Your Dollar Savings is Another's Debt

The way most modern banking systems are setup, it is impossible for someone to save money without somebody else going into debt.  That's because, as I described in a previous post, all money is created as a debt.  Therefore, for anyone to get a dollar, they must either have borrowed it, or gotten it from someone (who got it from someone who got it from someone... etc) who borrowed it.

So how does this work in practice?  Let's say we have in our country 300 million people exactly.  Let's also say that everyone, but one person, wants to save a dollar.  That is, they want to spend one less dollar than they make.  The only way that is possible is if the remaining person goes an extra 299,999,999 dollars in debt - 1 dollar for every other person who wants to save an extra dollar.

Think about what that means.  It means it is impossible for anyone to have more dollars than they owe, without at least one other person or entity(company, non-profit, government, etc...) owing more dollars than they have.  At first this conclusion may be hard to accept, but once you accept that all money is created as a debt you'll realize that it has to be true.  Let's take a look at a few more examples to better illustrate.

If you buy something from the Dollar Store, you are 1$ poorer and the Dollar store is 1$ richer.  No money was created and the Dollar store is richer at your expense.

Dollar Store +1

You - 1

Net = 0

Now let's say you buy a 25 thousand dollar car from a dealership, but have to borrow the money from Fifth Third bank. Fifth third lends you the money so they're now 25 thousand less dollar, but have your loan as an asset.  You have a car and a 25 thousand dollar debt.  The car dealership is now 25 thousand dollars richer.

Fifth Third - $25,000 cash

Auto Dealership + $25,000 cash

Fifth Third + $25,000 asset(your loan)

You - $25,000 debt to Fifth Third

Net = 0

As before, let's say you buy a 25 thousand dollar car from a dealership, but have to borrow the money from Fifth Third bank. This time, however, let's say that Fifth third doesn't have the cash on hand and has to borrow it from the federal reserve.  This changes things a little bit, but still no one getting ahead.  Instead of being out $25,000 cash, they take on a $25,000 debt to the federal reserve.  Also, there is extra cash in the system now too.

Federal Reserve + $25,000 asset(Fifth Third Loan)

Federal Reserve - $25,000 cash (which it creates)

Fifth Third -$25,000 debt to federal reserve

Auto Dealership +25,000 cash

Fifth Third + $25,000 asset (your loan)

You - $25,000 debt to Fifth Third

Net = 0

Everything still nets to zero.  The only difference is that the federal reserve had to create 25,000 in cash to fulfill Fifth Third's requested loan.  The federal reserve didn't have to borrow that cash since it creates cash at will.

Now let's take this even further.  The auto dealership isn't just going to hang on to the cash it just received.  They're going to take that money and put it in their own bank.  Let's say Chase Bank.  Chase, is going to then take that money and lend it to somebody else.  Let's say to your neighbor as a home improvement loan.  Now all that's happened is that the auto dealership exchanges cash for an asset, and your neighbor gets cash in exchange for a debt to Chase.

Federal Reserve + $25,000 asset(Fifth Third Loan)

Federal Reserve - $25,000 cash (which it creates)

Fifth Third -$25,000 debt to federal reserve

Auto Dealership +25,000 cash (you gave them)

Fifth Third + $25,000 asset (your loan)

You - $25,000 debt to Fifth Third

Auto Dealership - $25,000 cash (deposited to Chase)

Chase + $25,000 cash (from Auto Deposit)

Chase - $25,000 debt to Auto Dealership

Auto Dealership + $25,000 asset (Bank Deposit)

Chase - $25,000 cash (loan to neighbor)

Neighbor + $25,000 cash

Chase + $25,000 asset (loan to neighbor)

Neighbor - $25,000 debt to Chase

Net = 0

I suppose I could keep going by having your neighbor go to home depot to buy supplies, but I think the point is made.  No where was cash or some other dollar asset created without a corresponding debt.  Granted, non-dollar assets (the car) changed hands, which is a good thing and is what actually makes the economy work, but the net amount of savings never changed.

One more case before I leave this topic.  Let's look at the effect of someone defaulting on their loan.  Let's say you default on your auto loan before even making your first payment and declare bankruptcy.  In the example where you borrowed from Fifth Third and didn't involve the federal reserve, what would happen is that Fifth Third would lose their $25,000 asset and you would lose your $25,000 debt.  After your bankruptcy, it would look like this:

Fifth Third - $25,000 cash

Auto Dealership + $25,000 cash

Net = 0

In the case where Fifth Third had to borrow money from the federal reserve, it would look like this after your bankruptcy:

Federal Reserve + $25,000 asset(Fifth Third Loan)

Federal Reserve - $25,000 cash (which it creates)

Fifth Third -$25,000 debt to federal reserve

Auto Dealership +25,000 cash

Net = 0

Fifth Third still owes the federal reserve $25,000 dollars.  That money will have to come from more profitable loans.  So no matter what, no money was created without a debt, and nobody made any money without themselves or someone else going into debt.  As you can see from these examples and the explanations, any dollars you manage to save, must be at the expense of someone else going into debt.

The Federal Budget is Not Like Your Budget

Once upon a time, the budget of the U.S. government was just like your budget or any other household budget.  This was because at one time the government was on a gold standard.  Each dollar could be exchanged at anytime for either a small bit of gold, silver, or some combination of both.  The amount of goldsilver that you could get with a dollar would change every so often until it was changed for the last time when the United States entered the Bretton Woods system which set the value of the American dollar at 35$ per gold ounce.  Then, 27 years later, in 1971 on the Ides of August, Richard Milhouse Nixon sunk the third proverbial knife into the Gold Standard by announcing the end of gold convertibility of the U.S. dollar(West Germany and Switzerland were first and second to exit the Bretton Woods system).  The U.S. budget was no longer like a household budget.

So what do I mean when I say household budget?  A typical household or business must either earn or borrow money before it can spend it.  Everyone knows this:  You can't spend 5$ until somebody else gives you 5$.  In other words your spending is "revenue constrained".  When the U.S. had to convert dollars to gold, it was revenue constrained because it had a limited amount of gold.  Since 1971 the federal government no longer has to convert dollars to gold.  Combine that fact with the fact that the federal government, and only the federal government, can create dollars and you'll realize that the federal government is no longer revenue constrained.

This last point bears repeating.  The U.S. government doesn't have to tax or borrow money to spend it.  Most of us learn in our civic class that the government taxes it's citizen and then spends it on roads and tanks and other items.  If the government needs more tanks or roads, it must raise taxes.  However, this is no longer the case for the federal government.  To buy the extra tanks or rail, the government can create money *poof* out of thin air to buy whatever it wants.  It could just create new money all day every day until the end of time and it would never run out or have to borrow or collect taxes.

From what I've seen, the first reaction most people have to this statement of fact is, "Inflation!  Inflation! Inflation! What about Inflation?" which just proves the point.  I think most people realize that the government isn't revenue constrained because nobody ever seems to say, "That's not true, the government can't spend whatever it wants!  It'll run out of dollars.", they just object to the obvious consequence of a government spending way more than it makes in taxes: inflation.  So let's put these these two statement of facts together.  If government spending isn't revenue constrained, but can cause inflation when it spends a lot, then government spending is constrained by inflation, not revenue.

Why is this significant?  Because if federal spending is constrained by inflation and not tax receipts, then it completely changes when the government can "afford" something.  If inflation is low or negative, then the federal government can spend more money or cut taxes. If inflation is high, then the federal government can't afford any more tax cuts or spending.  In fact, that means the government should spend less andor raise taxes.  These last two statements hold true no matter how high or low the current budget deficitsurplus is.  This means that if inflation is negative, the government can "afford" to cut taxes and increase spending even if it's already in debt.  It also means that if inflation is high, the government needs to increase taxes and decrease spending even if it has a budget surplus.

As you can see, this is not like your budget at all.  Where your budget requires you to make every dollar you spend, the federal government's budget does not require this.  The fact that government spending is constrained by inflation and not revenue is one of the central facts that Modern Money Theory is built on.

