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How does inflation occur?

by on December 31, 2012

Inflation is simply defined as “the general rise in prices over a continuous period of time”. It seems like a simple thing to understand and measure, but with inflation there are many things that go into it’s cause, and that is where inflation tends to get confusing and murky. I am going to discuss how inflation occurs and what causes it, and I will also bring in a little historical perspective to show how America’s general fear of inflation is misplaced in the wrong things.

The most common cause of inflation is “cost push inflation” or other times called “supply shock inflation”. What happens here is that when a common good, typically oil, food and/or precious metals, becomes more expensive to process, or its supply decreases (like a large oil spill, or a nationwide drought) it puts upward pressure on the price of these goods. When a supply of a common good decreases the demand for it typically doesn’t decrease with it, so firms that offer those goods raise prices to reach their previous profit levels. You could see in the graph below how much oil effects our price of goods:

oil and inflation

As you can see with the above graph when energy prices increase, we see a rise in the general level of prices. This was even more severe in the 1970’s when we were more reliant on oil for energy. This caused a shift to more energy independence (natural gas), which is why we see less of an effect from energy prices on our general prices. Later in this blog I will get into how the 1970’s era of high inflation caused an irrational fear, and how that fear was attributed to the wrong cause.

Another cause of inflation is what is called “demand-pull” inflation, or in other words, “when too much money is chasing too few goods”. This is the one type of inflation that most people fear, but it is also the rarest form and throughout history has only occurred a handful of times (Weimar republic and Zimbabwe are the most prominent examples). These cases are rare because it only in cases when a country experiences dramatic falls in production, which is what happened in Weimar (massive strikes in response to French occupation of the Ruhr) and Zimbabwe (with the confiscation of private farms and civil war).

Those countries made the mistake of printing more money without also increasing the amount of goods that money could buy. The risk of this happening in the United States is almost impossible. We would have to have a country bombing our factories, massive strikes or an EMP that shuts down all of our electronic devices, as you can see this would most likely never happen.  In the United States, when we spend or print more money, our firms actually produce more, so they increase supply to meet the increased demand.

As I previously mentioned it is important to go over this countries inflationary past, and as to why the 1970’s created a shift in economic thought on how inflation was viewed and treated. In 1973 we experienced a rise in oil prices (cost push inflation) that created a period of stagflation (rising inflation and rising unemployment). This happened because of an oil embargo by OPEC, and a drop in production from other Arab nations, many of whom the United States was dependent on for oil.

This rise in energy costs affected the prices of almost every good because energy is used to produce almost every good. So it caused a stir in the economics world and it put economics back into a “dark age” of economic thought. Economists started to let fear get in the way of understanding what was happening.

Before this oil crisis, most economists were nearly unanimous in believing that a little bit of inflation was a good thing because it meant we were keeping unemployment down. This period of crisis opened up a door for a competing and relatively obscure economic theory at the time, monetarism, which was brought into popularity by Milton Friedman. Friedman is well known for his economic theories and this particular quote which applies exactly to this historical moment:

“Only a crisis – actual or perceived – produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. That, I believe, is our basic function: to develop alternatives to existing policies, to keep them alive and available until the politically impossible becomes the politically inevitable.”

This quote is important in trying to get at the motives of Friedman. He was clearly motivated to change policies, whether they worked or not was another issue. So when the oil crisis occurred he took advantage of it and was able to get mainstream economists, politicians and the media to buy into his theories. At this point in history he was able to get people believing that it was a failure of monetary policy that caused this crisis (by increasing the money supply), even though monetary policy had nothing to do with it.

I already proved that it was an oil shock that caused the crisis, so Friedman played on the fears of people to invent a reason for the crisis that diverted attention away from the price of energy being the actual cause of stagnation. There is no reputable study that shows that monetary policy was the reason for the crisis.

Here is another graph that tracks the money supply, GDP growth, inflation and real domestic oil price:

Oil, inflation, money supply

From the graph you could clearly see that when oil prices increase, inflation increases. And in most instances money supply had an inverse relationship with inflation, meaning that when money supply was high, inflation was actually lower!

But somehow Friedman managed to get an entire world to believe that he was right and that everyone else (mostly Keynesians) were wrong, even though this only confirmed Keynesian theories.

We are still heavily influenced by the theories of monetarism and of Friedman, more aptly called neo-liberalism.  Both of our political parties are dominated by it, as is our media and the majority of voters in this country. It is time to wake up to the truth, to expose the lies and deceit and to vote people in who aren’t adhering to these inflation fears.  These fears are preventing economic growth and prosperity for Americans.

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12 Comments
  1. John Hobgood permalink

    Good read! In the 2nd to the last paragraph:

    “so Friedman played on the fears of people to invent a reason for the crisis,”

    is repeated. Just a bit of cleanup…

  2. JP Hochbaum permalink

    Fixed :)

  3. H Fatria G permalink

    to avoid inflation from printing more money then required increase in production or transaction, so fischer not wrong :)

    • JP Hochbaum permalink

      That really makes no sense, proper punctuation would help.

  4. H Fatria G permalink

    money inflation can occurs only when the economy is in full employment, so i agree with fischer

  5. JP Hochbaum permalink

    Ok, got it, I would agree.

  6. This is a very interesting article, with much truth in it. I also fully agree with the attempt to do away with the rather blatant ‘inflation’ fearmongering that the Libertarians are famous for.

    There are a few issues though: I don’t agree with your definition. Inflation always meant ‘an expanding money supply’ and this does indeed lead to rising prices…..if the economy is working at full capacity, which is a big if. The Money Power stooges with their eternal word games to obscure reality made the effect into the ’cause’ to obscure the relationship between the two.
    The Continental is also an important example, btw, for the American public. It was inflated into oblivion, by british counterfeiting, Washington warfinancing, and indeed also by ‘irresponsible politicians’, another enemy the Libertarians (rightly) love to hate.

    The ‘cost push’ inflation that you refer to, is caused to a large extent by the eternal growth of interest costs, associated with an expanding debt-based money supply, this is a very important issue to understand. It’s one of the key reasons why the dollar lost 97% of its value since 1913.

    As a final note: today we are in stagflation. The money supply is tanking (deflation), but many prices are rising because the Money Power speculators are driving up prices in the primary sector.

    Here’s my take on these issues:
    http://realcurrencies.wordpress.com/2012/03/09/inflation-deflation-stagflation/

  7. “I don’t agree with your definition. Inflation always meant ‘an expanding money supply’ and this does indeed lead to rising prices…..if the economy is working at full capacity, which is a big if.”

    Inflation is the general rise in prices over a continuous period of time. It has never meant an increase in the money supply.

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