What is Inflation?

The term “inflation” is bandied about quite a bit these days.  But what does it really mean?

Inflation means that the money supply has been inflated by increasing the amount of dollar bills in circulation.  The first people to get the newly printed money have more money to spend.  Eventually, prices go up.  What most of us see from this is the end result: higher prices.

Inflation goes up and down, and is somewhat cyclical.  It is also closely tied to government spending, especially deficit government spending (when governments spend more than they receive in tax revenue).  Inflation, the government statistics say, is usually around 2 to 4% per year.

This summer, things seemed different.  We know prices have gone up.  Prices of commodities like foodstuffs, natural gas, and petroleum have gone up.  These price increases have been 50% or more in the last year alone for some of these items.  Does that mean inflation has been at 50% the last year?

Thankfully, no, it does not mean that.  What it does mean is something related, but different.

Investors have money to invest.  If the stock market is bad, then investor will often choose something else, like real estate.  If that is bad, then investors may invest in dollar-denominated assets, like bonds, which are tied to the value of the dollar.  Since we now have a falling housing market, a struggling stock market, and a weak dollar, investors are looking elsewhere.

The result is that investors invest in something more stable, something that can be seen, touch, and tasted: commodities.  So investors buy into petroleum.  They buy into foodstuffs.  They buy into previous metals like gold, silver, and platinum.  They have even bought into some of the less-precious metals like copper, nickel, and chromium.  As a result, prices of all of these commodities have risen lately.  There are also other complicating factors, like wars, rumors of wars, and supply issues.  But largely, the price increases are due to this influx of investment cash.

When will this clear up, or will it stay this way forever?  Supply issues, like wars, for instance, will continue to affect the situation of certain commodities.  Government subsidies (i.e. for corn for ethanol production) will continue to also artificially inflate prices on some goods.  However, much of the cost will be recovered when the stock market/housing market/bond market recovers.  When they start to recover (hitting bottom would be nice), then investors start finding those to be attractive investments, and so they start pulling out from commodities.  In other words, they sell their stake in commodities, and purchase stocks, bonds, mutual funds, or some sort of real estate investment vehicle.  When this starts to happen, prices of commodities will go down.

Most people think that if we could smooth out the market, (i.e. with government intervention), then we could avoid these problems.  This is the thinking of the Democratic party, among others.  However, this thinking is flawed in that it does not take into account the current economic interventions and their effect.

It turns out that the business cycle is not a fundamental market phenomenon at all, but is instead a consequence of government economic intervention: artificially low interest rates set by central banks.  This is not an inevitable part of human nature.

In summary, commodity prices are high because of weak investment markets, but prices will decrease as the investment markets strengthen.

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Filed under Austrian Economics, fiscal policy, Libertarian, politics

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