Open the business section of any newspaper and you'll undoubtedly find a headline about inflation. You'll also find myriad explanations for inflation's cause. Employment conditions, wage increases, commodity prices, economic growth, government spending—all these and more have been vilified as causing inflation. These factors might have a short-term impact on general price levels, but, to quote the late, great Milton Friedman, over the long term, "inflation is always and everywhere a monetary phenomenon."
Inflation is the increase in the overall price of goods and services. Most people with a basic understanding of free markets know prices are determined by the intersection of supply and demand. If the demand for something stays constant but the supply decreases, the price of that item increases. This concept is absolutely true but can be somewhat misleading when considering inflation. Because we're used to citing prices in terms of the most common medium of exchange—currency—people often fail to see there are two sides to this equation. Prices are also influenced by the supply and demand of currency itself. Changes in the supply and demand for currency are reflected in inflation. Inflation is merely the "price" of currency in terms of the goods and services it will buy.
Central banks attempt to control inflation by influencing the supply of money relative to demand. By making adjustments to interest rates, bank reserve requirements, and other factors, central banks increase or decrease the amount of money available in an economy. If there's too much money supply, the value of money declines in terms of the amount of goods and services it will buy—resulting in inflation.
Our understanding of inflation is often inhibited by our deeply ingrained perception of money. When the price of an item rises or falls, we believe the value of the item has risen or fallen. In fact, the value of the item might not have changed at all—perhaps the value of the currency has.
To better understand the dynamics between money supply and inflation, let's take money out of the equation. Imagine a remote tropical island using two forms of currency—bananas and coconuts. The island dwellers harvest each year's coconut and banana crops and use them to buy clothes, food, iPods, and so on. The size of the harvests determines the island's money supply—you can think of the palm and banana trees as the island's central bankers.
The island's local bicycle maker usually sells his bicycles for ten bananas or ten coconuts each. One year, a longer than expected rainy season resulted in a bumper banana crop—the size of the banana harvest doubled. Because the supply of bananas increased, the relative value of bananas decreased. The coconut crop didn't double with the longer rainy season, so the value of coconuts remained constant. Because there were so many more bananas available, the bicycle maker found he could charge twenty bananas per bicycle, but he could still charge only ten coconuts.
Essentially, the island experienced inflation in terms of bananas because of an over supply of bananas but no inflation in terms of coconuts. It was the medium of exchange that changed in value, not the goods being purchased. Incidentally, the main headline in the Tropical Times read: "Senator Schumer Proposes Introducing a Wild Troupe of Banana Eating Gorillas to Control Banana Inflation, Coconut Inflation Well Contained."
If excess liquidity was distributed proportionally throughout an economy, and the resulting inflation impacted all prices equally, inflation wouldn't be much of a problem. We'd all have more money but the same purchasing power. One of the main problems with inflation is money is not only a medium of exchange, but also a store of value. Because inflation decreases the value of money over time, money saved becomes worth less. On our tropical island, banana-savers had the value of their savings cut in half by inflation, while coconut-savers weren't impacted.
Conversely, borrowers benefit from inflation because it reduces the value of the money they must repay. Wage earners are also impacted by inflation because wages don't immediately react to changes in inflation. In general, people tend to hate wealth redistribution, and inflation is one of the most egregious wealth redistributors around.
Obviously, modern economies are much more complex than our tropical island. In our increasingly global economy, forces such as currency exchange rates, globalization, and productivity also play roles. But this doesn't change that the supply and demand of money is the primary force behind inflation "always and everywhere."
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.