Inflation in Perspective

Yes, inflation is an increase in prices. But what does it mean in the larger scale of things?”

By David Behrens

        If you ask an average person what inflation means to them, you may expect them to say it’s an increase in prices. This isn’t that far off from the economically accepted definition, where inflation is the percentage increase in the price index over time. However, the definition of inflation is meaningless without understanding its implications, and most ordinary people don’t realize how complex these implications are. We hope to illustrate the differences between causes and effects of inflation in various cases, and shed light upon current and possible methods to deal with the phenomenon financially and politically.

What Inflation Isn’t

        Inflation, by definition, doesn’t necessarily decrease purchasing power, contribute to financial bubbles or harm the overall economy. In fact, contrary to popular belief, inflation isn’t even a bad thing sometimes. It is a natural byproduct of how a nation’s policymakers control the money supply in response to their analysis of the economy. However, this process of evaluation is crucially important, as are the corresponding actions. So, the question becomes: What does this entail?

Money Management in America

Since 1913, the United States Federal Reserve System has been responsible for monetary policy in the U.S. Technically, it is privately owned and operated, but its functions are indisputably connected with those of the government. Today, the Federal Reserve sets Required Reserve Ratios for banks, mandating that a certain proportion of a bank’s assets (currently 10%) be held as reserves to avoid liquidity issues. The Fed also sets capital requirements, acts as the lender of last resort, regulates lending, and insures banks in the U.S. via the Federal Deposit Insurance Corporation (FDIC).

Since 1978, the Fed has also been responsible for “stabilizing the macroeconomy” by attempting to keep interest rates steady at about 2%, in conjunction with keeping the economy at the estimated full unemployment rate of 4.5%. The Fed does this by manipulating the money supply and interest rates through a process called open market operations. For example, to increase the quantity of money, the Fed will buy bonds from some bank in the market, causing that bank to have more loanable funds available. That bank, in turn, will loan out as many of these funds as they can while maintaining the required amount of reserves. This process repeats in a cycle, resulting in a higher quantity of money and a lower interest rate. It should also be noted that the Fed does not print or coin physical money; two departments within the Treasury do this in accordance with the quantity of money controlled by the Fed’s open market operations. The Fed will engineer inflation with these operations in accordance with the stabilizing objectives mentioned above.

It’s All About Incentives

        Inflation is very politically useful, regardless of party lines, because it allows policymakers to affect the market without the noticeable consequences that come from fiscal policy. For instance, politicians have incentives to cut taxes for their constituents, but they also have an incentive to promise government funding for popular programs. They can resolve this conflict either by borrowing the money, or by allowing the Federal Reserve to engineer inflation. These methods still have their own considerable consequences. However, the general public’s reaction to them isn’t as harsh as their reaction to being taxed, which is convenient.

In fact, ordinary people often embrace inflation when it occurs, because they notice the higher price index for things they sell. Moreover, one of those things is labor, meaning inflation is welcomed in the form of higher wages, even if the purchasing power associated with those wages doesn’t actually increase. The problem is, monetary policymakers assume such a wage increase takes effect in the first place. Historically, it often has, particularly in fast-growing economies with a competitive labor market. But take the opposite case, in which jobs are not so plentiful, and there may be a different effect. In this case, workers at one job may not have any realistic opportunities to find another. Employers, understanding the labor market, have a diminished incentive to compete for their workers by offering them higher wages. If this happened, nominal wages would stay the same as the price index rose. In a certain (and not uncommon) set of circumstances, inflation will simply cause a relative pay cut for that set of workers with fewer prospects (Cowen 2016). It will also cause the relative value of savings to decrease, which will presumably affect older citizens more substantially.

Losing Control

We know a bit about how people realistically respond to inflation. But how does money management go off the rails? What causes the hyperinflation that has occurred in nations like Zimbabwe, where at one point it took an average of just over one day for all prices to double (Hanke 2009)? How are the causes connected to the incentives of both consumers and policymakers, and what can ordinary people do to help?

The great American economist Milton Friedman is famous for noting that inflation is “always and everywhere a monetary phenomenon,” meaning it isn’t directly created by fiscal policy. However, fiscal policy affects the economy in a way that monetary policymakers must attempt to account for. In the U.S., as we’ve noted, the pseudo-independence of the Federal Reserve prevents some degree of direct political motivation in engineering monetary policy. Notably, the U.S. hasn’t experienced major cases of hyperinflation or banking collapses, with the exception of the early stages of the Great Depression. For a thorough exploration of the Fed’s role in this crisis, I recommend A Monetary History of the United States, 1867-1960 (1963) by Milton Friedman and Anna Schwartz.

In nations with central banks, which are directly tied to the federal government, political incentives may influence objective decision-making when it comes to monetary policy. It seems, in this case, that the concept of populism may cause monetary policymakers to overlook the long-term effects of their management of the money supply, possibly allowing inflation to slip out of control before anyone notices, and leading to a crisis. The presence of a powerful central banking system is a conspicuously common thread in the major historical cases of hyperinflation, including those in Hungary (1946), Germany (post-WWI) and Zimbabwe approximately a decade ago. This is because inflationism is like binge drinking; the good effects come first, and the bad effects come later. Similarly, curing inflation is like curing alcoholism; the period of withdrawal is painful, but necessary. The pain is not the cure, but a necessary byproduct of it.

Centralizing power, however, is not the only explanation for the faults of monetary management. The reality is that keeping track of goods, services, transactions and wealth is extremely complicated in the first place. No one has developed a perfect index for prices — it is even widely acknowledged that the U.S. Consumer Price Index is always overestimated– and there will always be incentives and patterns of action that we don’t fully understand, as we mentioned above with inelastic employment. There is very little that individuals can do to prevent problems sometimes caused by inflation; we can only hope the money supply is managed adequately, and wait for natural experiments and crisis situations to allow us to make that process more simple and less volatile.


Image: Payne, David. Drop in Prices Not Likely to Delay Fed Rate Hike. Kiplinger.