Inflation, deflation, and hyperinflation

This post is about the economic definitions of Inflation, Deflation, and Hyperinflation.  It is a basic primer on these three concepts and how they are related to the supply of money in circulation.

Inflation

When most people hear the word ‘inflation’, they associate it with rising prices.  There are several reasons why prices might be rising: an increase in demand for goods and services; a decrease in the supply of goods and services; or an increase in the money supply.

An increase in demand for goods and services results in higher prices because consumers compete with one another for the purchase of those goods and services.  In doing so, consumers who want the good the most (and who are thus willing to pay more for it) bid up the market price of the good or service. Once the price reaches the market-clearing level, everyone who is willing to pay the market price will obtain the good.  Others who are not willing to pay the market price, or who are not able to pay the market price, will not obtain the good.

A reduction in the supply of goods and services results in higher prices because, once again, consumers are competing with one another for the purchase of those goods and services.  Consumers who want the good the most bid up the market price of the good or service. Once the price reaches the market-clearing level, everyone who is willing to pay the market price will obtain the good.  Others who are not willing to pay the market price, or who are not able to pay the market price, will not obtain the good.

Increases in the money supply also result in higher prices for goods and services.  The classical definition of inflation in economics is ‘an increase in the money supply’.  It is this increase in the number of dollars that results in the rise in the overall price level.

Here’s how it works.  Any time that the supply of a good or service increases, the value (i.e., the price) of that good or service falls because it is less scarce.  Dollars are not immune from this effect.  Accordingly, when the number of dollars in circulation increases, the value of each dollar in existence is reduced.  This is the basis for the old axiom that “a dollar today is worth more than a dollar tomorrow”.

The people who sell goods and services realize that the value of each dollar is falling when the money supply is increased.  This reduction in the value of a dollar means that if the sellers keep their prices stable while the money supply increases, they are losing the purchasing power of each dollar that they accept for the good or service that they sell.  To maintain the same level of purchasing power that they enjoyed before the money supply increased, the sellers must increase the price of the goods or services that they are selling.

In this way, it can be seen that rising prices are not inflation.   They are merely the symptom of the corresponding increase in the money supply.  This is why Milton Friedman stated that “Inflation is always and everywhere a monetary phenomenon.”

Deflation

Most people haven’t heard of deflation.  And if they have, it was probably from a PhD economist who was telling them that deflation is bad for the economy.  Deflation is the opposite of inflation, falling prices for goods and services.  Just as with inflation, there are several economic reasons why prices may be falling.

A reduction in the demand for goods and services will result in a lower price for those goods and services.  Consumers who want the good or service don’t have to pay as much as they previously did for the good or service.  The reduction in price also leads to the Added Buyer Effect: people who couldn’t afford the good or service before are now able to purchase it at the lower price.  Others who were not willing to pay the market price before, or who were not able to pay the market price, will now be able to obtain the good or service.  A decrease in prices due to a decrease in demand thus leads to more consumers being able to purchase the goods and services whose price has fallen.

An increase in the supply of goods and services will also result in falling prices for those goods and services.  Remember, anytime the supply of something increases, the value of that thing is reduced.  Consumers who want the good or service don’t have to pay as much as they previously did for the good or service, and this leads to the Added Buyer Effect. Others who were not willing to pay the market price at the higher level, or who were not able to pay the market price before, will now obtain the good or service.  Thus, an increase in the supply of goods and services leads to more consumers being able to purchase goods and services at the new, lower prices.

Decreases in the money supply will also lead to lower prices for goods and services.  The classical definition of deflation in economics is ‘a decrease in the money supply’.  This reduction in the money supply means that each dollar that remains in circulation now has a higher value than it did before; people can now buy more goods and services with their dollars than they did before.

Hyperinflation

The economic phenomena known as hyperinflation occurs when prices rise very rapidly.  According to Investopedia.com,

There is no precise numerical definition to hyperinflation. Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless.

When associated with depressions, hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money. Left unchecked this causes prices to increase, as the currency loses its value.

The most famous occurrence of hyperinflation was that of Germany between 1921 and 1923.  It was neither the only example, nor the most recent as seen in the table below.

Hyperinflations of HistoryEven the most moronic economist realizes that hyperinflation is bad for an economy.  In fact, hyperinflation destroys an economy and the currency that it uses.

Advertisements


Categories: Deflation, Inflation, Money Supply, Uncategorized

Tags: , , ,

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: