. Their value scales are constantly changing. For example, an individual at one point in time may value purchasing gas, over the notion of purchasing a steak. This maybe true if the person just ate a steak! How can the price of Steak be "stable", if people's desire for steak constantly change? Same with the need for gasoline? Since value scales are changing constantly, the notion of price stability is a quixotic chase.


In closing, the mainstream definition of inflation does not incorporate the notion of the increase in the money supply and money stock. This leads many down the incorrect path of economic analysis due to the lack of specificity in the definition of inflation.  Inflation is simply the increase in the money stock, and prices rising can occur from that money stock increase.

No comments: