Inflation is not a mystery!
There is a persistence to describe inflation as this mythical thing that happens all on its own, and honestly, it’s getting a bit too ridiculous. Inflation is not a mystery, it's a very simple phenomenon, and after reading this post, you will understand it like never before. Spoiler alert! It’s not Putin’s fault.
The simplest way to think about inflation, is to think about money chasing products. That’s all it is. When there is demand for a product, people will bid up the prices, until the point just before no one can afford them any longer. If you consider it from this perspective, it becomes clear that the quantity of money in circulation is at least one of the crucial factors influencing prices. As the amount of money in circulation increases, so does the intensity of bidding wars in the market. Don't you agree?
What is interesting about the topic of inflation, is that when I propose this rather obvious argument, not everyone is completely convinced. Even supposedly skilled economists, especially the ones working in Central Banks, will argue that this is not exactly how prices work.
Yet if I turn the argument around and ask what would happen to prices, if suddenly, we were to experience a massive supply shortage across all product ranges, everyone will agree that this sudden scarcity would cause prices to rise.
So, in the first instance people object to the fact that prices are a function of the supply of goods and services in demand and the amount of money in circulation, and in the second instance, they accept it. Yet in theory, the two examples are exactly the same.
However there is one final variable that I have left out so far, that I also think is the culprit of most of the confusion around this topic. See the difference between products and money, is that where products for the most part only exchange hands once, money exchanges hands continuously. The same gold coin can be used in multiple trades in a single day. And so it is not only the amount of money in circulation that has an effect on prices, the other factor you have to consider is how many times each unit of money is used.
This factor is called Money Velocity or (V), and when it is multiplied with the total money supply, you have a measure for the total theoretical money supply. In terms of the price level, it makes no difference whether there is one gold coin in circulation that is used in 10 different trades, or whether there are 10 gold coins in circulation that are only used 1 time each. The outcome is the same, and the average price level per product purchased, is 1 gold coin.
The irony, is that the economists that objected to the relationship between money in circulation and the price level are on the one hand correct. Prices CAN be unaffected by an increase in the money supply if the Money Velocity is decreasing at the same rate.
As the graph below indicates, money velocity has indeed experienced a continuous decrease the last 30 years. What we see is an increase of the money supply of about 470%, but what we also see is that the money velocity has been falling and somewhat countered the money supply increase.
Especially noticeable here, is how in the early days of the coronavirus stimulus bonanza, where the US government just showered everybody with fresh new money, the velocity of money collapsed, because everybody was in lock-down and didn’t know how to spend all that money. That’s until they just started buying a lot of electronics and created the semiconductor shortage in the process.
So, price movements can be broken down into these three individual components as expressed in the formula below. If prices are increasing, it can either be caused by an increase in the Money supply (M), or an increase in the Velocity of Money (V), or both. Or it can be caused by a decrease in the general activity in the economy or number of products or services that exchanges hands (Q). This is the story of inflation. I promise you, there is nothing else to it! And with this in mind, the last 30 years of US CPI movements can be summed up as follows:
Money supply (M) increased A LOT, while Velocity of money (V) dropped quite a bit. Finally, continuous productivity increases and a growing population, meant more products and services were produced and thus we had an increase in economic activity or (Q).
However, neither the decreasing money velocity, and the increasing economic activity, were sufficient to counter the massive increase in money supply, and then the inevitable net result, is inflation, as evident in the graph below depicting the consumer price index (CPI).
Most of the critics of this way at looking at inflation will say that we have seen many examples in the past, where money supply is increasing and prices don’t move, but we now know that there are various scenarios in the short term, where this could actually happen.
Money supply can increase, but if V drops and Q increases, the inflationary effect can be countered. And this is actually the usual pattern in the short term. In the longer term however, the variables even out and this is how you explain the current inflationary trends.
When you increase the money supply, you make money less scarce, there are now more money chasing the same amount of goods, and so money are doomed to lose value. This creates what is referred to as the ‘Fischer-effect’, where people are incentivized to spend their money before they lose their purchasing power. This in turn incentivize producers to increase production of goods, and so the activity in the economy rises and counters the money increase effect.
But in the longer term, an economy based on credit expansion will ultimately experience productivity declines, because the constant new flow of money and artificially suppressed interest rates, means that too many resources are tied up in unproductive companies that otherwise would have defaulted.
And so, in the end, the increase in economic activity cannot keep up with the money expansion, and inflation begins to increase dramatically, which is what we are going through now.
