A (Small) Treatise on Inflation

Imagine, dear reader, that you are managing a company dealing in some trade. What you basically do is buy a good one day and then sell it a few days or weeks later. If one asked you the reasons for doing this, the answer would be obvious: profit, of course. Any firm wishing to stay afloat should sell higher than it buys, or at least intend to do so. Now, imagine if someone told you that we would have deflation in the economy, meaning that if you buy the good at €10 you would have to sell it at €9 or less because money would be scarcer and each unit of money would be worth more. Would you be willing to put your business and yourself through the trouble of buying and selling, if, at the end of the day you would end up with a loss? Doubtful.*

The situation presented above is the main reason why inflation is useful: it presents the opportunity for investment and growth because the incentive for profit-making exists. Deflation, on the other hand provides a disincentive for investment. This is not to say that all inflation is good. At times, an increase in the level of prices can prove disastrous for the economy, as for example in the cases of hyperinflation or stagflation. What follows is an attempt to explain what causes inflation and how at times of distress, having the notion that inflation will prevail assists in economic growth.

Milton Friedman became famous by promoting that "inflation is everywhere and always a monetary phenomenon". Although his aphorism may hold for hyperinflation up to a point (although hyperinflation and money supply are closed linked, hyperinflation cannot occur without the initial circumstances of a productivity shock occurring) and, as some studies claim, in the long-run, the short- and medium-term inflation is not fully explained by just the increase or the stability of the money supply. First of all, we need to understand that in order for the level of prices to increase, we need to experience a surge in demand, specifically in aggregate demand. The rationale behind this idea is that if we only witness an increase in the demand for good A while the one for good B is decreased then, when the basket of goods is calculated, they may cancel each other out and we will thus witness no alteration in the level of prices.

What an increase in the supply of money does is essentially make people richer in nominal terms. Thus, if people are richer they should spend more, at least according to theory; this will in its turn increase demand and make prices rise. The same would occur when additional credit is created via the banking sector. Both these actions make people richer, again in nominal terms, which means that they will spend more and thus we can experience an increase in the price level. 

The key word in the above paragraph is the word "spend". While in the long-run prices will more or less adjust themselves based on the money supply as the Quantity Theory of Money asserts (although this does not really hold) in the short run the consumer has to spend that money in order for the change in the level of prices to occur. If the money remains sealed in the banks and is not used for any productive means then no change in demand will occur. 

In economics, supply and demand are the factors which mostly affect the (temporary) equilibrium thus we should first focus on factors which shift demand, the first of which is consumption. Consumption is based on income, which in its turn is based on money and credit (and aggregate demand in itself). Most importantly, in the short run, consumption depends on the rate of time preference which dictates the propensity to save, subsequently affecting the velocity and quantity of money in the economy. We have seen how money and credit affect consumption (and effectively demand) in the previous paragraph; what remains is explaining how the propensity to save does it. Again it is relatively simple: if you save more, you consume less, thus aggregate demand falls and prices fall as well (if more money is saved than before, then both the velocity and the quantity of money circulating is decreased). Even if your income is higher than before or if you have access to more money (e.g. helicopter drops) or more credit than before, it does not really matter if you spend less than you did. Current prices are not formed by the potential for spending but from actual spending (although the argument that prices also reflect future expectations of inflation can be made, I seriously doubt this. Only current investment is based on expectations). What affects the rate of savings is peoples' perception of the future and their understanding of the current situation; this leads to higher savings rates during distress periods because uncertainty both about the present and the future is higher (for details on the subject read this).**

Another of the issues which affects consumption is obviously income. Income is nevertheless linked to consumption and inflation. When experiencing inflation, workers see their employers receive higher profits and thus have the incentive to bargain for higher wages. This in its turn increases consumption and demand, which re-enforces the inflationary cycle of wages and prices. Thus, when the propensity to save is increased, it opposite can be observed, i.e. both aggregate demand and prices fall. In addition, this means that profits for the employer will fall and that the employer will be forced to let some employees go in order to survive.

This brings to the surface another factor which affects inflation, albeit indirectly: the unemployment rate. When unemployment is high, demand is lower than before (since on aggregate people have less income than before) which means that prices should fall. Conversely, a decrease in the rate of unemployment indicates that people will have more money to spend (since aggregate income will rise), thus demand will rise and prices will rise in response.

Moving from the causes which affect demand, we take a look at the forces which account for aggregate supply. This can affect the level of prices in two distinct ways: either by increased supply costs or by a shortage in supply, both of which increase the level of prices. A shortage in supply is much more difficult to occur in times of distress than in times of boom, unless the good in question is a natural resource and we witnessing its depletion. Thus, when demand is on the rise, it will be more difficult for supply to keep up with it thus making prices rise (this, of course, depends on how fast demand in growing and how fast the economy can adapt to growing demand).

The next question would then be what affects supply costs. The answer is again is quite simple if we consider the costs a firm has to face: wages, raw materials, rent, new equipment. Consequently, a rise in any of these might cause the level of prices to increase (with the possible exception of new equipment which is most likely been accounted for in the pricing equation). Economists might argue that a change in the price of a good/service might affect its demand. This is true although up to a point. If a firm sells approximately 2 million goods per year and faces increased costs of €200,000, it may have to either increase its price by €0.10 to meet its targets or lay off some employees or reduce their salaries. Although the first option may (in theory) appear to be of unsure result due to price elasticities, in real life, the change in demand as a response to the price of a good depends on the existing price. For example, demand for automobiles will not really change if a new one costs €5001 instead of €5000. Conversely, if the price of a pencil is increased to €0.20 from €0.10 people might choose to buy something else, although it may again not matter as much as we think it does. (Yes I do understand elasticities. Yet, calculating elasticities is not as easy as it appears in real life; in fact, it is nothing more than a mere estimation)

Returning to the discussion of supply costs, an increase in wages, as we have already seen before, leads to an increase in the level of prices, both because of increased consumption as well as increased costs (this is sometimes called the wage spiral). To sum up supply costs, increases in the prices of raw materials, cause the price of the produced goods to increase. These may include both internationally set prices (e.g. oil or gold) or they may include goods whose is price is determined  by their sellers and buyers. Nevertheless, the increase in the price of raw materials, as well as the increase in finished goods can also be attributed to something which has been largely ignored by the academic society: a deliberate increase in the profit margin.

