Why Inflation is Inevitable

If you have been following the news lately you have been hearing more reports predicting that inflation is headed our way. But have you ever wondered where inflation comes from and why the government likes it?

To begin with inflation is essentially a result of the relationship between the amount of goods and services our country makes, compared to the amount of money the US Treasury releases into circulation. Here is an overly-simplified version of how it works.

Suppose you have access to some fine quality wood, some tools, and a seven-year old kid who knows about computers. You figure out a technique to mass-produce yoyos and your young protege devises a way to insert a small receiver in them that picks up signals from a cell phone; so whenever people spin those yoyos, they makes all sorts of creative sounds. Before long, you are making a million yoyos a year.

If it cost you a dollar each to make those yoyos and you sell them for three-dollars each, then your little empire is adding two-million dollars per year (one million yoyos times two dollars each) to the Gross Domestic Product (GDP).

In the meantime, and on regular occasions, the FEDs get together to discuss the state of the economy. Since people like you have “created” wealth out of thin air (you gotta love Capitalism) the Government needs to release some new money into society, otherwise we would have more goods, but no new dollars, and that would cause prices to drop. The Cato Institute has a good definition of deflation.

Note: If you are not sure how that works, imagine a group of ten children who each has $1. and they each want to buy one of your yoyos. If they only have one dollar, then that is the most you can get, but if they earned another dollar, then you could sell your yoyos for more. Another way to look at it is, assume there is only one dollar in all of out society and you have it. That would be a very valuable dollar and everybody would be lowering the prices of their products to attract some of that precious money. On the other hand, if we all had a million dollars, we could pay a lot for the things we want, but no single dollar would be worth very much. So inflation is a relationship between the amount of goods available and the amount of money available. Edna Carew has another good explanation.

If there are too few new dollars relative to the goods and services created there can be deflation. The Cato Institute explains it well.

So, one of the FED’s purposes is to determine how many services and goods (like your yoyos) have been manufactured and to release the correct amount of money into society to keep prices in balance.

However, the point of this article is to establish that the FEDs have a more sinister motive than simply keeping prices “in balance”. In fact they actually like inflation. I will tell you “why” they prefer the cost of every thing to go up the next time, but for now I hope you realized “how” they do that (by releasing more money into society than the new goods and services justify) Here is a good article about money supply.

One additional point before we move on. Rising prices is not always in our best interest. While there is no doubt we all like to get pay-raises at work, that new infusion of income can easily be off-set if we have to pay more for everything else. Furthermore, there are certain people who are severely damaged by higher prices. Seniors, and anybody else who has fixed income, suffers if prices go up. As a result, inflation eats away at their standard of living. When inflation is rising quickly, you will here these people talking about “COLA” but they do not mean soda pop. They are talking about Cost Of Living Adjustments in their Social Security checks. USA today has article about the pain these seniors experience.

All of this sets up an interesting political dynamic because the congress is generally trying to inch prices up, but the most active voting block is the very group who dislikes inflation the most. So politicians are constantly balancing the benefits of inflation against the anger of the seniors.

In my next post I will tell you “why” the government flies in the face of the seniors and pursues inflation anyway. After that, we will talk about how you can use all of this to your advantage.

Several other stories about inflation

An article on my website about inflation

Until then, I welcome your comments.

And, don’t forget to visit my other blog.