By Tim McMahon
A simple way to define inflation is “an increase in the price you pay for goods” but that only tells part of the story…
It could also be seen as a “decline in the purchasing power of your money”.
But there is more to inflation than that. There is two sides to inflation “Price Inflation ” and “Monetary Inflation “.
Price Inflation vs Monetary Inflation:
Technically, Price Inflation is when prices get higher or it takes more money to buy the same item and this is what people commonly think of when they hear the word inflation .
Monetary Inflation is an increase in the money supply which generally results in price inflation. This acts as a “hidden tax” on the consumers in that country and is the primary cause of price inflation.
Monetary inflation is commonly referred to as the government “printing money ” although the actual process is a bit more complex than just cranking up the printing presses but the effects are essentially the same.
As the money supply increases the currency loses it’s purchasing power and the price of goods and services increases. In a large economy like that of the U.S. this process usually takes 18 months to 2 years so the government is able to spend the newly minted dollars at the old value before consumers realize that they have been cheated into accepting something that will purchase less than they originally thought it would. See How does the Money Supply affect our Inflation Rate?
Inflation is measured by the Bureau of Labor Statistics in the United States using the Consumer Price Index. See What is the Difference between Inflation and the Consumer Price Index?
What Causes Inflation?
Inflation and the Money Supply
There are a variety of different causes for inflation. The primary cause of macroeconomic inflation is an increase in the money supply. As “more money chases fewer goods” the price of the available goods is bid up. So simply increasing the money supply will increase prices. See Inflation Cause and Effect or watch the inflation and the money supply video .
A secondary cause that is generally more limited in scope and duration is a temporary shortage of goods either due to a natural disaster like Hurricane Katrina and Hurricane Sandy. In this type of situation the disaster has created a shortage of goods, but the supply of money has remained the same. And the demand for the goods is the same or even increased as rebuilding is necessary. So once again prices are bid up because there is more money than goods. But this situation is usually short lived as producers ramp up production to handle the increased demand or in the case of a localized disaster, producers may ship goods in from unaffected areas.
A third cause of inflation could be the effects of an organized cartel that is purposely restricting supply and artificially raising prices. This only works as long as the cartel maintains a monopoly. Economic theory tells us that if prices are raised it will encourage competitors to enter the business and eventually drive prices back toward the cost of production. But if the producers collude together they can raise prices by restricting supply. This happened in the 1970’s as OPEC agreed to limit oil production in an effort to raise Oil Prices. The effectiveness of this type of price manipulation depends on the unity of the cartel because as prices rise there is more incentive to “cheat” on production quotas. Thus other members of the cartel bear the cost of restricting supply while the individual gets the benefit of increased sales at a higher price. Thus most cartels are generally only successful in the short run. The one notable exception is the DeBeers Diamond Cartel.
So from a macroeconomic point of view the only cause of long term inflation is an increase in the money supply, since the other causes are self-limiting and of limited duration.
The primary risk in inflation is that your purchasing power will be eroded during the time that you hold the money. In other words, you will be able to buy less. If you work one hour and expect to be able to buy one toaster with the money you receive from your labors but you don’t need a toaster at the moment you expect your money to retain its value so you can buy that toaster at a later date. The primary risk of inflation is that the longer you hold those dollars the less they will buy. So after a year that money that used to buy a toaster will now only buy 90% of a toaster or 50% of a toaster. The higher the inflation rate, the faster the purchasing power decreases. And consequently the quicker people want to unload this depreciating asset. Better to buy the toaster now, even though you don’t need it at the moment, rather
than wait and have to spend more money later. This causes people to spend money faster and faster the higher the inflation rate goes. The speed at which people unload their money is called the velocity of money .
Definition of Inflation in Economics
However, it appears that the meaning of the word inflation has changed over time. Let’s look at how to define inflation and how the definition has changed and what that actually means to you the consumer.
Webster’s 1983 Definition of Inflation
According to Webster’s New Universal Unabridged Dictionary published in 1983 the second definition of “inflation” after “the act of inflating or the condition of being inflated” is:
“An increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet the demand.
This definition includes some of the basic economics of inflation and would seem to indicate that inflation is not defined as the increase in prices but as the increase in the supply of money that causes the increase in prices i.e. inflation is a cause rather than an effect. But…
Webster’s 2000 Definition of Inflation
The American Heritage® Dictionary of the English Language, Fourth Edition, Copyright © 2000 Published by Houghton Mifflin Company says:
Inflation : A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.
In this definition, inflation (rising prices) would appear to be the consequence or result, rather than the cause.
So between 1983 and 2000 the definition appears to have shifted from the cause to the result. Also note that the cause could be either an increase in money supply or a decrease in available goods and services.
Webster’s Revised Unabridged Dictionary. © 1996, 1998 MICRA, Inc. Relegates Price Inflation to number 3. and says:
Undue expansion or increase, from overissue; — said of currency. [U.S.]
WordNet ® 1.6, © 1997 Princeton University, has a witty definition that says:
inflation 1: a general and progressive increase in prices; “in inflation everything gets more valuable except money” [syn: rising prices] [ant: deflation, disinflation]
The overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index and the Producer Price Index; opposite of deflation.
From this page we can see that even Dictionaries don’t agree on the definition of inflation and economists continue to argue over its primary cause. Although it is generally agreed that economic inflation may be caused by either an increase in the money supply or a decrease in the quantity of goods.
Therefore it should be equally obvious that falling prices will result from a decrease in the money supply or a rapid increase in the quantity of available goods. Recent years have seen a virtual explosion of inexpensive goods produced in China and other former Communist Countries. So it is no wonder that we in the United States see falling prices rather than the effects of inflating the money supply in our economy. The opposite of inflation is Deflation .
The inflation rate is generally measured on a percentage basis in annual terms. In other words, the percentage increase of prices over the previous year. So if something cost $1.00 a year ago and costs $1.10 now there has been 10% inflation. See How Do I Calculate the Inflation Rate? for more information.
You may also want to compare the Cost of Living between two cities you can use our Cost of Living Calculator .
An inflation hedge is a method of protecting yourself against the effects of inflation. So if you would like to buy something a year from now but want to protect your purchasing power in the mean time you might purchase an “inflation hedge” commonly inflation hedges are commodities under the assumption that if paper money is depreciating then physical commodities will be appreciating. Typically precious metals like gold and silver are considered the best inflation hedges because they are easily transportable, divisible, and readily accepted. See Gold the Timeless Inflation Hedge .
Occasionally, other commodities can be used as an inflation hedge. If you are hedging large investments Oil might serve as an inflation hedge. During times of HyperInflation such as that of Weimar Germany people would buy any commodity they could get their hands on such as soap, matches, teacups, whatever… assuming that anything was better than holding on to money that would be worthless shortly. Once they had a commodity they could exchange it with someone else for what they actually needed.