Explaning economic inflation to my daughter.

Factual Questions
1

I was talking about price increases over time the other day regarding some items my 13 year old daughter wanted from the mall. She asked “Why DO prices increase over time?” and I said “inflation” suddenly realizing, as the words leapt from my lounge, that I had no good working explanation of what causes inflation.

In researching this on the web I found most explanations are highly involved and there is no common meta-theory as to the root causes of inflation. The main answer seems to be “it depends”.

Britannica. com has a detailed review of inflation theories
http://www.britannica.com/bcom/eb/article/7/0,5716,43347+1+42394,00.html which outlines the quantity theory, the Keynesian theory, the “cost-push” theory and the structural theory.

Is there some “sort of kind of” generally correct explanation for what causes inflation suitable for a bright 13 year old and a befuddled daddy or is the answer really “it depends”.

2

Business A and Business B both buy products from each other. Business A needs/wants more money for whatever reason. They raise their prices. Business B will now have to pay more money to get products from Business A. They raise their prices. Business A will also have to compensate… and it goes on and on, you will have to pay more and more money until you demand a raise, which forces your business to want more money, and further compounding the effect.

At least, that’s how I understand.

3

The classic reply is that inflation is the result of more money (demand) chasing the same supply of goods. But I’ve never understood why, if inflation just means that money is worth less, why wages don’t automatically inflate at the same rate as prices. In fact, when most people talk about inflation, they mean a wage-price spiral that leads to a real increase in their cost of living.

4

Oh sure, wage-price spirals. Hell, I think that’s in a Britney Spears song somewhere.

Here you go, dumbed down to a 13-year old’s level:

Let’s say your daughter find a bunch of pretty rocks on the beach. She takes them to school and starts selling them. At first, she only charges a dollar each for them, and lots of her friends want to buy one. Pretty soon, she only has a few rocks left. her friends realize that she’s going to run out of rocks before she runs out of people who want to buy them, so some of her friends start offering her $2 each for them instead. Since she has some people willing to pay $2 each to get one of the last few rocks, she’d be crazy to keep selling them for a dollar each, so she raises the price to $2. When people realize that there are still more buyers willing to pay $2 than there are rocks left, they start offering me $3, and she can raise the price again. Etc.

That’s the simple version, and it has two components-- the more people want something, the more the person who’s selling it can charge for it. That’s the law of demand. Also, the fewer there are of things that people want, the more the seller can charge for each one. That’s the law of supply. An excess of demand or a lack of supply causes inflation.

There’s a hell of a lot more to it on a macroeconomic level-- competition from another person with pretty rocks can have deflationary effects (more supply) or it can add to your daughter’s costs (advertising to differentiate her rocks from the less pretty ones her classmate is selling for 75 cents); labor costs can drive prices up (you daughter has to hire people to get more rocks from the beach to keep her supply up while she’s busy selling, and has to pay them enough so that they don’t go tell other people where the rocks come from); and so on.

5

What if she doesn’t run out of rocks, just like the world doesn’t run out of products? She gets greedy, raises prices, her friends get poorer, raise the prices for whatver it is they sell, she has to raise prices for the rocks to compensate… just like in my original post.

6

If she does not run out of rocks, and is able to continue to increase prices, competition will enter the picture.

At some point one of her classmates will decide that it is worthwhile to go find some rocks of their own to sell.

This will bring prices back down.

7

One thing for sure. Inflation and rising prices are not the same thing. The US has not had inflation except during wartime. Surprised? You shouldn’t be.

Inflation means “inflation of the currency”. It involves a situation where the currency becomes devalued because more money is put into circulation than the underlying economy can justify. Suppose the government decides to double or triple the money supply to pay for a war. Factories then run flat out producing war materiel. Consumer goods actually become scarce as there is no factory capacity to produce them That is inflation. Hence the common but poorly understood explanation that inflation involves too much money chasing too few goods.

Since when are there too few goods today? Factories in the US typically operate at about 80% capacity. In fact, there is a glut of goods. There is huge overcapacity in every sector of manufacturing on a worldwide scale. To keep profits up, manufacturing capacity is continually removed from production during crises where deflation threatens.
Prices will go up if it will maximize profits. Period. This can disrupt the economy, but has nothing to do with inflation. Mostly, price increases are blamed on workers getting too high wages and are used as justification to put downward pressure on wages and therefore to further increase the rate of profit. By raising prices and holding wages below the rate of price increases, real wages can be made to lowered. And this is what has happened.

So why is there so much confusion? Precisely because it is profitable for people to be kept ignorant of the true situation. It’s amazing how many so-called educated people will mindlessly repeat the children’s fables they learned in Econ. 101 and which are endlessly propagated by the mainstream press and academia.

OK, let’s hear from the propagandists of the Chicago School.

8

Hey…I don’t resemble that remark! You have to admit thought that there must be something in the water they serve at the University of Chicago. They’ve had what, 8? Nobel Prize winning economists in the last 20 years. I may be way off on that but whatever the number it’s more than their fair share.

It might comfort astro to know that in general products don’t cost any more today than they did in 1910. IIRC an expensive hotel room in New York in 1910 cost something like $12 per night and an expensive meal for a few people around $8. Today those numbers are more like $1,000 for the hotel and $600 for the meal. (note: I heard those numbers awhile ago and probably remember them wrong but they’re fairly close and get the idea I’m getting at across).

How are those numbers the same? Because the impact on your pocket book is almost exactly as hard in 1910 as it is today. Prices may be much higher today than in 1905 but you also make a helluva lot more than your 1910 counterpart did. Earning what a McDonald’s fry cook gets today would make that person fairly wealthy in 1910.

9

Hey – did you know that you can send away (to the treasury dept, I believe) and receive a number of astoundingly dorky yet amusing comic books that explain the ins & outs of banking, international trade, and – you guessed it – inflation for a youthful audience? My father, knowing my love of incredibly dorky things, had some sent to me. They are super-cool in a super-lame way.

10

This remark here made me curious. I’m not an economist by any means, and don’t really know much about this.

I’ve always heard (from the good old unspecified sources) that inflation in the US averaged roughly 3% per year. Now I hear from you that the US has zero inflation except during wartime. I can think of several ways to reconcile that apparent contradiction, and thus need some help figuring it out.

Possibilities I can think of:

1 - The definition of inflation used in the 3%/year quotation is a lay definition that corresponds to rising prices. It’s a crappy definition, in the eyes of economists, hence the difference. Prices have been going up at about 3% per year, but that, in and of itself, does not define inflation to economists.

2 - The 3% figure is one I simply dreamed up. Perhaps I’m mistaken in thinking I’ve heard that.

3 - I didn’t dream it up, and it has, in fact, become common wisdom. But it’s wrong common wisdom. Prices really haven’t been going up at anything approaching a nice 3% per year. I guess this could apply to either the lay or technical meaning of inflation described in (1).

My gut tells me that it’s (1) - people who don’t know what they’re talking about equate rising prices identically with inflation, and this is not right.

Galen, or anybody else - can you help me out? If it is (1), could you elaborate a bit more on the true definition of inflation, and perhaps what has led to these multiple meanings of the term?

Yep, you guessed it: I don’t know what I’m talking about, and need a pretty low-level explanation. :slight_smile:

11

astro, the best explanation I ever had as a kid was from a Scrooch McDuck comic. Since I can’t find that here’s an interesting page on the elimination of silver from the monitary standard. It actually talks about deflationary pressures which is a good counterpoint to why can’t prices just stay the same. http://www.micheloud.com/FXM/MH/Gold_Stand.htm

12

Okay, here you go, The Chicago theory for your edification:

Inflation is the result of an imbalance in the supply and demand for money. You can have inflation two ways: One, your can print more money. Since you have a greater supply of money, the value of it drops. Or, you can have an increase in demand for goods and services. The increased demand coupled with a fixed supply of money causes inflation.

There are other factors, such as the velocity of money (some money is tied up and unusable, and has the effect of lowering the supply. If money is fluid and changing hands rapidly, that affects things). But by and large, it’s simple supply and demand.

If the economy reacted instantaneously to changes in this supply/demand, inflation wouldn’t be as destructive. But in the real world, inflation has many bad results:

There is a lag between price increases and wage increases, which causes turmoil.

Also, inflation has opposing effects on debtors vs savers, which screws up the economy even more.

Finally, inflation screws with the transmission of information through the money supply. I think there was a Nobel awarded on this subject a few years ago. Basically, the price system acta as an information network, telling suppliers to ramp up production, consumers to scale back consumption, etc. But inflation plays havoc with this.

If shirts go up a dollar in a perfect world, it’s because there is an increased demand for them. So shirt manufacturers make more of them because there is a higher profit. The higher profit attracts competitors, which increases overall production for a product in demand. That’s what we want. But if the shirt goes up a dollar in an inflationary world, it’s hard to tell WHY. Thus, consumers and manufacturers can’t respond as well to this information, leading to economic inefficiency.

13

Ok, about the “greed” explanation for inflation. Some people have stated that inflation happens because producers are greedy, so they raise prices, so people have to pay more. Inflation!

But this is silly. ALL producers are greedy, they all want to raise prices as high as possible. Of course they are going to raise prices if they can, since they make more money that way. So why doesn’t you local supermarket start charging $10 for a loaf of bread? They are greedy, right, and if they raised prices they’d make more money.