All I've said in this post is that government spending is constrained by inflation, not revenue.  What I did not say is that the government can  or should spend all willy-nilly without consequence.  There is a consequence and it is inflation.  What I am saying is that when congress decides if it can "afford" to do something, it shouldn't make that determination based on what the current budget deficitsurplus is, it should make that decision based on how high inflation is.  Unfortunately, the people running our country either don't realize this or act like they don't realize this.

How money is created: As a debt

Not a lot of people sit around and wonder how money is created, but for some reason I did.  I found my answer and thought I would share it with you.  In our economy, money is created by borrowing it.  The story of money creation starts when someone wants to take out a loan.  Say you want to borrow twenty-thousand dollars to buy a car.  You go down to Bank of America (BofA) and take out a loan.  They then put that money into the auto dealer's bank account and you drive off the lot with a new car.  At this point:

• You are twenty thousand dollars in debt
• The auto dealership is twenty thousand dollars richer
• BofA has twenty thousand less dollars, but have a twenty thousand dollar asset (your loan) which nets to zero(not counting interest).

This is an example of money being created using the Money Multiplier concept.  If you add up all the money spent and borrowed, it equals the amount that was earned and is owed.  However, until that loan is paid off there is now extra money in the economy rather than sitting in a bank account.  Now, let's say that BofA didn't have the money to loan you.  That's no problem, they can just borrow that money from the federal reserve.  Before BofA gives you the money, they go to the federal reserve and borrow twenty-thousand dollars.  The federal reserve goes *poof* and money is deposited into BofA's account, then they give it to you, and you give it to the auto dealership.   In this case,

• You are twenty thousand dollars in debt
• The auto dealership is twenty thousand dollars richer
• BofA has a twenty thousand dollar asset (your loan).
• BofA has a twenty thousand dollar debt to the federal reserve.

While all the assets and liabilities equal zero, that 20 thousand dollars that the federal reserve created is now in the economy, and that's how money is "created".

The government has to borrow money too.  Any money spent by the federal government that isn't offset by taxes must be borrowed from the federal reserve.  The federal reserve temporarily loans the government that money and puts it into U.S. treasury's account at the federal reserve.  The federal reserve then auctions off that borrowed money as U.S. bonds and other securities.

This leads me to make two observations of this system.  I call them "observations" because I'm not sure if they are bugs or intended features of the system.

The first observation is that for our money supply to grow, people must continually borrow money, not just from each other, but from the banks and, eventually, the federal reserve.  Not only that, but each year more money must be borrowed than the previous year just to keep up with interest.  That's because when I borrow 20 grand, I have to pay that back with interest: Say, 21 grand in total(just to keep the math simple).  That means I have to earn back the 20 thousand I gave the auto dealership plus another thousand dollars.  I could work for the auto dealership and earn back the 20 grand, but where am I going to get the extra thousand dollars?  It's going to have to be from someone who takes out a new loan (for money that came from the federal reserve) and pays me a thousand dollars for some service like driving them around in my brand new car.

Therefore, what this means for the economy at large, is that if the amount of money being borrowed ever levels off or drops, somebody-somewhere, is going to have to default on their loan.  The reason will be because there won't be enough money in the economy to pay back all those previous loans with interest.  Again, I don't know if this is a bug or an intended feature when congress setup the federal reserve system.

My second observation is that if every entity in existence paid off all their debts, there would be no money left in the economy.  Think about it, what money would be left if all money is created as a debt?  There's no way for someone to save a dollar without another person or entity owing someone a dollar.

These two observations disturb me.  You would think this would cause problems, but I don't really see or hear many people talk about it.  If you think my two observations are incorrect, or I missed something, please let me know in the comments.

The Cost of Unemployment

Economists and the fed talk a lot about inflation and it's huge costs to the economy.  However, since the fed currently controls inflation by wrecking the economy and causing unemployment, we should be aware of all the short and long term consequences of unemployment.

Unemployed is the state of wanting to work, but not able to.  Of course, the most obvious consequence of this is on the people who are unemployed.  They lose their wages and means to support themselves.  That means they have to spend less, tap into savings, and possibly disruptive events such as losing a home, a car, or other assets bought on credit.  These are just the short term consequences of short-term unemployment.

