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The Difference Between Inflation and Increasing Price Levels

The Difference Between Inflation and Increasing Price Levels
by Alex Merced

One of the biggest debates right now is the inflation versus deflation debate, and much of this debate hinges on the events in consumer goods prices, but can inflation occur even if prices drop? Can prices go up even if inflation hasn't occurred? Yes, and to understand this you need to have a proper definition of inflation As your baseline.

Inflation - Inflation is an increase in the money supply, not the mere act of rising price levels. The Money supply can increase and prices react in all sorts of ways across different sectors of the economy, no matter how they react the fundamental relationship between the demand for goods and the supply of money has changed and it will have it's effects on the economy.

Hyperinflation - Hyperinflation has more nuanced definition, it's not just merely that prices are increasing at super speeds, but that the faith in the money as a medium of exchange has broken. A good money requires people to believe that if they accept it that they can in turn use to trade with someone else, cause the seller usually has no interest in the money itself other than for trading. Although if the supply of money is expected to grow at large rates for the foreseeable future less people will accept the money due to the fear of the loss of purchasing power from the growing supply. If people have believe that the money in itself is stable measure of value they have no reason to stop using no matter what happens to prices due to innovation gains or natural increases in demands.

Cause of Hyperinflation in a Fiat World - So in a sense hyperinflation occurs when people lose faith in the money, not when prices are allowed to merely rise. In todays Fiat money world, if a governments budget gets larger than it's tax base it must participate in deficit spending. If the government can borrow domestically or from other countries the effect on the supply of money is minimal, but if it cannot find the demand for it's debt from willing lenders then it's central bank will create the demand by increasing the money supply, although this punishes the original domestic and foreign lenders by giving their investment purchasing power risk.

Because of this risk, those lenders in future financing will decide to lend less if not at all meaning the central bank will have to further increase the money supply at even larger quantities. Once a governments budget gets to the point that the only way of financing is through these liquidity injections with no end in sight, less people will begin willing to sell their foreign currency for the domestic currency, meaning foreign goods will begin rise in price dramatically. So as the world begins to lose faith in the domestic currency, the amount of the currency needed to exchange for goods cause of the wavering faith in the currency will see it's hyper inflationary crash. Thus it's crisis of faith in a currency, not a crisis in consumer good prices.

Price Increase and Decreases - While increased in the money supply (inflation) will have upward pressure on prices and a decrease in the money supply (deflation) prices can still go down and up in either environment for a variety of different reasons. Prices of technology go down in an inflationary environment cause of innovation in technology allowing to make the same good at lower prices, although inflation can erase much the nominal drop in price. Another you may see a drop in prices is a drop in demand which may be for a variety of reasons such as better alternatives, credit crunches, and more. Prices can increase in a deflationary environment cause demand for new goods is large, or special programs make credit available for certain goods such as housing or college tuition. Although all these price and increases/decreases would affect the consumer price index (CPI) although they have no fundamental bearing on weather the money itself is a stable medium of exchange. So essentially programs like fannie, freddie, and sallie may help create price bubbles it's really the money supply increases from the central bank that will lead to the destruction of the currency.

So how do I assess todays environment? - Well take the true monetary definition of inflation/deflation one must ask which one are we in? It really depend on which measure of the money supply you use, if you use the numbers like M1,M2, M3 which go beyond the base bank reserves and measure the circulating credit then it would appear as we've been spinning towards deflation. Since there's less credit available there is essentially less money available meaning demand will be limited causing price drops which clearly have been seen in goods such as clothing and other luxuries, although this doesn't really paint a picture of what's going on when the government finances it's budget.

If you take a look at the monetary base (bank reserves/dollars), this number has exploded has doubled and tripled at certain points. When the central bank injects liquidity to help finance the governments budget, the entry point is the monetary base and while credit hasn't been created on top of this base yet, it's still a sign to lenders of the future risk of their investments in US Treasuries (government debt). With many of the politically difficult to remove expenditures of the government budget, deficits seem to be perpetual and the amount of willing lenders has decreased to the point where the central bank is the largest holder of that debt. So while you may not see runaway prices increases you are seeing the faith in the dollar as stable medium of exchange eroding with only the fact that it's the reserve currency of the world, which is something that will take some time for the rest of the world to divest from, but it won't take forever.

Bottom Line: While credit contraction will have downward pressure on consumer prices, the increasing monetary base in order finance a growing government deficit will erode the faith in the currency to cause the inevitable hyperinflation.

Posted Jul 17 2010, 11:12 AM by Alex Merced