What Is Inflation?

Okay, so if you Google’d “what is inflation” you probably got a flurry of websites talking about the horrors of inflation, about the joys of inflation, how important it is, how unimportant it is, how evil it is, how good it is…

After all that confusion, you landed here. Let’s put all that craziness to rest and get some common sense answers.

The Short Answer

First off, if you want the short and dirty:

Inflation is an increase in prices broadly across the economy, due either to an increase in the money supply, or (theoretically, but not actually) something that increases aggregate demand.

If you don’t know what any of that means, or you want a more detailed explanation of inflation, read on.

Understanding Inflation

If you have done any amount of searching, you’ve probably run into one of the following definitions:

1. Inflation is a rise in the general price level

2. Inflation is a decrease in relative purchasing power

3. Inflation is an increase in the money supply

SNORE!

So, what does any of that even mean, and why should we care?

Let’s start with the second definition. Inflation has to do with purchasing power, right? Well “purchasing power” is just a fancy way of saying “how much stuff you can buy with your money.”

And the fancy term in the first definition is “price level,” which is just a smart-sounding way of saying “the average price.”

Now that we’ve brought economics back into the realm of plain English, let’s look at an example that will help us understand how price level, purchasing power, and inflation are all related.

Assume you want to buy some amount of a good or service, like a hundred apples, or three bushels of hay, or 100 grams of cocaine.

Now, say that the prices for all these goods were $1 per apple, $15 per bushel, and $100 per gram of cocaine. Let’s also assume, for the sake of simplicity, that these were the only goods available to purchase in the market.

That would make the “general price level” of the market $39 (the average of all three prices). Pretty simple.

Now you can go tell all your friends that you know how to calculate the price level of the economy, just like a real economist:

1. You make whatever assumptions you want about the goods/services people want to buy,

2. You take rough estimates of the prices of those goods,

3. Then you do a series of calculations any first grader could perform and Voila!

(Okay, so maybe it’s not quite that easy…)

Anyway, back to our totally realistic market of goods and services.

Say you had $1,000 dollars of income to spend across all the goods in the market. You could buy 10 grams of cocaine (and starve), you could buy a thousand apples, or a lot of hay, or some combination of the three.

Let’s say you spend all your money on cocaine, because you have a serious problem. An economist would tell you that your “purchasing power” would be .01 grams of cocaine for every dollar of income you have ($1 of income ÷ $100 per gram of cocaine).

Inflation Enters The Picture

But what happens when we throw inflation into the mix? What inflation really is, is a rise in prices. Remember, our first boring definition was “an increase in the general price level.” Recall that the “general price level,” or the average price, of our market is $39.

Imagine for some reason, perhaps a consolidation of power amongst the international drug cartels, that the price of cocaine rises to $120 per gram next year.

After performing our sophisticated econ math, we find that our new price level is now $45!

And so there you have it: INFLATION!

The new price level has a resultant effect on your purchasing power: you can now only buy .008 grams of cocaine with $1 dollar of your income. Or stated otherwise, you can only buy 8 grams of cocaine with all your income, rather than the 10 you could buy this year.

Notice that we didn’t have to raise the prices of apples or bushels of hay to increase the price level in this example (more on that later). Also, take note we assumed the price of cocaine rose through normal market forces (sort of), and not through government action.

Understanding Inflation

So now that our example is over, let’s try to understand why inflation matters. In that example, we saw how inflation is both an increase in prices and a decrease in purchasing power. In other words, you couldn’t buy as much as you could before.

he deadly combination of inflation is:

1. Your real income stays the same (or goes down) and

2. Prices go up.

By "real income" I mean your income adjusted for inflation.

If your income next year increases by 2%, but we have 5% inflation, then your real income has actually gone down. You can buy fewer goods, even though it seems like your income went up.

It should be obvious by now why many economists decry inflation as a “destroyer of wealth” or as the “silent tax.”

But what about that third definition above? What’s all this business about the “money supply?” Well, the real world operates somewhat differently than our simplistic example...

In our example, there was one good that heavily influenced the price level, but in the real market, the prices of many goods would have to rise in order to create the same effect across an entire economy of goods.

Since the prices of so many goods are uncorrelated, there are very few causes for this kind of widespread inflation. Historically, the government's creation of money has been the largest driver of inflation.

The economist Milton Friedman once famously said that inflation is

“always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.”

What he meant was that the central bank of the United States, the Federal Reserve, which is tasked with managing inflation, is usually the principal cause of inflation via poor monetary policy. This creates a situation where lots of new money floods the economy, but the economy doesn’t actually produce more goods than before.

In our example above, it is as though the same amount of cocaine exists, but now everyone somehow has twice the income to buy it. The result is that prices rise as suppliers meet the new demand that is artificially created by the increase in the amount of money floating around in the economy.

Conclusion

So there you have it, now inflation makes sense. Go out and start demystifying it for everyone else (and be sure to let them know where you found such valuable knowledge).

Also, if you're feeling like maybe there's more to the stroy of inflation, and you want to know why inflation happens and what to do about it, keep a look out for my new book on inflation. It is set to come out in March of 2023.

The book I'm writing will cover all of the topics discussed here at a much greater depth while also staying in the realm of plain English. You're welcome.

Oh, and please subscribe to my YouTube channel, podcast, and email list! I'm sure you don’t watch enough YouTube, listen to enough podcasts, or get enough emails yet, so add some of mine!!!