But no. If your local supermarket raised the price, you’d stop going there, you’d go to the competitor who’s charging the regular price. So instead of making more money, they are now making less money…they were selling 100 loaves for $2.00 at their cost of $1.00, and making $100. They wanted to sell 100 loaves at $10.00 at their cost of $1.00, making $900. But now they are selling, say, 5 loaves, their cost per loaf $1.00, meaning they lose $50.00.

But what if everyone raised prices…what if there was a conspiricy and all the bakers raised prices, or if there was a wheat shortage, or whatever? Well, yes, prices could rise…but the consumers are not helpless. If the price of bread is too high, you will switch to tortillas, or rice, or potatoes, or stop eating bread, or make it at home. When prices are high, people will substitute.

But galen. You say that under your definition, inflation has only occured during war. But what about the 70s and 80s and 90s, where we had huge budget deficits? The government was borrowing money like crazy…that means more money is around, but there are the same number of goods. Result: inflation.

Now, why don’t wages rise as fast as prices during an inflation? Well, because it is easier for a company to slap a new price tag on their goods than it is for an employee to demand a new contract. Yes, in a few months or years, the employers have to raise wages, but there will be a lag. After all, employers will only raise wages if they have to. This is why unions used to negotiate cost-of-living increases, basically giving union members automatic raises based on the rate of inflation.

But most employees do not have their wages set this way…typically the employer offers a job at such-and-such a wage, and the employee is free to take it or leave it. If too many skilled workers leave it, the employer must raise their wages. So in an inflationary economy, an employee typically takes a job for a certain amount. Prices go up, so the employee must demand a wage increase, which the employer of course does not want to give. In a frictionless economy, the employee could simply take another job that pays better, but as we all know this isn’t as easy as it sounds…if you quit your job you may be without income for months. So the employer has an slight advantage in an inflationary economy, which means employees feel pinched.

14

No, this was not infaltion. Even if there was more money in circulation because of deficit spending, it was not nearly enough to sop up the overproduction which is always a part of the US(i.e.,capitalist)economy.

Prices went up because they could, not because they were bid up because of a shortage of goods. Did you ever see a shortage of goods? The only time I ever saw one was during the oil embargo of 1973. That was a temporary and artificially induced shortage, the kind which normally occurs during wars.

Also, Sam Stone, in trying to elaborate on the Chicago School succeeds in demonstrating the bankruptcy of that school. Miltion Friedman has a good position on drugs, but he should get out of the economics business.

[Note: I fixed the quote tags. -manhattan]

[Edited by manhattan on 08-26-2000 at 11:46 AM]

15

Okay. I am an economist.

Inflation is an increase in the aggregate level of prices. It does not have to be accompanied by a “shortage of goods” whatever that means.

The cause/s of inflation are complicated and very controversial, so don’t be too surprised if you can’t explain it to your kids. I taught intermediate macroeconomics last semester and not one student managed to tell me in the exam why inflation matters. It’s not easy.

An easy way to start to understand this is via the quantity equation:

Mv=Py where “M” is the quantity of a monetary aggregate, “v” is the velocity of money - how fast it goes around the system, “p” is the aggregate price level (or if you like an index of the vector of prices) and y is (national) income.

Thus stated, the equation is an identity: the financial value of transactions per period must equal the nominal value of income; or expenditure must equal income.

Supposing that v is more or less fixed turns this into the quantity theory of money. Velocity is more or less fixed due to banking technology, customary payment procedures and other institutional factors.

If this is so then changes in the money supply cause changes in nominal income. If real output (y) is fixed, changes in the money supply cause changes in the aggregate price level. If that is so then if the cental bank can control the supply of money, it can control changes in the aggregate price level.

However, if at least some markets fail to clear (if quantities as well as prices adjust in response to shocks) then y is not fixed, at least in the short run. For example, there seem to be quantity adjustments in labour markets (unemployment - although not all economists agree that it exists).

Further, if the central bank cannot control - but merely influence - the relevant monetary aggregate, things are much more complicated. Once again, it looks like this is true.

So the simple view is that excessive growth in the money supply as controlled by the central bank causes inflation.

More complicated views suggest a combination of:
[ul][li]price and contract misperceptions[/li][li]expectations of future prices and events[/li][li]unresolved distributional struggles between factors of production (labour, capital, land, government)[/li][li]uncertainty about institutional responsibilities and linkages between fiscal and monetary authorities[/ul][/li]cause inflation.

picmr

16

Ok, so you’re an economist. Then why didn’t you explain anything above? Answer: Because the job of economists is not to explain the true working of the economy, but to obfuscate.

Just one other comment and then I’ll shut up. You say:

“Inflation is an increase in the aggregate level of prices. It does not have to be accompanied by a “shortage of goods” whatever that means”.

