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Inflation and Prices clearly Explaned

by JS 


I’ve been reading a lot about inflation lately and wanted to write a quick post about what inflation really is. How the government reports inflation is grossly inaccurate, so I attempt to provide a clear example of how inflation is a cause of higher prices and not the other way around.

In order to understand the effect that inflation has on prices, we need to understand three relationships:

  1. The relationship between an item and its value
  2. The relationship between supply and demand and prices
  3. The relationship between dollars and prices

Once these three relationships are understood the overall effect of inflation on prices will be clear.

What’s the Real Value of Something?

This is a question that is almost always left out of a discussion of inflation and prices, but it is essential to understand that there is a difference between value and price.

If there was a world without money, the value of an orange would be expressed in terms of how great it tastes, or the nutritional benefits of the vitamins it provides. In the same vein, the value of a gallon of gas would be measured in the number of miles that can be driven in your car when that gallon is poured into the tank. If that gallon of gas allows you to get to your job for a couple days, then the value would be quite high.

While the value of an orange or a gallon of gas could be different to every individual person, it is important to see that value is not based on, or even related to money. If there was no money, things still have value.

Supply and Demand and Prices

Before we get to the relationship of inflation on prices, we need to understand supply and demand.

From our example above, if there is a frost and the orange crop is damaged, the price of oranges will go up. It’s important to note that this raise in price is not inflation. It is a common misunderstanding that inflation is a result of rising prices, but this is false. Inflation can cause prices to rise, but so can many other factors — the most notable of which is supply and demand.

The way governments measure and report inflation is actually flawed for this reason. If the Consumer Price Index (CPI) goes up, as a result of the price of oranges or other products going up, then the government reports inflation, but it would be more true to say prices are increasing, and it may or may not be caused inflation.

Dollars and Prices

Finally we can look at the relationship between the cost of an item and number of dollars available in the economy. In order to create a manageable example, we’ll take our orange and imagine eating it on an island country where the sum total of all money available is only 100 dollars.

If we go back to the “value” of an orange in this economy we could express that value (which is based on the benefit derived from eating the orange) as 1/100th of the total value of all the goods available on the island. Obviously this is just an arbitrary figure, but in reality, since our money is finite, the principle is sound… everything has a price which is a reflection of its value, that can be expressed as a fraction of all the money available to spend on any possible item for sale.

Now let’s double the total amount of money available on the island, due to the island government creating a stimulus package. :)

Now there is a total of 200 dollars available on the island, but the value of an orange has not changed. It still has the same great taste and health benefits. Therefore still has a value, when expressed as a percentage of all available money or 1/100th.

But now there are 200 dollars so 1/100th of 200 dollars is $2. The price of an orange, due to the government stimulus package which doubled the amount of money available, has also doubled from $1 to $2.

This is the essence of inflation as a result of money supply. This should help us understand what MUST result from the government’s recent bailout package.

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