Dispelling Cost-Push "Inflation"

I think we need to set this straight, my favourite of all public services, the BBC, has published an article on the Bank of Englands decision to keep interest rates at only 0.5%.  They goes on to discuss inflation and supposedly how the BoEs interest rates affects it.  However they seem to have confused themselves and are giving the public the wrong end of the stick.

Inflation, in the true economic sense of the word, is an increase in the money supply.  This is sometimes referred to as Monetary Inflation to distinguish it from what I suppose the BBC is getting at: Price Inflation.

With the nations most popular broadcaster spouting claims like "Inflation continues to be boosted by rising commodities prices" it is no wonder that Mervyn King can still scalp the British public for his utterly useless services.  In order to debunk this myth please follow me through a couple of simple examples, using only the economics 101 supply & demand graph as our aide (for those unfamiliar with this law of economics have a quick look here).

The confusion with inflation comes from assuming that price increases are the cause of inflation, but this is a fallacy; higher prices are a result of inflation.  Let us first consider a scenario based around this mistake, where a company (or several) put their prices up whilst the money supply is kept constant.  Our supply & demand chart shows us what happens when a company increases its prices, either we can move towards equilibrium (the point where supply & demand are balanced) or away from it.

For the first scenario we must remember that a company cannot increase prices to infinity as demand will keep on decreasing, they must strike a balance between price and demand which results in a sustainable profit.  The same rule applies equally for when a price increase moves towards equilibrium, it is only viable so far as income remains fixed or increases.  So if we assume that company A increases prices, then a higher proportion of the total money supply (which is fixed) will be spend on product A, which means that other companies will witness falling demand (less money available to be spent on their goods).

Contrary to the popular belief in spiralling wage hikes to keep up with increased costs of goods, company B will find that it can no longer afford to pay its employees such high wages (as the money supply is fixed where could they magic up the extra cash?).  Therefore higher prices in company A may also see it witness further falling demand.  In order for any price increase to be sustainable it can only go up providing other sectors of the economy can still afford to buy its goods whilst witnessing falling demand for their own product.  The fixed money supply means that a balance will naturally occur, where one sector increases only to a sustainable amount at the expense of other sectors in the economy.

The often proposed "inflationary spiral" where prices increase, so workers demand higher wages, so price increase, to infinitum simply cannot occur without an increase in the money supply.  Where does the extra money come from to increase the price in all goods or the salaries of the workers to purchase these goods?  Can you have more than 100% money supply?  This is a zero sum game, although prices have changed there has been no overall increase in the cost of money, a.k.a no inflation.  So where does inflation actually come from?

There are two possible causes: firstly we haven't accommodated for growth or recession, which we can easily identify as the economies output vs money supply.  In the case of growth we are producing more goods, therefore if the money supply is kept constant then we will witness deflation in the value of the currency.  The chart below may go some way to help picture this:

Consider 1x multiplayer as your economies current state, as it grows the multiplier increases and goods seem cheaper (purchasing power increases) and in recession your economy contracts (decimal multiplier is a shrinking economy) and goods seem to cost more (decreased purchasing power).  Note how as your economy doubles goods cost half as much, or when it shrinks by half (0.5 multiplier) goods cost twice as much.   (Any mathematicians may have noticed this would form a perfect asymptote, y=1/x.)

To best understand this form of inflation is to consider currency as a good just like any other, in recession the number of other goods is declining (increasing demand) whilst the supply of currency remains constant.  Therefore consulting our supply & demand chart will show us that prices will increase in recession & decrease in growth.

The only variable we have haven't altered yet is the actual money supply, this is delt with very simply by our favourite chart.  Demand for money stays the same, although I could argue that it actually falls, but as supply increases the equilibrium has shifted lower.

This reduction in the value of money reduces the purchasing power of all goods due to comparative value (e.g a car represents more labour and materials than a paper clip even without currency).  This could also been seen as an increase in the demand for currency (as you require more of it to buy the same item) on the above charts for growth and recession.  If you increase the supply of one good vs another then the one of limited supply will be traded for more of the readily available good, which we view as increasing prices.  This is true inflation as prices have increased for all goods in the economy compared to the currency, even though they maintain value compared to one another.

So there you have it, true inflation can only be caused by one of two things: excess money supply or recession (only where the number of goods actually shrinks).  Increasing prices are a result of inflation not a cause; perhaps I'll send this essay to the BBC.