Inflation Explained in Plain English

By David L. Kendall, Ph.D.

Inflation around the World

Clearly, different countries experience different rates of inflation. Which countries seem to have
the highest rates of inflation? Do they have anything in common?

Copyrighted by David L. Kendall, 2008.

Annual inflation rates in the U.S. in the 20th Century.

It’s clear that the rate of inflation changes over time. See if you can match up high rates of
inflation with historical events (think particularly about wars and other periods that involved
unusually high levels of federal government spending). Doing so will give you some insight into
the causes of inflation (think about unusually high levels of federal government spending).
Notice that inflation has generally been positive, not zero or negative. How could we understand
that? Notice when inflation has been negative. Notice that inflation has been much more stable
and generally lower since 1990 in the 20th Century. We might want to understand why this is so.
Based on the data here, what would be your best guess for the rate of inflation for next year?

Inflation is a sustained increase in the average of prices for all goods and services.

We use price indexes to measure the rate of change in the average money price level. Three
widely used price indexes are the Consumer Price Index (CPI), which measures the average
price of a defined set of consumer goods, the Producer Price Index (PPI), which measures the
average price of a defined set of producer goods and services, and the GDP Deflator, which
measures the average price of all goods and services for the entire economy.

We construct a price index based on a well defined basket of goods and services. For example,
the CPI is defined for a basket of goods and services typically bought by consumers. We
calculate the average money price of the set of goods as a weighted average. We use expenditure
shares of goods in the basket for the weights. The weighted average price for the basket of
goods can be compared over time to measure the rate inflation. Any particular measure of
inflation may be broadly defined or more narrowly defined, depending on the definition of the
basket of goods and services included in the price index.

Effects of Inflation

If everyone could correctly forecast the rate of inflation (clearly not possible), and if adjustments
to anticipated inflation were costless (also clearly not possible), then inflation might not be much
of a problem. But unanticipated inflation always creates gainers and losers in the economy.
Some people like inflation; others don’t. Here is a list of effects that inflation may cause.

Uncertainty about future purchasing power of money can retard economic activity in
general. Think about how difficult it is to plan for the future if the purchasing power of
your dollars keeps changing and you can’t accurately forecast how much it will change.
It’s rather like trying to measure a distance when the length of a meter or a yard stick
keeps changing in unanticipated ways.

Redistribution of wealth:
o Inflation can redistribute income away from people on fixed incomes, such as
pensioners, toward people whose income will adjust upward with inflation, such
as current workers.
o Unanticipated inflation can redistribute wealth away from those who lend to those
who borrow. But if borrowers and lenders can correctly anticipate future inflation,
Copyrighted by David L. Kendall, 2008.
 the nominal rate of interest they negotiate will include an inflation premium, such
that

Nominal interest rate = Real interest rate + expected rate of inflation

Changes in Exchange Rates: If the U.S. rate of inflation were higher than the rate of
inflation in Japan, the value of the dollar will tend to fall relative to yen, other things
unchanged, which means the dollar-yen exchange rate would be rising and it would take
more dollars to buy one yen in the foreign exchange market. Of course, many other
factors affect exchange rates, so this is not the whole story of changes in exchange rates.
Unanticipated changes in exchange rates can cause changes in trade flows between
countries. When the dollar loses value compared to the yen, Japanese companies import
more goods and services from United States producers. U.S. companies import less
Japanese goods and services from Japan. Some people will like those changes, others
will not.

Shoe leather costs: These are costs incurred by households and businesses trying to
protect themselves from loss of purchasing power of money. An example would be
spending time hunting for a checking account that pays a higher daily rate of interest on
demand deposits.

Menu costs: These are costs incurred by firms that must advertise or post new prices as
inflation occurs. That’s not free.

Relative Price Distortions: Some prices in an economy are “sticky,” which means they
change more slowly than others during an inflationary episode. If all money (a.k.a.
nominal ) prices don’t rise at the same rate during inflation (and they don’t), then relative
prices will be distorted by inflation, causing distorted impressions of relative value. Such
distortions can cause households and business to make different economic choices than
they would make in the absence of inflation.