Long term consequences of being unemployed can have devastating effects on a person's family, their physical and mental health, and potential income.  Studies have shown a correlation between unemployed spouses and divorce.  It can even affect children of the family.  The mental health of a person who's been unemployed for an extended period of time is enormous.  For reasons that should be fairly self-evident, the unemployed are more likely to suffer from depression and anxiety than those who aren't.

Finally, the financial hit taken by the unemployed isn't just the immediate loss of wages, it is also lost future income.  If you are unemployed for a year or more, then that means you've lost an entire year's worth of experience.  That's a year that will never be gained back and can mean less earnings than someone who had managed to stay employed.  The loss of savings can add up as well.  Spending a year reducing your savings instead of increasing it through investment can be a long term hit to one's saving goal.

The societal costs of lengthy unemployment is also high.  It can raise poverty, loss of labor hours that can't be regained, and a deteriorated workforce.

Long term or high unemployment can cause more people to slip into poverty.  The strain of poverty on a society is very high.  All the strains it puts would require it's own post to go into.  Just so highlight some of the thing.  Higher poverty often(not always) leads to increased crime, decreased opportunity, and bigger strain on government services.

The cost to society of unemployment isn't best measured in dollars and cents, it is best measured in hours lost.  Labor is a unique resource in that every hour it's not being used means that income is lost forever.  If someone is unemployed for a year, that means an entire year's worth of labor that could've been spent creating something or providing a service is now lost.

Finally, this is a problem economists and many employers have noticed.  The longer someone is unemployed, the more likely they will lose their effective work habits and experience.  The Fed recognizes this.  They said, "Long-term unemployment not only imposes exceptional hardships on the jobless and their families, but it also erodes the skills of those workers and may inflict lasting damage on their employment and earnings prospects."

So when someone is unemployed, not only are their lost hours of work gone forever, but when initially returning to work the person will sometimes be less effective then they were before.  To top it all off, an unemployed person will more likely need government assistance once they reach the poverty level.  That makes unemployment to be a very costly thing to a society.  One would think that we all would spend more time worrying about such a thing.

Deflation is Really Bad

One constantly here's about the dangers of inflation and constantly rising prices.  However, what about the opposite of inflation:  Deflation?  If inflation is bad, than it's antithesis should be good, right?  Well, not exactly.  While a decrease in prices is normally a good thing.  Check out the video below.

The video does a pretty good job of explaining one of the way that deflation can hurt the economy.  There's a couple more ways that deflation can wreak havoc on an economy.  One way is the additional burden it puts on those with any outstanding debt like on a mortgage, car, or student loan.  Paul Krugman summarizes it well.

even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum affair, since creditors experience a corresponding gain. But as Irving Fisher pointed out long ago (pdf), debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. So deflation exerts a depressing effect on spending by raising debt burdens – which, as Fisher also points out, can lead to another kind of vicious circle, in which depressed spending because of rising real debt leads to further deflation.

The third way is the problem known as the Liquidity trap.  Since the most active way to fight a recession is by increasing the money supply, deflation poses a particular challenge.  Once the federal reserve lowers the interest rate to near zero, it has no further tools to stimulate the economy.  In deflation, the value of money grows even if it doesn't earn interest.  Therefore, even with near zero percent interest rate, there's no other monetary solution to try and get an economy going again.

How We Currently Control Inflation

I laid out all the bad things about inflation and why it should be kept low and steady.  So how does our policy makers currently control inflation?  By trying to wreck the economy.  Long ago, congress entrusted the federal reserve to conduct monetary policy to promote "promote maximum employment, production, and purchasing power".  The people at the federal reserve have tried many different things to stop inflation and encourage "full employment".  In the end, the tool they use most often is by setting interest rates.

When unemployment is high, the federal reserve leaders lower interest rates.  This encourages people to borrow money to buy stuff which creates demand.  It also encourages businesses to expand and invest which increases demand and creates jobs.  Unfortunately, all that borrowed money increases the money supply and all that spending and investing can increase demand faster than supply.  All of this combines to cause the inflation rate to rise.  Once that happens, the federal reserve leaders decide to raise interest rates.  This discourages consumer borrowing and business investment.  Those two things cause unemployment to rise.

So, when I say that we control inflation by wrecking the economy.  This is such an accepted and non-controversial idea, that the federal reserve freely admits that they willingly cause unemployment.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

So why do these people constantly vote to wreck our economy, and why does congress let them?  It's not because their evil.  It's not even because their stupid.  It's just that it's the only way they know how to control inflation and think it's the best way to control unemployment.  It's a way of thinking based heavily in the Monetarism school of economics.  It is pretty much the dominant economic theory in congress and government, business, and even the International Monetary Fund.

They believe that both some inflation and some unemployment is a good thing.  The belief is that having a little bit of each will keep both of them low.  It's a good theory that I think is a correct observation.  My problem is with the solution.  Causing unemployment and all the problems it causes society(poverty, loss of work ethic, disrupted families) is a very high price to pay for price stability.  Unfortunately, it's the best our mainstream thinking offers.  Given that, I understand why they do it, I just think we should be actively looking for a way to lower inflation without causing massive unemployment.

I bring this up for a reason.  When talking about other possible solutions, I think it's important to compare those solutions to what we currently do.  Right now our only solution to lowering inflation means that people must be laid off and rendered unemployed.

Why is Inflation Bad?

Yesterday I talked about what inflation is and what can cause it.  Today, I'm laying out the all the reasons that I can see as to why inflation is a bad thing.  In preparing this article, I was shocked to find how few people actually talk about the negative sides of inflation.  For something that economists study, and the department of labor measures, and market watchers fret over, and the entire federal reserve board is obsessed over, you would think there would be plenty of articles explaining all the negatives behind inflation.  Therefore I've decided to lay out all the negative effects of inflation that I could find.

I found an article where the Federal Reserve lays out all the problems it has with inflation.

What's so bad about higher inflation?High inflation is bad because it can hinder economic growth, and for a lot of reasons. For one thing, it makes it harder to tell what a change in the price of a particular product means. For example, a firm that is offered higher prices for its products can have trouble telling how much of the price change is due to stronger demand for its products and how much reflects the economy-wide rise in prices.

This is a legitimate concern.  Inflation can cause inefficiencies in the market.  However, this isn't a problem with inflation per se, it's a problem with inflation that was constantly accelerating and decelerating.  If inflation was at a steady rate, this wouldn't be a problem.

Moreover, when inflation is high, it also tends to vary a lot, and that makes people uncertain about what inflation will be in the future. That uncertainty can hinder economic growth in a couple of ways—it adds an inflation risk premium to long-term interest rates, and it complicates further the planning and contracting by businesses and households that are so essential to capital formation.

Again, this isn't a problem with inflation per se, it's a problem with unsteady inflation.  High inflation is only described as a problem because that tends to lead to a unstable changes in inflation.

That's not all. Because many aspects of the tax system are not indexed to inflation, high inflation distorts economic decisions by arbitrarily increasing or decreasing after-tax rates of return to different kinds of economic activities. In addition, it leads people to spend time and resources hedging against inflation instead of pursuing more productive activities.

There are two good points about the problem of inflation.  The first is that it can shift the tax burden in ways the legislatures may never have intended.  For instance if your wages rises precisely at the same rate as inflation, you will not actually be making more money.  However, its possible that your income tax could slip into a higher bracket and you would end up paying more taxes.  Another example would be a sin tax.  At first an extra 5 cent bottle deposit might sound like a lot, but over time, that 5 cent deposit isn't the incentive it used to be to recycle cans.  Fortunately, this can be solved by indexing some taxes to rise and fall with inflation, as well as a legislature that's ready and willing to adjust tax rates as needed.

The second point is a good one.  If you are worried about inflation, then instead of being a productive person and making more money, you may find yourself wasting time managing your current savings so that it isn't eaten up by inflation.  Unfortunately, as long as inflation is anything besides zero, this problem will always exist.  The only way to mitigate it is to keep inflation low.

Another problem is that a surprise inflation tends to redistribute wealth. For example, when loans have fixed rates, a surprise inflation redistributes wealth from lenders to borrowers, because inflation lowers the real burden of making a stream of payments whose nominal value is fixed.

Once again, this isn't an argument against inflation itself, just unsteady, rapidly changing inflation.  If the inflation rate was always constant, the person making the loan could adjust the interest rate to accommodate long term inflation.

