Understanding Inflation

In an article entitled "Inflation", Economist David Ranson said "Still more difficult than measuring inflation is the problem of identifying its root cause. In spite of its long and rich history, few subjects in the field of economics are more confused. Professional economists have still not reached broad agreement as to the origins of the inflation process."

There are two main sides in this debate. The monetarists say that in the long term, inflation is entirely due to increases in the money supply, such as printing more cash. The non-monetarists say that inflation is due to other factors such as the wage-price spiral, where demands for wage increases by unions force manufacturers to increase prices.

One principle that everyone will agree with is that large increases in the money supply will cause inflation. This has been shown repeatedly throughout history since the times of the Roman Empire. So the debate between the monetarists and non-monetarists boils down to whether there are additional causes besides monetary factors.

The best way to decide if non-monetary factors can be responsible for inflation is to attempt a proof by contradiction. Let's consider an economy with a fixed money supply, say there are exactly one trillion dollars in circulation and there is no way to create more. Now let's say that due to some non-monetary inflation, the cost of an average home becomes 1% of all the money in the economy. At most 100 people will be able to afford a home, but usually there are many thousands of homes for sale. Those sellers will be forced to lower their prices in order to have a reasonable chance of finding a buyer. In fact, the free market will not let prices get as high as in this example-sellers will realize the need to lower their prices long before the market becomes this skewed. The same process will occur in all other markets at some price level and this will put a limit on the net amount of non-monetary inflation. This proves that the only permanently sustainable cause of inflation is an increasing money supply.

The next logical question is: To what extent is our recent inflation due to increases in the money supply? This is something that can be measured, but it requires an understanding of deflation. Deflation is the decrease in prices due to technological development. It is easiest to see in rapidly advancing markets like the computer market, but almost all markets will see a deflationary pressure over time. For example, a liquor company may be using the same recipe that it used 100 years ago, but its cost of production will have gone down significantly. These savings come from continual upgrades to the manufacturing plants and the lowering prices of the ingredients due to their own deflation. The lower cost of liquor will yield a lower price in a competitive market. Deflation seems to run counter to our intuition, but only because we are so used to living in economies with ever-expanding money supplies.

It is not easy to measure this deflationary pressure, but we can approximate it by the change in the inflation adjusted Gross Domestic Product (GDP). The GDP measures the total annual domestic production of goods and services. Its rate of growth will include many factors, such as increasing population (more people to produce) and increasing efficiency (more production per person). These factors are the causes of deflation, which justifies the use of the change in the inflation adjusted GDP as an approximation for deflation.

Now we can write down an equation that tests whether our current inflation is due to growth in the money supply. The standard measure of inflation is the Consumer Price Index (CPI), which averages the prices of a wide range of goods, and the official data on the money supply is called M3. If our current inflation is due to growth in the money supply, then the rate of inflation should be equal to the inflationary pressure minus the deflationary pressure, or D(CPI) = D(M3) - D(GDP), where each term represents an annual percentage change (D stands for difference). Equivalently, we can check if (D(M3) - D(GDP)) - D(CPI) = 0. This quantity is plotted in the figure. On a year by year basis, there is very little evidence that the equation holds-it is off by as much as 8% in some years. However, when the quantity is averaged over all the years from 1960 to 2006, the result is 0.2%, represented by the dotted line in the plot. This is good evidence that long term inflationary pressure is proportional to growth in the money supply and that long term deflationary pressure is well approximated by growth in the GDP.