Tax Bracket Creep: Inflation pushes some people into higher income tax brackets (since
money incomes rise with inflation), raising their marginal tax rates even though their real
(a.k.a., inflation adjusted) income may be unchanged. People who believe that Congress
should control more of the nation’s GDP probably like this effect. People who believe
that the Congress already controls too much of the nation’s GDP probably don’t.

What Causes Inflation?

The answer to this question has been debated long and loud among economists and non-
economists. Before we begin to think about this, let’s be sure we understand that inflation is a
sustained increase over time in the weighted average of all money prices. So, if the money
prices of oil and health care are rising, but all other money prices are staying the same or even
falling, that is NOT inflation, even though the newspapers will doubtlessly call it inflation.

To begin to think about what causes inflation, think first about whether we could have inflation
in an economy that did not use money. Clearly, such an economy could not have inflation, since

Copyrighted by David L. Kendall, 2008.

all exchange of goods and services would occur through barter, and all things bartered would be
real things. We would not even have money prices in such an economy. So, by definition, we
could not have a sustained increase in the average of all money prices! Relative prices (i.e.,
“real” prices), by the very idea of what we mean by the term “relative prices,” cannot possibly all
rise at the same time. The statement “a rise in all relative prices” simply has no meaning. Don’t
think about it too long, since it has no meaning. This line of reasoning should convince you that
inflation is “every where and always a monetary phenomenon,” just as Nobel laureate Milton
Friedman said. Although a complete understanding of inflation is a bit more complicated,
Milton Friedman’s observation is a good place to start.

Since inflation is always a monetary phenomenon, we will want to think about the supply of
money and the demand for money to understand what causes inflation. In other words, we will
want to think about how much money there is compared to how much money people want. If
more money exists than people want, people make behavioral adjustments. The same is true if
less money exists than people want.

When we talk about money, the term “demand for money” does not mean demand to spend
money. Just the opposite. Demand for money means demand to “have and hold” money in an
inventory (such as in your wallet or in your bank account). That’s just the opposite of spending
money. We all want to spend lots of money; maybe even an unlimited amount of money in the
aggregate. But none of us wants to hold an unlimited amount of money in our wallet or in our
bank account or even in our saving account. Keep this point clearly in mind; the demand for
money is a demand to have and hold money in an inventory, not a desire to spend money.

If the quantity of money that exists is equal to the quantity of money that people want to hold as
an inventory of money, then the average money price level will not tend to be changing either up
or down. Put another way, if the quantity of money that exists equals the “demand” for money,
then the weighted average of all MONEY prices would not be changing, even though some
RELATIVE prices might be changing. Remember, inflation is about rising MONEY prices, not
about a rising relative price for one or even many goods or services.

Let MS denote the quantity of money in existence in our economy. Remember that the quantity
of money for the most part includes currency in circulation (the money in your wallet) plus
demand deposits (i.e., balances in checking accounts of all kinds), and savings accounts that can
quickly be converted to demand deposits without loss of value. Let MD denote the quantity of
money we demand (i.e., how much money we want to hold in inventory, not spend). If
MS = MD, then the average of all money prices will not tend to be rising or falling. The reason
this is so is that no behavioral tendencies would be present that would cause all money prices to
either fall or rise. The supply and demand for money would be in equilibrium. So, as we will
see below, inflation is the result of a disequilibrium condition.

If MS > MD, then people have more money in their inventories (i.e., wallets and bank accounts)
than they want to hold. Keep in mind that people have to hold all the money that exists. If you
decide you have more money in inventory than you want, what will you do? To keep from
holding the money you don’t want, you will either buy something, destroy the money, or give it
to someone else. Guess what most people do? They might buy a good or service, or they might

Copyrighted by David L. Kendall, 2008.

buy a financial asset, such as a stock or a bond. But they will buy something instead of continue
to hold money they don’t want to hold. In the aggregate, as lots of people try to buy something at
the same time, they will collectively be bidding up the money prices of the stuff they are trying
to buy, since there is no immediate increase in the amount of stuff they are trying to buy. That
means we have behavior that will be tending to cause money prices of lots of stuff to rise, even if
the relative prices of stuff is not changing (which would be the case if all money prices are rising
by the same percentage). As the average price level rises, the quantity of money that people want
to hold in inventory begins to rise, simply because people will need more money at the ready to
transact expenditures they want to make expenditures that now take more money, since money
prices are higher. If the quantity of money in existence didn’t keep rising, eventually the
inflation would stop when the quantity of money people want to hold had risen enough that
quantity of MS equals quantity of MD. All the money there is must be held by someone, so it is
quantity of MD that must adjust to restore equilibrium, if the quantity of MS is not changing.

