Inflation and Deflation

Everyone has heard of inflation and deflation, but many people don't know what they really are and what causes them.

Most people think inflation means rising prices. This is true, but there are two main causes of rising prices. One cause is shortages. For example, as oil gets scarcer its price rises. Most people understand this intuitively.

The other cause of inflation is an increase in the money supply. This is the kind of inflation I'll be focusing on, because it is the most insidious and the one with the most potential to cause economic disaster.

The amount of money in an economy goes a long way in determining how much things cost. Imagine a simple economy where there are only ten $1 bills and ten oranges. In this case, each orange would cost one dollar. What would happen if we added ten more $1 bills to the economy? In that case, the cost of each orange would rise to two dollars. The money supply would double and the buying power of each dollar would be cut in half. That is monetary inflation. So inflation is largely determined by the amount of money in the economy; and the amount of money in the economy is determined by how much the government, the Fed, creates.

Deflation is caused by a decrease of money in the economy. When the money supply decreases, the buying power of each dollar increases, because there are less of them. This drives prices down.

Now, I oversimplified things because inflation and deflation are not just caused by the amount of money in the economy, but also by the speed the money moves around in the economy. If there is a lot of money out there, but no one is spending it and it is not moving around, that can cause deflation, too. This is what happens when an economy is sick. And this is why when the economy gets sick and threatens deflation, the Fed, as it is doing now, feverishly tries to pump up the economy by creating money. It also explains why, even with all this money being printed, inflation is not a big threat; because when an economy is sick it just wants to lay down and get better. It doesn't want to be given a stimulant so it can get up and run around the bed. This is the state of our economy at this time.

True economy-wide deflation rarely happens in the U.S., while inflation seems ever with us. Is this because inflation is hard to tame, or is it because the government chooses to create some inflation?

Remember that modern governments, via central banks, in our case the Fed, can create or remove money any time they want to. The Fed says that its dual mandate is to maintain high employment and low inflation. But if you watch what they do you'll see they are actually trying to produce some inflation. In fact, since the creation of the Fed in 1913, the U.S. dollar has lost 95% of its buying power to inflation.

Each year for the last 22 years the Fed has kept inflation below 5%. But the fact is they could drive it to -5%, that is, 5% deflation, or more, if they wanted to. But they don't. They act like inflation is this beast they are fighting to tame, when actually they are the ones producing it by printing money.

So why do they choose to reduce the buying power of the dollar on a regular basis?

We'll see in the next post.