Inflation 101
Though perhaps everyone has heard enough about inflation already, it’s a phenomenon worth understanding fully if the concept is still a bit shaky to you. This article will explore in detail the basics of what inflation is and how it works, how supply and demand affect it, and then how it discourages saving, creates asset bubbles, and perpetuates wealth inequality. These are all very relevant and important considerations so let this be your guide to a first-principles approach to the mystery of inflation.
Inflation is often made out to be a very complicated phenomenon when, fundamentally, it’s a fairly simple concept. To start, let’s just briefly explain money because that’s crucial for putting all these pieces together. Money is just a tool for measuring value in the world. It’s essentially a ledger for tracking all the value people transfer among each other. We use money/dollars to easily transfer value for all the goods and services we buy and sell because it makes commerce easier than constantly trying to trade specific goods for specific goods—like trying to trade clothes for groceries, which would be pretty weird and inconvenient. But the money isn’t separate value from all those goods and services, it is equal to all the goods and services—it represents all the goods and services and their value via a dollar amount. When you go to work, you create value through your services and store that value in the money you earn. So when you buy something, you are really just transferring the value of your services to someone selling goods or other services you need. Money, then, isn’t inherently valuable, it’s just a mechanism for storing the value people create.
So now let’s move to inflation. If there is x amount of value in the world from goods and services in the economy, then the entire money supply we use to represent that value equals x (money supply = goods and services). So if, for example, the United States had a total money supply of $1 trillion, the goods and services of its economy would equal $1 trillion. And if the US printed another trillion but all the goods and services stayed the same, all those goods and services would now equal the new money supply of $2 trillion. No new or better goods and services were created, but the tool we use to count all that value just doubled. So inflation, in its most basic sense, comes from more money chasing the same amount of goods and services. When you print more money, you are just changing the nominal value of those goods and services, not their actual value. You’re changing the number we use to count their value, not their inherent value. The value of food at a grocery store didn’t change—chicken didn’t become more nutritious or more scarce, but the currency used to measure its value was increased meaning the value of that chicken that was unchanged is now represented by a larger number of dollars.
To simplify this, take the example of a small village using seashells as their currency. Say the village has a total of 100 seashells everyone is using to buy things. A banana costs 1 seashell, a spear costs 2 seashells, and so on. Then imagine you take a walk on the beach and find (print) 100 more seashells. You take them back to your hut and begin spending them in the village economy. Eventually (once all those sea shells are spent into the economy) the total supply is 200 seashells. There aren’t twice as many bananas or spears and the effort to find or make those things hasn’t changed, but everybody seems to have twice as many seashells to spend and is able to buy twice as many bananas and spears. All those extra sea shells have created higher demand chasing the same number (supply) of goods. The merchants selling bananas and spears notice they keep running out of their supply and are forced to raise their prices to compensate for the new increased demand. By raising the price of bananas to two seashells and spears to 4 seashells, demand is back to normal. In other words, the fair value of those goods is back to normal. The increase in seashells led to the appearance of more wealth in the short term, but it just created more demand because bananas and spears were now relatively cheaper than they used to be despite their inherent value not actually changing. Once the merchants selling those goods recognized this and compensated for demand, prices rose and demand was back to normal. That is, the value of those goods was back to normal after that artificial increase in money and demand.
Keeping this in mind, it should put the current supply chain issues we’re experiencing in context. If you’re keeping up with the news about inflation, most politicians or political pundits have accredited the inflation solely to supply bottlenecks. Shutting down the economy during the pandemic and firing it back up so quickly has left supply chains rattled and unable to meet the demand it once did. While this is surely part of the story, is isn’t the whole story. Having a smaller supply of goods available to sell will lead to higher prices if demand stays the same or increases, but demand is very much related to the amount of money in the system. Going back to the seashell example, if the merchant selling bananas had fewer available to sell than normal, it would have exacerbated the situation, but it wouldn’t have changed the increased demand from introducing more seashells into the system. So when the US printed 40% of all dollars ever created in an 18 month period and handed it out through unemployment, PPP, and the like, they added considerably more purchasing power into the system that is now chasing the same (or fewer with supply bottlenecks) goods and services. The government and media may be right that supply constraints are contributing to higher prices, but the massive increase in the money supply without a commensurate increase in real value in the system is also likely a huge factor in rising prices.
Alright, now that we have our basic understanding of inflation and how both money supply and supply and demand play into it, let’s talk about why inflation is a problem. The obvious problem is that things are more expensive. If wages aren’t going up at the same rate as the price of goods, things cost more and you are earning less relative to the cost of living. So if things are getting more expensive not only are you able to save less because you have to spend more, but you are encouraged to spend more today because things will cost more tomorrow. If you see goods getting more expensive, you’re gonna want to buy more now before they go up even further. Why would you want to save money in your bank if it’s going to be worth less in the future? This is how inflation discourages people from saving money—inflation just eats away at your savings. The only way to actually save with inflation is to buy assets that hold their value. If you were the banana merchant and held all your wealth in bananas, the seashell inflation wouldn’t affect your savings because the price of your bananas would just go up. But if you were just a random villager who didn’t get any of those 100 new seashells, bananas are just twice as expensive for you now. Printing money doesn’t create more bananas or more houses or any other asset, it just creates more money. So if you store you wealth in money, it’s going to lose value, but if you store your wealth in assets, it will retain its value and actually increase in dollar amount because the dollar is losing value relative to it, which brings us to how inflation perpetuates wealth inequality.
If inflation devalues money and increases the dollar value of assets, who is making money in dollar terms? People who hold lots of assets like homes, stocks, gold, etc. And who generally owns lots of homes, stocks, and gold? Rich people. Poor people own dollars and slowly lose purchasing power each year through inflation, but rich people own assets that grow in value each year as inflation persists. This is exactly why we’ve seen such a dramatic widening in the wealth gap over the decades. Inflation has outpaced wages and average people who work for and save in dollars have had their savings and purchasing power slowly squeezed away while the rich have made more and more money through asset appreciation. And the asset appreciation resulting from inflation and so many people looking to protect their money is what has led to so many massive asset bubbles. The more people flee the dollar to protect their wealth, the higher asset prices get bid up by buyers chasing yield to outpace the inflation. In doing so, bubbles inflate and inflate well beyond fundamental value, which makes the rich unimaginably richer and is how someone like Elon Musk or Jeff Bezos can make over $100 billion in one year.
But one thing I want to point out about this is it isn’t the rich people you should be blaming. So much rhetoric around wealth inequality paints rich people as the villain when it’s the government creating the inflation responsible for this. Rich people just know how inflation works and have the means and awareness to profit from it. They are just the benefactors of the government’s failed monetary and fiscal policies that are driving people to beat inflation. If the government stopped inflating the currency by relentlessly printing and spending, the average person could easily save in dollars without fears it will be worth less tomorrow than it is worth today. The government likes to scapegoat rich people because they’re an easy target and it shifts the blame from them, but it’s their policies and malinvestment that have led to the asymptotic decline of the dollar since its peg to gold was broken. If you wish to resolve wealth inequality, you have to create a system where people are free from inflation, where they can actually save and wealth isn’t only generated from asset appreciation.
With all that said, I’d like to end this article with a quote by novelist Ayn Rand:
Inflation is not caused by the actions of private citizens, but by the government: by an artificial expansion of the money supply required to support deficit spending. No private embezzlers or bank robbers in history have ever plundered people's savings on a scale comparable to the plunder perpetrated by the fiscal policies of statist governments.