So of the 5 reasons the federal reserve gives of why inflation is bad, 3 of the reasons aren't against inflation, just "surprise" inflation.  Of the other 2, one could be solved by small tweaks to tax laws.  So that leaves only 1 reason for the fed to hate inflation.  People spending time hedging against it, instead of being productive.  It kind of makes me laugh to think that we have an entire institute dedicated to fighting inflation for that one reason.

Fortunately, that's not what the fed does.  The fed likes to set a target rate of inflation and try to keep it as close to that target as possible.  That way 3 of the 5 problems go away.  They also try to set that target for inflation to be low.  That's to mitigate the last 2 problems as well.

There are other very good reasons to keep inflation low that the federal reserve doesn't mention.  For instance, inflation can make some one destitute if they are living off of a fixed income.  Examples would be people living on a pensions or a "reverse mortgages".

Inflation can also hurt people living off of their savings because the value of their savings goes down.  Of course people can mitigate this problem by try and invest and hedge against inflation, but then you have the problem the fed mentioned which is people wasting time managing their existing savings instead of trying to add to it.

The last problem with standard inflation is the "menu" problem.  Imagine inflation was 10% a year - that's a high rate.  That would mean restaurants would have to order a new menu every 6 to 12 months that adds 5 to 10% to all the prices on the menu.  This, of course, wouldn't be a problem just for restaurants, but any retail or service company.  Instead of spending money on hiring new staff or expanding, they have to waste time and energy constantly updating their prices.  Obviously, not a productive use of time.

Finally, we come to "hyperinflation".  Some people describe Hyperinflation as very very high inflation.  I think that undersells the problem with hyperinflation.  Hyperinflation is usually a self-feeding loop.  More money is needed, so more is created, which leads to more inflation, which leads to more money being needed.  This results in ridiculously high inflation of 100% per month and even higher in some cases.  Hyperinflation can be both a symptom and cause of a bad economy - usually both.  So it's important to make sure that inflation never starts to get that high.  How high does inflation have to be to qualify as hyper-inflation?  Unfortunately, there's no set definition, but it must be ridiculously high and keeps accelerating.  I personally define it as more than 100% a year, but that's purely subjective on my part.   I'll talk more about hyperinflation in the future.

So that's all the reasons that inflation is bad.  As you can see, most of the problems with inflation deals with surprise accelerating and decelerating inflation.  There are also problems with a high inflation rate.  Therefore the goal of our economy should be to keep inflation at a very steady, low rate to avoid these problems.

What is Inflation?

The basic idea of inflation is deceptively simple.  It describes a phenomena where the price of everything tends to rise. However, understanding what inflation is, what does and doesn't cause it, and even just trying to measure it, are incredibly difficult and leads to lots of really smart, educated people to argue and vehemently disagree. In fact, if you were to know everything there is about inflation, then you'd probably know everything there is to know about macroeconomics. I'm just going to lay out the generally accepted concepts.

Definition

Here's three definitions of inflation from three different sources.  The Merriam-Webster dictionary defines inflation as "a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services". Whereas Wikipedia defines it as "a rise in the general level of prices of goods and services in an economy over a period of time". Finally, the International Monetary Fund defines inflation as "A sustained increase in the general price level, often measured by an index of consumer prices. The rate of inflation is the percentage change in the price level in a given period."  These definitions are pretty much the same with one subtle difference.  The dictionary and IMF define inflation as "continuing" or "sustained", Wikipedia doesn't give that stipulation. I think the difference here is how economists define inflation and how the general public defines it.  On this blog I'll try to use the more correct term of inflation as being "sustained" or "continuing".

So what causes inflation?

There are several things that can cause inflation, however, they all boil down to 1 of the following 3 situations:

1. An increase in the money supply
2. A decrease in the amount of goods in the economy (or "aggregate supply")
3. An increase in the demand for goods in the economy ( or "aggregate demand")

1) An increase in the money supply is just a fancy way of saying "everybody has more money".  If the amount of money everyone has increases but the amount of goods doesn't, then all you've really done is made money worth less.  This is best demonstrated by an example:  If 10 people live on an island, and on this island there is nothing but coconuts.  Let's also say that there are only 20 coconuts and $20 on the island.  Therefore each coconut is worth $1.  But let's say everybody wakes up the next day and find an extra $10.  People who want to buy coconuts will be willing to offer more than 1$ for a coconut so as to outbid other buyers, but those other buyers will also have more money, so they too will offer more than a dollar and the bidding will continue to "inflate" the value of coconuts until price stability is achieved.