If MS < MD, then people do not have as much money in inventory (i.e., in their wallets or their
bank accounts) as they would like to have. If you decide you do not have enough money in
inventory, what will you do? You can’t create money yourself. Bottom line; you will sell
something to get money or you will refrain from buying so much stuff so you can hold on to the
money you already have. Such actions would increase the average quantity of money you hold
in inventory over time. In the aggregate, lots of people will be trying to sell assets they own, or
they will be refraining from buying stuff that’s for sell. That creates downward pressure on lots
of money prices of goods and services in the economy, and the weighted average of all money
prices begins to decline or at least doesn’t grow as fast.

As an empirical matter (i.e., historical data show it), aggregate demand for money is a rather
stable proportion of real aggregate production (which is the same thing as real aggregate income;
think of the circular flow model) . The adjective “real” means just what you think it does; it’s
real, not just a nominal or monetary phenomenon. Think of it this way. If the money price of a
cheeseburger is $2, then the nominal value of the cheeseburger is $2 x 1 cheeseburger = $2. But
the real part is just 1 cheeseburger. So real aggregate output is a measure of real stuff that gets
produced. The terms “real output” and “real income” refer to the enormous pile of real stuff that
we produce in a year. The terms “nominal output” and “nominal income” refer to money value
of that enormous pile of stuff, given current money prices.

Certainly, as real output rises with population growth and improvements in technology of
production, the demand for money does tend to rise. But the demand for money does not tend to
rise or fall over the long term if real output is not rising. In other words, people don’t usually
just wake up one morning and suddenly want to hold larger inventories of money unless their
real incomes are rising. Short-term fluctuations in the demand for money can and do occur, but
they tend to offset one another over time. For example, if you’re planning to buy a house, you
might hang on to a larger inventory of money for a while, but after you buy the house, you don’t
want that larger inventory of money any more. The long-term secular trend for growth in MD is
due mainly to rising aggregate output.

If you are following this reasoning, it should now be clear that a sustained rise over time in the
weighted average money price across all goods and services must be due to sustained growth in

Copyrighted by David L. Kendall, 2008.

MS that is greater than growth in MD, causing MS > MD to persist over time. For that to happen,
the quantity of MS must keep growing, since the quantity of money demand will be rising as the
average price level rises. If whoever it is that creates money (that would be the Fed) keeps
increasing MS faster than MD is increasing, the average price level keeps rising. That’s called
inflation.

Now, some people might want to split hairs and argue that we COULD have other forces that
causes MD to fall (causing MS > MD even though MS is not rising) or cause MD to rise at a rate of
growth less than the prevailing rate of growth in real aggregate output while the monetary
authority is increasing MS at the rate of growth of real aggregate output, either of which would
also result in MS > MD and thus inflation. While that COULD be the case, in reality, that doesn’t
happen much , and it certainly doesn’t happen in a sustained way over long periods of time.

Bottom line–inflation is caused by the quantity of money growing faster than real aggregate
output. The next question would be why does the Fed cause MS to grow faster than the trend rate
of growth in real aggregate output? It is the Fed that controls what we call the monetary base
(currency+banknotes and coins+ commercial banks' reserves with the central bank), which
means the Fed controls MS. Again, some people might want to split hairs and argue that the Fed
doesn’t have absolute control of MS (for a variety of technical reasons we can’t get into here),
but again, while that COULD be the case, in reality, that doesn’t happen much, and it certainly
doesn’t happen over long periods of time. Simply put, the Fed controls the quantity of MS and
its rate of growth over time.

So why does the Fed cause the quantity of money to grow so fast that we get inflation? That’s a
question about motives of particular people (notably, the people that comprise the Fed’s Open
Market Committee, which is led and influenced by the Chair of the FOMC, Ben Bernanke just
now). I have some ideas about such motives, but some of them are not particularly charitable. I
will offer here some of the more charitable ideas.