For example, a firm may choose to mark-up its products at a costs+30% margin. This would mean that if a product costs €10, the firm will sell it for €13. Suppose now, that the firm can change its profit margin by a small amount and this will have no important change in the demand for the good. For example, if the firm decides to sell the good for €13.5, thus earning a margin of 35%, it is quite doubtful whether the fall in demand would cancel out the increased profits. Thus, it is to the firm's best interests to raise the price, even if it means sacrificing some customers. Although some might argue that prices are at equilibrium and the firm will choose to increase prices only if demand is increased, this may occur also in the case where demand is lower. The supplier may assume that since demand is low, the price of the good for sale can be increased, since this will not alter demand by much (and may be, on occasion, be correct). Thus, increasing the margin will mean that the level of prices will be increased as it will cost more to buy the good now.

What should be noted is that if this happens in the first link of a supply chain, it is then almost impossible to realize what caused the increase. For example, as demand increases oil prices, it is more than rational to assume that the production prices in the economy will be increased as well, causing an increase in the level of prices. Yet, for goods which are not publicly traded like oil, it is much more difficult to distinguish the cause of the increase. For example, an increase in the price of a specific beer brand might be due to bad weather and increased wheat and barley prices, higher wages, higher transportation costs, higher electricity costs or just because the retailer or the wholesaler or the producer wishes to charge more.

It is infeasible to distinguish what causes prices to increase and by what extent, yet the reduction in prices can be focused just on lower demand or a deliberate shortage of money in the economy. As the latter is not a case which has taken place anywhere, and is doubtful that it will ever appear, focus should be shifted to the first case. Regressing to the example in the first paragraph, it makes it easier to see why businessmen wish for inflation when it comes to investing their money in a business. Inflation means that demand for goods will be higher in the future, which makes potential profits visible. Thus, this gives them an incentive to invest and, in their turn, boost the rise in demand by decreasing unemployment.

What has been described in the previous paragraph is nothing more than what is called inflation expectations. If investors believe that demand will rise in the economy, then it makes sense for them to invest in something which will yield them some profit from this increase. Elaborating on the point made above, when expectations of inflation are high, people wish to use the money they have saved in the economy to invest in goods. Nevertheless, the fact that expectations are high before the actual observation helps to smooth its movement by spreading inflation evenly throughout the period and not by having spikes every time inflation is announced. Thus, as expectations rise, investment also rises (which is what makes credible QE attempts successful in the longer run as shown here). In addition, what is also increased is consumption and inflation in the future. When investment is higher, it means that unemployment will fall and income will rise. This, as we have seen before, means that the level of prices will rise in the periods to come. Thus, although inflation is not currently increased by expectations, future inflation is.

Summing up, what affects the level of prices is basically everything which  affects aggregate supply and aggregate demand in the economy. What has not been mentioned yet is something which affects demand for goods directly, but is an issue which will trouble us more in the future: population. This issue had not traditionally received great attention by economists because this was something no-one could envision 50 or 100 years ago. In fact, the opposite was considered a problem, as Malthus had argued. This appears to no longer be the issue. Nevertheless, as population appears to be reducing, the interesting question of what will happen once less people are here to consume arises.

If, in any given period, we expect to have lower population than before, it means that we either have to face permanent deflation, if total money and income are the same, or a permanently increased level of money and public spending. The most known alternative for this, migration, will be to be infeasible in the case of world population decline. Just like Japan's recent experience has pointed out, in the case of a prolonged recession, it is much easier for fertility rates to fall. This will in its turn make aggregate demand fall even further, which would create further distress thus creating a vicious circle. Economic distress and signs of decay lead a country to population decline; while economic prosperity may also lead it down the same path (growth in income usually makes people have less children than before). The solution would be simple: incentives for people who have children could greatly benefit the economy as a whole. This would also increase demand and perspectives as with more people to consume in the future inflation would undoubtedly be on the rise.

Concluding, although inflation is not an issue clearly explained by economists, it is nothing more than a case of supply and demand. If we can manage to distinguish the factors which affect them, no matter how difficult it may be, then it will be easy enough to distinguish between what affects inflation and what does not. Furthermore, we have to understand that inflation is not the peril we have grown up to believe. Without inflation, no rational investor or businessman would bother to invest, and economic growth as we understand it would simply be brought to a halt.

*First of all, this is an accounting loss as accounting does not take into consideration the real value of money. Nevertheless, this could potentially be an economic loss as well since the real rate money does not necessarily need to be greater than 0 even in a deflation. In addition, precise ex ante knowledge of what the real rate will be is impossible.

** Readers may question whether interest rates affect inflation. Theoretically, they should affect it as higher rates create more incentive for savings. Nevertheless, it is not that rates are high or low to induce people to save or invest. They fluctuate because the business cycle fluctuates and not because of manipulation. Thus, interest rates are low when the propensity to save is higher (i.e. when demand for saving is high) and high when the propensity to save is lower (i.e. when demand for saving is low).