I wrote in an earlier post about price movements for individual goods. “Inflation” is the term we use for price increases in goods and services across the board.
The typical layman’s understanding of inflation is simply more money, chasing the same or fewer goods, resulting in rising prices. There is an assumption behind this however, “all other things being equal”. Unfortunately, things are not likely to be equal, and it is important to understand some of those “other things” in order to understand inflation, or deflation which is the term for falling prices.
Consider our recent financial crisis. The Federal Reserve pumped trillions of dollars into the economy, and very little inflation resulted. Clearly there is more than just the quantity of money at work in determining whether inflation occurs.
In addition, deflation, is almost always associated with a failing economy, so if falling prices are bad, and rising prices are bad, then stable prices are the appropriate goal. The reason the Federal Reserve engaged in the exercise of creating so much money was to avoid deflation. They actually succeeded in this effort.
Let’s start with a discussion of two economies, both stable, but one twice the size of the other. In order for both economies to function properly, the larger economy will need twice as much money to facilitate transactions. After all, if the economy is twice the size, there must be twice the activity, and corresponding money, to support it. So, if we are going to grow the smaller economy over time to equal the larger economy, we must have additional money added to the economy gradually in order to maintain price stability in the context of the growing economy.
Without the additional money, the economy will have to overcome the challenge of not enough money to grow.
During the colonial period, there was not enough money circulating in the US and the British restricted attempts by the colonists to rectify the situation. This was one of the factors that led to the revolution, though it is seldom mentioned in history books today. (If you would like to know more about this, you can research the “Land Bank”, one of the attempts by the colonists to solve the problem.) A growing money supply is necessary to maintain stable prices in a growing economy.
Velocity of Money
Another factor impacting inflation or deflation is the Velocity of Money. The easy way to think of this is the number of times a unit of money gets used in an economy over the course of a year. If money is moving faster, then you need less of it to maintain a given level of economic activity. If money is moving slower, then you need more of it to support the same economic activity.
During the recent financial crisis, the velocity of money dropped dramatically. The Federal Reserve attempted to offset this by adding a lot of money to the economy, avoiding massive deflation. Whether this tactic has been implemented well won’t be known until we get back to normal, but what is clear is that so far inflation has been modest because the change in the velocity of money, and the increase in the amount of money, have offset each other.
Gold as an Alternative
You’ll find commercials running all the time touting gold and other precious metals as an investment, and people touting gold as an actual currency. This idea also holds sway in prepper circles. Gold does have the virtue that government cannot simply print an unlimited amount of it, destroying value along the way. On the other hand, it doesn’t work easily for stable prices because you can’t control the amount in circulation. For instance, if the economy grows you need more money to maintain stable prices. Where will the extra gold come from?
In the 1600s the Spanish were able to bring back huge quantities of gold from the New World. The Spanish thought they had struck it rich, but the extra gold in circulation set off a tremendous amount of inflation. Extra gold caused inflation, but did not translate into increased economic activity.
If you are looking for stable prices, gold is a bit more difficult to deal with in the context of growing, or shrinking economies, changing velocity of money, and other factors. Gold’s main virtue is avoidance of totally out of control money creation, unless you’re in Spain in the 1600s. 😊
We now have, the quantity of money (M), the velocity of money (V), and the level of actual activity in the economy (T), all acting as influences on price levels (P). P is what we are trying to stabilize.
Trying to control inflation, or deflation, is challenging because inflation is driven by multiple factors, including the quantity of money, the amount of economic activity, the velocity of money, etc. and most of these factors cannot be controlled by central banks, such as the Federal Reserve. Government spending (fiscal policy) complicates matters, and the mathematics involved is only as good as our current understanding of economics (fair at best).
As a result, many people seem to think the central bank is some sort of sinister entity when they fail to hit inflation targets. Maintaining stable prices while controlling only one of the many factors involved is a challenge. Sometimes it works well, and sometimes events overwhelm the efforts of the central bank.
Note that our central bank, the Federal Reserve, also has the goal of maintaining full employment, despite the fact that this is at odds with price stability. (Thank you, Jimmy Carter and the Humphrey-Hawkins Act!) In contrast, the European Central Bank has only one goal, price stability. The fact that European inflation generally runs slightly lower than US inflation is no surprise considering the differing central bank goals.