Inflation: the lowdown on higher prices
- jasonsix3
- May 28, 2024
- 6 min read
Updated: Jul 31, 2024
This article is an excerpt from the full article 'Economics in One Lesson: An Analysis of Basic Economics' which analyses the work of Henry Hazlitt.
Inflation
Inflation is a feature of the modern economy - sometimes called a tax – that is not only tolerated by the powers-that-be, but actually has a target (often two to three per cent). Inflation refers to a general rise in prices throughout an economy and, despite its often-bad reputation, is a reliable companion of central banking policy. A central bank aims to keep inflation at a level considered to be ‘just right’; somewhere between providing a boost to the economy and avoiding a bank-run.
“The Reserve Bank uses an inflation target to help achieve its goals of price stability, full employment, and prosperity and welfare of the Australian people. This is because price stability – which means low and stable inflation – contributes to sustainable economic growth. Targeting inflation of 2 to 3 per cent avoids the many costs to the economy from inflation that is too high or too low.”
Interest rate targets are a bellwether for those set by banks and affect broader economic activity. Central banks control the interest rate for lending between commercial banks who can, and do, ‘pass on’ the higher cost of money to the rest of us, creating a knock-on effect for various decisions made by businesses and consumers about things like lending, saving, investment, employment, and spending. Adjusting interest rates in such a way is a key part of ‘monetary policy’.
Another tool of monetary policy is the expansion of the money supply, which in practice often occurs by the central bank purchasing debt from the government (in the form of ‘bonds’, which are essentially loans made to the government). Increasing the money supply is considered by some to be a contributing factor to inflation.
“But central banks are not like commercial entities. Unlike a normal business, there are no going concern issues with a central bank in a country like Australia. Under the Reserve Bank Act, the government provides a guarantee against the liabilities of the Reserve Bank. Furthermore, since it has the ability to create money, the Bank can continue to meet its obligations as they become due and so it is not insolvent. The negative equity position will, therefore, not affect the ability of the Reserve Bank to do its job.”
Money is created by banks by making new loans from money that did not previously exist and, in the same way, when banks make fewer loans and existing loans are paid off, the money supply decreases:
“From the perspective of money ‘creation’, deposits can also be created when financial intermediaries make loans. While the process of extending loans is central to the process of money creation, this does not mean that financial intermediaries are able to make loans and create money without limits. Deposit-taking institutions need to meet certain regulatory requirements and must be satisfied that borrowers can pay back their debts.
Deposits can also be created by the Reserve Bank, such as when the Reserve Bank purchases government bonds. When the Reserve Bank purchases government bonds from the non-bank private sector, households and businesses ultimately deposit the proceeds of the sale into the banking system, adding to total deposits.”
(https://www.rba.gov.au/education/resources/explainers/what-is-money.html#fn1)
Inflation is generally measured by changes in the Consumer Price Index (CPI) – that is, the price of household goods and services (which does not, interestingly, include buying and selling existing housing, and therefore excludes the effects of the rapid real estate price rises experienced by first home buyers in most major cities). There are, however, other measures of inflation such as the wage price index, the producer price index, and the residential property price index. For the record, the annual growth in wages hovers around 3-4% in Australia, while residential property prices rose over 24% across all capital cities to December 2021. [10]
The causes of inflation are disputed, differing on whether it is an increase in the money supply, or demand and cost pressures in an economy that are mostly to blame. Regardless of the cause, once prices begin to rise in some parts of an economy, inflation generally spreads by producers adjusting their prices upwards in response to higher demand or input costs, followed by workers demanding higher wages.
The primary negative effect of inflation is to decrease the purchasing power of currency already held; consumers can buy fewer goods and services with the money they have saved because, on the whole, prices are higher. Each unit of currency is worth less than before. The effects of inflation are not equal across the economy, and some industries and sectors benefit from higher prices; for example those that own tangible assets such as housing and other property.
The positive effects of inflation include the ability of producers to reduce the real wages of workers when needed (yes, you read that right). This occurs when wage growth is lower than the increase in prices. An important and related concept is that of ‘real wages’; this is the amount of goods and services a wage can afford, as opposed to nominal wages, which is simply the money value of wages. As a rule, when wages rise less than inflation, wage-earners are losing out.
Arguments
Money is often confused with wealth; if everyone had more money, then we’d all be wealthier and be able to buy more things. But Hazlitt describes such thinking as ‘naïve’ because it doesn’t consider the inflationary effects of an increase in the money supply. Similarly, those who advocate for policies to print more money either misunderstand that more money will also, over a period of time, increase commodity prices. Others believe that such policies will have a positive effect on the economy.
Real wealth is goods and services - what we produce and consume. Money is simply a means to an end and a measure of value, but has little value in itself; we can’t eat it, wear it, or drive it.
More money does not mean more wealth, because prices increase as result. Increasing the amount of money raises prices in a chain of cause-and-effect: the first recipients of the additional money uses it to buy more goods and services, the sellers who receive the money respond to higher demand by increasing prices, other people will react to news of inflation, and the process will continue throughout the economy until a general rise in prices occurs.
Inflation is really like a tax, the effects of which are distributed unevenly and disproportionately affect the poor, whose cost of living remains the same while the prices they pay increase. Inflation results in greater wealth inequality because those who are late to the party and don’t receive the early benefits of the extra money (when the prices of goods and services has not yet adjusted upwards); in the short-term, the average consumer continues to receive the same salary.
Productive resources are misallocated as a result of demand created from those who benefit from the initial increase in purchasing power. In addition, inflation can contribute to the onset of recession or depression by causing a misalignment between wages, costs, and prices (for example, between the cost to produce a good and its sale price) and thereby reducing the incentive to produce.
Analysis
While money may not be the source of all wealth or the root of all evil (a claim based on a misquote from Bible which condemns the love of money), it’s useful to consider what money is when discussing issues like inflation, if the rate of inflation is influenced by the quantity of money in an economy as well as the price of money (set by the rate of interest).
Is money something that must, or should, be tied to a tangible commodity (like gold) to prevent it being manipulated and devalued, or is it just an abstract concept that gets its value by virtue of being issued by the authority of government (otherwise known as ‘fiat’)?
In the past, the devaluation of a currency occurred when authorities ‘debased’ it by reducing the size of coins or minting larger quantities of coins that contained less of a precious metal such as silver or gold. The Romans are known to have been sneaky silversmiths and the Chinese tinkered with their legal tender by printing more paper notes.
These days, central banks are fairly transparent about fiddling with fiat currency, which is no longer tied to a tangible commodity and derives its value from being issued by a nation’s central government (and based on the expectation that the nation will continue its economic activities – that it’s workers will continue to work). Consumers are using less cash and transacting with cards instead, a trend that’s only increased since the recent pandemic [17].
Some central banks have begun issuing digital currencies, an enticing prospect for regulators and bankers alike, with a range of potential benefits such as increasing control over tax collection, greater and more direct control over economic activity, and the ability to monitor and restrict consumer transactions for a range of economic and political purposes.
Greater government control over money and economic activity is an alluring idea for some and evokes dystopian visions for others. It seems true that a gold standard, for example, limits government intervention in the money supply as the money supply is backed by, and convertible into, physical gold (in theory, at least), but also that its total quantity is difficult to predict or control.
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