Price Inflation and The Real Inflation

In all corners of the western world we can regularly hear that inflation is low, or “well-anchored” in the language of central bankers. References to inflation are usually references to price inflation, more often than not as measured by the CPI – the Consumer Price Index. Such indices were initially constructed to provide a measure of the purchasing power of money – if prices goes up, the purchasing power of money goes down and vice versa.

It is not only the supply and demand of the various goods and services included (and excluded) in such indices that affect the prices, but also the supply and demand of money. Enter the quantity theory of money which in a mechanic interpretation crudely states that if the supply of money increases the prices of goods and services will increase proportionally. In real life, the relationship is not that clear cut and will certainly not be linear as the marginal utility of money will gradually decrease, ceteris paribus. The supply of money is perhaps the more important of the two. As the supply of money goes up (down), prices are likely to go up (down), too. This is the primary reason why some economists in the good old days often referred to an increase in the quantity of money as inflation, and not the increases in prices per se (which is a mere symptom).

Looking at the western world, there are substantially more goods and services produced and sold today than say 100 years ago. As this has driven up the number of exchanges, it is safe to conclude that the demand for money has also increased during this period. This increased demand for money will tend to increase the purchasing power of money, which by itself leads to a lowering of prices for goods and services. Still, most prices have increased during the last 100 years. How can this be when in addition businesses constantly improve and become more efficient at producing, not least due to economies of scale and improved technology? The answer is simple; the supply of money, or the quantity of money, has increased even more.

Therefore, next time you hear a central banker or your favourite politician say that inflation is low, two questions should pop to your mind immediately: 1) how much did the money supply grow during the same period and 2) what had the price inflation as measured by the CPI been IF THE MONEY SUPPLY HADN’T INCREASED AT ALL? Answering the first and being able to imagine the latter will make both you and your finances better “anchored” than simply swallowing the low CPI naivly.

I write regularly on money supply developments for especially the U.S., but also for the Euro Area, UK and Norway on EcPoFi where you can access these reports.

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