“Whatever that means”? You are an economist and you don’t know what a shortage of goods is?!

OK. If there is a worldwide famine and there is not enough food for everyone, that is a shortage of goods. If our factories were all producing war materiel and there was no productive capacity left to produce consumer goods a la WW II, that is a shortage of goods. If by some act of God, all the food processing plants burned down so that the population was starving and supermarket shelves were bare, that is a shortage of goods.

If the shelves are bulging with goods and there is plenty of excess capacity and the prices are going up only because it is possible to maximize profits by doing so, it is not inflation.

We have not discussed hyper-inflation a la Gemany and Hungary in the '20s. That is a whole 'nother story. I really don’t know much about it except that they say that people used wheelbarrows to carry their money around.

17

I’m sorry you thought my prior post obfuscation Galen. I’m trying, and I did try to answer the OP.

There is always a shortage of goods. People would like more stuff.

Your examples relate to what is known as “demand pull” inflation - which is characterised crudely as “too much money chasing too few goods” - and “cost-push” inflation - where despite the absence of excess demand in goods markets, and indeed in the presence of unemployment, increases in the general level of prices occurs.

For some reason, you have decide that one of these is not really inflation. Not so, although they may well be symptoms of different underlying problems.

It is in general a mistake to suppose that inflation is caused by firms pushing up prices to maximise profits. First, firms can only benefit from increasing prices if they can sell the product, and frequently not even then (firms can benefit from increasing prices if the demand curve they face is inelastic).

Secondly, firms are always after a buck. If they can make profits by increasing prices, they will, but this can’t be a cause of sustained price increases, only once off increases to the profit-maximising level. So continued increases in the prices of a bundle of commodities in the absence of increasing market power cannot be due to firms just wanting to increase prices, but must be the result of other conditions in the economy.

picmr

18

If I’m reading the intent of the OP correctly, I think what they were asking might be paraphrased as “Why has the economy of the West for the past 400 years been characterized by a slow but steady (on average) inflation of wages and prices relative to the units of money used?”

For example, in England in the 17th century, a single copper penny was a significant unit of money- enough so that it was still worthwhile to mint farthings, or quarter-pennies. Today they debate whether they should even bother minting them anymore. Likewise when the US was founded 200 years ago the basic unit of money, a dollar, was probably closer to 100 dollars today in terms of how big a piece of cash it was. In fact, if we were still on the gold standard, I suspect that one ounce of gold has aproximately the same purchasing power as one ounce of gold did in the 18th century.

I’m wondering therefore if there’s a relationship between this “long-term” inflation, and the expansion of the overall scale of the economy that has been the rule over the past four centuries.

19

Interesting questions. I can’t really answer the second one, since it would require an answer to “why have (some) economies grown so much” which is a biggie.

As to the first question:

Deflation generally accompanies really bad times - recessions and depressions. Moderate inflation is not too much of a problem and if - as now - it is accompanied by rising living standards, then many people are prepared to put up with it.

More cynically, there is a sense in which governments gain from inflation in the form of tax revenue, and it is not much of a stretch to say that unless inflation gets out of control governments don’t mind.

The US and UK currencies have really been pretty stable - neither have had noughts crossed off them at any time IIRC. Given that the Pound has lasted a thousand years, that’s quite impressive.

picmr

20

Also, one has to be quite careful when discussing inflation in the purely academic sense and the price indexes which serve as proxies for inflation, the Consumer Price Index being the most prominent.

The way the CPI works is to basically ask how much does it cost to buy a particular bundle of goods and comparing that over time. However an academic would be more concerned how much more does it cost to reach the same level of welfare (not welfare in the politco-speak sense).

The differences are relevant in that the CPI probably tends to bias the perception of inflation upward. There are several reasons why this may be true, some having to do with problems in the formulas used by the Bureau of Labor Staitstics, some having to do with their sampling methods.

But probably the two main issues that deal directly with the wedge between the CPI and theory are quality bias and substituion bias.

Quality bias is pretty easy to understand. A car today may cost twice as much as one 20 years ago, but it is also a far superior car in almost every way. And how do even measure something that didn’t even exist 20 years ago like a DVD player? THE CPI does make some adjustments for quality, but they tend to lag.

Substitution bias is a little trickier to understand. When the price of beef goes up relative to chicken people start substituting chicken. Since people can subtitute lower-priced chicken it would not cost them as much to maintain their welfare then if they were forced to buy the same quantity of beef. Don’t be confused, however, “prices” have still gone up, just not to the extent that the CPI would have us believe.

Anyway, this may have little to do with the OP but it is interesting nonetheless.

A couple of cites:
http://www.ssa.gov/history/reports/boskinrpt.html
http://stats.bls.gov/orersrch/ec/ec960170.htm