Why is there inflation?

Question

I know what inflation is, how it is calcultated and how it affects the economy. But what I DON'T know is WHY is there inflation? If prices rise 3% a year and that is acceptable to everyone... In 50 years it is going to cost 100 bucks to go to the movies. Why?

Answer 1

Inflation occurs when the supply of money grows faster than the supply of goods and services. If you have more money but the same amount of goods that can be purchased, people will be willing to "bid up" a higher price for the same goods.

Here is an overly simplified example that demonstrates the relationship between money supply and inflation. Let's say you have a $10 trillion economy, meaning that $10 trillion was spent on all of the produced goods and services. The government then prints an extra $1 trillion of cash, but the economy does not grow. There is now 10% more cash available to spend on the same amount. This would lead to 10% inflation (note that even if people save the extra cash, most of the savings are invested by banks and thereby "spent").

The exact formula is:

Inflation = (Velocity x Money Supply) / Real GDP Growth

"Velocity" is the number of times money changes hands in a year.

"Money Supply" is the total amount of all cash in the economy.

"Real GDP Growth" is the percentage change in the total value of all goods and services produced by the economy.

There are other factors that have short-term or cyclical effects on inflation, such as energy prices, new technologies, health care, population growth, etc. I will focus my answer on money supply growth, since this is the area over which we have political control.

The primary influencer on US money supply is the Central Bank, which is administered by the US Federal Reserve Department (most other industrialized countries have a similar central bank system). The purpose of the Central Bank is to supply cash to other banks which, in turn, loan the cash to businesses and individuals. As long as a bank loan meets certain federal requirements, that bank can borrow the needed funds from the Central Bank.

The Central Bank controls money supply in two ways. First, it can reduce the overnight interest rate that it charges to other banks for cash. A lower rate will means that banks can reduce the rate they charge to their customers, which results in more cash being pumped into the economy in the form of loans. This tends to raise inflation. A higher rate has the opposite effect, reducing the infusion of cash into the economy and thus lowering inflation.

A second way the Central Bank controls money is by buying and selling government bonds. The Central Bank can purchase bonds from other banks at a guaranteed interest rate to take money out of the economy. For example, if a bank can earn 3% profit on its cash by loaning it to the private sector and the government is offering to pay 3.5% for the same cash, the bank will sell the cash to the government, resulting in less available cash for the private sector. Conversely, the Central Bank can sell bonds to banks at a lower interest rate to pump money back into the economy.

So, "loosening" the money supply lowers the cost of money so that banks can loan more. If the money supply grows faster than the economy, you get inflation. "Tightening" the money supply makes money more expenseive and reduces the amount loaned to the economy. If the money supply grows slower than the economy, you can get deflation and strangle economic growth.

In an ideal world, the Central Bank would have a crystal ball that predicts exactly how fast the economy will grow and then grow money supply by that amount. Since this is impossible, the Central Bank can err on the side of being pumping in too much money or too little money. Since too little money slows the economy, the Central Bank prefers to err on the side of too much money. Therefore, we always have a certain level of inflation.

Inflation itself is not necessarily bad. If prices grow by 3% per year, wages tend to follow. What is bad is an inflation rate that is so high that wages cannot keep up or an inflation rate that is unpredictable. Someday, a movie ticket will cost $100, but your income will be more than enough to cover it.

Answer 2

This is a good philosophical question that I've never seen a good answer to. The above answer is a heroic attempt but I don't think it answers the basic question of why? Loose money policy only enables inflation if people do indeed borrow money and then buy stuff at such a rate that producers find that they can steadily raise prices. Why does that happen? After all, if producers were in the habit of producing more goods and services than people wanted, there would be no impulse to raise prices.

I think the inevitable conclusion is that generally, demand leads supply. Consumption leads production. It's a constant game of catch-up, with price increases signaling producers: "Make more. Make more."

I can guess that consumers are driven by an impulse for ever more stuff. Most people are never satisfied. They always want more. This is easy to understand -- if you've known people who switched into much more lucrative careers, now they make 5 times as much money as before but they still spend it all. That's human nature.

And on the other side of the coin, I would guess that the profit motive and the need to contain costs generally keep producers one step behind consumers in supplying them, causing just enough of a delta between supply and demand to make for chronic modest inflation.

Answer 3

Thats a question economists have worked on, and the answer (such as we currently have) is way complicated, but consider this:

People make their plans about investing in their businesses based on their expectation of what it will return, and what that money will be worth when they get it (that is, how bad inflation will be).

The monetary authority controls the rate of money growth (not perfectly, but with some wiggle).

When interest rates are low, people are more interested in investing (higher return because less cost to borrow) but people know that inflation is encouraged by overly low interest rates. So they will only invest if they think they can make more on an investment than the interest they pay (real) and the rate of inflation.

The monetary authority can lower interest rates by throwing out more money, but in doing so will cause inflation.

People expect the money guys to try that trick and expect inflation.

So, what happens if the money guys change their mind? What if the monetary fails to throw out the money?

The interest rate goes up, and that curtails investment slowing down the economy. Thats the last thing the monetary authority wants, so it has to throw in at least all the money people expect.

Its a positive bias. Thats why zero is not a sustainable inflation rate. People think the Fed (for example) will trick them in to over-investing so anticipate inflation. When people anticipate inflation, the Fed has litle choice but to give it to them.

The real trick (and Allan Greenspan and Paul Voelker's real heroism) has been to lower the rate of inflation people expect, which has lower the rate of inflation we get. It was an ugly change (early 80's), but it has paid off incredibly.

Answer 4

If there was a fixed amount of money in the economic system, there wouldn't be any inflation. If more people wanted a product and had to spend more money for the limited supply, they would have less demand for another product and the price would go down. The problem is that the money supply increases and that increase means people can pay more for a product.

Answer 5

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Answer 6

Because the bureaucrats we have in government, are all the time screwin things up.