Inflation
The economic concept of inflation is a simple idea which can be surprisingly confusing for many. Most people know it has to do with the increase of prices and the costs of living, but they don’t understand the reason behind it, nor its deleterious effects. Unfortunately, this is where the People get taken to the cleaners–for the hidden truth is that inflation is the means by which wealth is transferred from the poor and middle class to the wealthiest among us.
Simply put, inflation means the total number of actual dollars in circulation is increasing–the money supply becomes “inflated.” For example, let’s say that in the year 2010, there were 1 billion dollars in circulation. By 2011, the number has increased to 1.1 billion dollars. This would amount to an inflation rate of 10%, as the total amount of dollars in circulation has increased by 10%.
2010 2011
$1B $1.1B
Inflation = 10%
You are probably thinking, “Ok, I get it, so what? Big deal.” And indeed you would be correct–this is a very big deal. What this means is that the more dollars there are in circulation, the less each individual dollar is worth than it was previously. Let’s take a look at it in terms of…
Supply and Demand
In a free market, the price of anything is determined by an agreement between how much a seller is willing to accept for a particular item, and how much a buyer is willing to pay for it. For example, let’s say a person collects baseball cards. As a gimmick to induce sales, the baseball card company has announced that every player in the majors has personally autographed one of their own baseball cards, and these autographed cards have been included randomly in all the packs of cards sold nationwide. Some lucky collectors will find autographed cards inside the packs of cards they purchased.
Question: Will an autographed card be worth more than a normal card? Why?
Answer: Yes. All else being equal, the one autographed card is worth more than the multitude of plain cards because of its scarcity–its low supply. There is only one autographed card, whereas plain cards abound. Now let’s say that because of this, one player’s autographed card will sell for $1, whereas his plain card trades for 10 cents.
Now let’s say that the baseball card company has sold out all of their initial stock of cards by the end of the first half of the year. Since they make money by selling packs of cards, they decide to issue a new round of plain cards to be sold during the second half of the year. How do you think this effects the value of the previous cards?
Since there are now twice as many plain cards in circulation as there were before, the price of every plain card falls in value, since who can charge 10 cents for a card when there are so many other people with the same card offering it for less? The doubling of the supply of plain cards has caused the value of each to be cut in half. Plain cards previously selling for 10 cents in the first half of the year are now only selling for 5 cents each. Voila. The inflation of the supply of plain baseball cards has caused each individual card to be devalued to a price half as much as before.
Now I bet you are still wondering about that autographed card… what happened to its value, after the supply of plain cards doubled? If the baseball card company issued 100,000 plain cards in the first half of the year, the autographed card was 1 in 100,000. With a second issuance of 100,000 cards, the autographed card goes from 1 in 100,000 to 1 in 200,000. It’s scarcity increased relative to the total supply of plain cards and, assuming demand goes unchanged, a corresponding rise in price ought to be expected. In our baseball card metaphor, the autographed card acts much more like sound money–gold, silver, etc–which retains its relative value in part because the baseball card company cannot print autographed baseball cards at will (unlike plain cards). For more information on sound money, click here.
There’s no Crying in Baseball… but There is in Monetary Policy
The example of devalued baseball cards due to inflation of the overall card supply is simplistic, but really no different than what goes on with respect to our currency in circulation. The higher the amount of dollars in circulation, the lower the value of each individual note: it truly is that simple.
Some people have a hard time understanding this part. A One Dollar bill, they say, still has the words “One Dollar” printed on it, no matter how many dollars have been added into circulation. And this is true. But since the numbers printed on the notes cannot change, the market makes up for the diminished value of the currency by raising the price charged for the same good or service. Take a look at the following chart:
Inflation At Work
If the concept of inflation, which is the devaluation of a currency by an inflation of the money supply, has yet to fully sink in, I’ll have to bring out the big guns… Scrooge MacDuck and his nephews Huey, Dewey and Louie. They find out about inflation the hard way!
Recap
By now you should be able to see the process by which inflation of the money supply causes prices to rise. It is pretty straightforward. What is not quite as obvious, perhaps, is the way in which inflation steals the wealth of the People away. That profundity will be delved into in our next section.
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