Like everyone else, the Fed cannot accurately predict the rate of growth of real aggregate output.
The Fed certainly cannot predict short-term fluctuation in real aggregate output – things like
hurricane Katrina or 9-11– even if it could predict the long-run trend. If the Fed overestimates
the rate of growth of real aggregate output persistently, then it might cause MS to grow too fast.
So, the Fed simply might make mistakes. But mistakes should be short-run mistakes, not
persistent mistakes that get repeated year after year. If inflation were simply the result of
mistakes, we would expect to see both inflation and deflation over the long term. We don’t; we
see only inflation over the long term.

The Fed also does not want to cause deflation because falling prices are generally not seen as a
good thing by producers and sellers of goods and services, or by workers who would see their
wages decline if we had persistent deflation. This predisposition may be mostly a psychological
thing, a type of money illusion, but still, it generates a bias at the Fed toward a low rate of
inflation instead of a low rate of deflation. Getting a zero rate of inflation most of the time might
just be too difficult to achieve, so the Fed may opt for a low rate of inflation somewhere
between 2% and 3% per year.

Copyrighted by David L. Kendall, 2008.

The Fed may be forced by fiscal policy (i.e., spending and taxing decisions made by Congress
and approved by the President if not vetoed) to cause the quantity of money to grow too fast to
keep inflation at zero. If Congress spends more than it collects in taxes (which is particularly
likely during times of war), then where does the money to finance federal spending come from?
The answer has often enough been “from the Fed.” If the Fed refuses to create the new money to
accommodate too much deficit spending conducted by Congress, what would happen? Interest
rates would start rising as Congress borrows more and more in excess of what households want
to lend. The U.S. Treasury can sell all the bonds it wants to sell, if the rate of interest promised is
high enough. Ultimately, loanable funds must come from saving of households or from money
creation (where else could loanable money come from?). If interest rates rise, businesses will
borrow less to finance new plant and equipment, since the cost of borrowing (i.e., the cost of
renting someone else’s money) is higher at higher rates of interest. As businesses spend less on
new plant and equipment, real aggregate output either grows slower or even declines. That’s
called a recession. So, the Fed may decide the best course of action is to accommodate excessive
federal deficit spending by creating money faster than the rate of growth of real aggregate output.
That causes inflation, of course.

Okay, now I’m going to tell you a less charitable reason the Fed might grow MS faster than the
rate of growth in real aggregate output. Banks make money through the process of money
creation. The more money the Fed creates, the more money its shareholders – banks – make.
Does that suggest anything?

Is it a good thing or a bad thing that the Fed causes inflation? Well, that’s a normative question.
You’ll have to decide that for yourself. The Fed has done a pretty good job over the last decade
and a half of keeping inflation low and stable. Some folks think that’s a fair price to pay for
letting the Fed control the money supply, even if inflation does create profits for the Fed’s
member banks.

Some people have even less charitable explanations for why the Fed causes persistent, enduring
inflation. Edward Griffin’s The Creature from Jekyll Island presents a particularly disturbing
explanation. Murray Rothbard’s What Has the Government Done to Our Money presents more
reasonable, but still less charitable explanations. Read them both; they’re out there on the web
and easy to find.

Bottom line: the growth rate of money supply compared to money demand is the only real
explanation of persistent, enduring inflation. In the United States, the Fed controls the long-term
rate of growth of the money supply. The long term rate of growth of money demand is virtually
the same as the long-term growth rate of real output.

Draw your own conclusions. If you like inflation, and you might, you’ll be a fan of the Fed. If
you realize, though, that since the Fed’s creation, the purchasing power of a U.S. dollar has
fallen from 100 cents to a bit less than 9 cents, and if you realize who got the benefit of that
decline in purchasing power, you might not be a fan of the Fed.

Can you hear your nest egg shrinking? It’s an ugly sound. With inflation averaging just 3% per
year, the purchasing power of every dollar you save will fall to just 50 cent in just 26 years. But

Copyrighted by David L. Kendall, 2008.

that purchasing power isn’t just vanishing; it’s being usurped by someone–real persons. Who?
You now know enough to figure that out for yourself.

Copyrighted by David L. Kendall, 2008.