Inflation is Not Natural
The price of everything in our economy seems to slowly rise over time. For example, in 1915 the price of a gallon of milk was $0.36 and today it is over $3.00 per gallon. People tend to refer to this general rise in prices over time as inflation. However, it is perhaps more appropriate to think of inflation as increasing the overall money supply. The important thing to realize is that this rise in prices over time isn't something that naturally happens, but rather it is something that happens because the money supply is being increased.
The thought experiment below is designed to serve two main purposes. First, I want to clearly show the natural correlation between increasing the money supply and increasing prices. Second, I want to point out that increasing the money supply is not necessarily bad.
Magical Inflation Thought Experiment
Imagine everything related to the dollar just went up by a factor of ten for everybody. If you had $10 in your pocket you would now magically have $100. If you had $500 in your bank account you would now magically have $5,000. If you made $8 per hour you would now earn $80 per hour.
Initially you might think this multiplication of dollars would be a reason to celebrate. However, this magical multiplication of dollars would also mean that a $200 credit card debt would become $2,000. It would also mean that a gallon of milk or gallon of gasoline would be ten times more expensive.
With a little thought it is clear that these changes would bring fourth no meaningful change in anybody's financial situation. Your rent would be ten times as much, but you would have ten times as much in the bank and you would also make ten times as much at your job. Your savings would still have the same purchasing power. Your wages would still allow you to achieve the same standard of living. All debts would carry the same burden. The economic welfare of everybody in this thought experiment is completely unchanged.
This thought experiment shows the money supply instantly being multiplied by a massive factor of ten which is something that could shock an economy into complete chaos. However, the economy would effortlessly contain this massive financial shock as long as things such as prices are also increased by the same factor of ten. There is an obvious strong correlation between the money supply and prices.
It is also interesting to point out that in the thought experiment the money supply and prices were increased by a factor of ten and there were no negative consequences in the economic welfare of any person. Apparently in theory it is possible to increase the money supply without hindering anybody's economic welfare. I mention this to make it clear that an increasing money supply does not necessarily have to be a bad thing.
The Reality of Inflation
In reality inflation does impact the economic welfare of people. For example, imagine how disastrous the thought experiment above would be for your financial situation if it were a reckless government that increased the money supply ten-fold by printing money and spending it on politically motivated projects. There would be winners and losers depending on how this new, unearned money is spent. Unfortunately for the majority of people, this type of reckless government spending would be an inefficient reallocation of resources which serves the agenda of those spending the money and therefore it is highly unlikely to benefit prosperity as a whole. For the majority of the people this massive inflation would devalue their savings and wages by increasing the cost of living making it so they would have a much tougher time financially.
I believe John Maynard Keynes was concerned with "inflationism of the currency systems" created by "belligerent Governments" when he included the following words in his 1920 book The Economic Consequences of the Peace.
"By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some."
» Continue to Chapter 3: Price Deflation is Natural
« Back to Chapter 1: Overview of US Monetary System