The word “inflation” is thrown around quite a bit, but it’s meaning has changed over time. It used to refer to an increase in money circulating in the economy. When this happens, more dollars begin chasing the same amount of goods and services. What happened to prices afterward was dealt with separately. This is why Milton Friedman memorably contended that ”inflation is always and everywhere a monetary phenomenon.” This meant not only a change in the money supply, but changes in money demand. Inflation can arise if consumers begin to spend their money at a faster rate.
Today, even most economists use the word inflation to describe something different: a general and sustained rise in the average price level. The media takes it a step further and will often describe the price of one asset or one sector as “inflating”. Turn on CNBC and you’ll hear about things like energy inflation, simply meaning that energy prices are rising relative to other goods and services. The price increases in a single sector like energy only represent that the demand for energy resources is increasing faster than the supply of energy resources. The fact the price went up only reflects underlying real changes in the economy.
Discussing inflation like CNBC in a single commodity, asset, or sector is nonsensical. Prices are the result of real inputs into supply and demand. If the price of one good rises, it can’t create a ripple effect through the entire economy causing the average level of all prices to rise. Everyone only has so much money to spend. If you use more dollars to fill up your car’s gas tank and heat your home, you have fewer to use on other things. The demand for some other good will fall, as will the price, all thing’s being equal.
So the old meaning of inflation referred to changes in circulating money while the new meaning refers to a sustained rise in the average price levels of a select basket of goods and services. The technical term to describe the old inflation is demand-pull inflation. The government needs to pay for things it can’t afford and prints extra money. This causes demand for goods and services to go up with the extra money circulating. Voilà, prices increase.
We should be asking why prices are going up (or down). If it’s due to real resource constraints, consumer demand, and consumer preferences in saving, so be it. But if it’s due to changes in monetary policy, that is sure to create distortions in the economy. If all of the sudden more people are coming to your burrito stand, is that because your burrito’s are more popular or there is just more money circulating in the economy? Amidst monetary inflation, a business owner might mistakenly decide that their burrito’s are more popular, and expand their business to meet the demand. That is a distortion, which can be taken away when the money supply contracts. Once the burrito stand owner realizes the real demand for his burrito, he’ll be forced to cut back his production.
The Fed has expanded its balance sheet to an unprecedented $2.492 trillion. Much of that money has not began circulating in the economy, instead being hoarded by the banks. When and if it does make it out there, we’ll see demand-pull inflation.
Money and prices are a veil, but they also have real effects which distort our view of the economy. We should look through the veil to the real underlying factors. Prices are not what we care about. We care about our command over goods and services, or the purchasing power of our money. Milton Friedman argued for small, constant growth of the money supply. I personally don’t fear deflation in all cases, so I’m not necessarily on board with him on such a fixed policy. However, a low, consistent increase in the money supply is better than erratic monetary policy because people can set their expectations accordingly. Unfortunately, inflation in the old sense doesn’t equal growth or a higher standard of living. When the next nominal GDP figures are released, ask yourself how much of that is real growth and how much of it is demand-pull inflation (or debt which must be repaid with interest later). Real growth requires improvements in human capital (our education system is killer), productivity, labor productivity, entrepreneurship, and technology. That’s where our focus should be; not on deficit spending, defense spending, and increasing the amount of money circulating.