Every economist agrees that expanding the money supply can cause inflation.  In fact, it is the original definition of inflation.  Back in the days when money was backed by gold or silver, private and public banks would print paper money that could then be redeemed at their bank for a set amount of gold.  "Inflation" referred to the practice of banks printing more money than they could back.  They "inflated" the amount of gold they claimed to have.

2) A decrease in the amount of goods in the economy (or "aggregate supply") can also cause inflation.  Aggregate supply is, again, a fancy term economists use.  It means all the goods and services that are produced within an economy.  Going back to the coconut island example, let's say that, instead of everyone finding more money, they all wake up one day and half the coconuts are gone.    The value of the remaining coconuts would go up.  People would be less willing to sell their coconuts and buyers would have to offer more money until the sellers finally agree to sell.

In a modern economy, this would have to happen on a large scale to lots of products.  For instance, if the amount of DVDs decreased because a DVD factory burned down it wouldn't really cause inflation because only DVDs would be affected and inflation, by definition, is a "General Rise" in prices.  An example would be a natural disaster destroying a large portion of crops and factories.  If this were to happen, the number of goods being produced in the economy would go down, if the amount of money doesn't also go down, it can cause inflation.

3)  An increase in the demand for goods in the economy ( or "aggregate demand").  Aggregate demand is, again, a fancy term economists use to mean all the stuff that people are offering money to buy.  Taking one last trip to our coconut island.  Let's say that everyone needs only 1 coconut a day to live.  But, they all wake up one morning to find their metabolism has changed and they all need 2 coconuts a day to live.  The price of coconuts would go up because people will want more coconuts.  In a modern economy this can only happen if a very large number of people are demanding more goods and services from a variety of industries.

What inflation isn't.

Inflation is not, by definition, the event of the price of a single good going up.  For instance, in a large, complex economy, if the price of pianos suddenly skyrocketed, that would not be inflation because it is only one good.  Inflation must be a "general rise" in all prices.  For instance if the cost of milk, gas, and DVDs rise that would be better described as inflation.  (This doesn't mean that a rise in the price of a commodity can't lead to inflation)

How to measure inflation?

There are several different ways to measure inflation.  Here in the U.S. the two most common are the Consumer Price Index(CPI) and the Producers Price Index(PPI).  The difference is that the CPI measures what consumer's pay for goods that they consume, and the PPI is a measure of what businesses pay for the goods they use or consume to make other goods that they sell.  Both indexes require exhaustive research, adjustment, and calculation.  If I understood everything that goes into figuring out these indexes, I would be seriously underpaid.

You might think it would be as easy to measure inflation.  One would only have to select a few random stores and see how much they charge for a few "random" items and see if the prices go up or down every month.  That might seem simple, until some common problems come up.  Just to give you an idea of how hard it is to measure inflation on a large scale, let's give some example problems.

1.) Obsolete items:  Let's say that one of the items that you're measuring the price of is typewriters.  Circa 1975 this might have made sense.  However, 20 years later, nobody is buying a typewriter because they've been replaced with computers.  You could substitute computer's, but they're more expensive because they do more things.

2.) Combined items:  Let's say that two of the items that you're measuring the price of are DVD players and VCR players.  How do you measure DVDVCR combos?

3.) Replacement:  Let's say that one of the items that you're measuring is iceberg lettuce.  For some reason, there is a shortage from drought or flooding.  The price of iceberg lettuce would go up and consumers instead decide to buy romaine lettuce instead.  Would you continue measuring the price of iceberg lettuce or switch to romaine or some combination of both?

I hope this gives you an idea of how hard it must be to measure inflation.

My Next post will explore the negative impacts of inflation and why it's considered an economic pariah among economists and politicians alike.