Explaining inflation: Its the money supply, stupid
Back in May, Reuters ran an article asking: “Why is UK inflation so high and how do other countries compare?” The authors offered various possible explanations for high inflation in Britain, including freak weather, Russia’s invasion of Ukraine, and Brexit. But they did not mention the money supply at all. As in the United States, this increased rapidly as the British government responded to Covid-19 and, as in the United States, this lead to an increased rate of inflation.
Anything that claims to explain current high levels of inflation in the United States or elsewhere but doesn’t mention the vast expansions of the money supplies ought to be disregarded.
“various US economic policies” and “customer demand”
A recent CNN article which asked ‘Why do businesses keep raising their prices?‘ ran through the same suspects as Reuters – “pandemic-era supply chain bottlenecks, the war in Ukraine and various US economic policies” [emphasis added] – and threw in the nonsensical notion of ‘greedflation’.
But it went on to note that:
…according to preliminary findings in a New York Federal Reserve survey, there might be something else at play.
The survey of 700 businesses across New York, Atlanta and Cleveland found that strength of customer demand outranked all other factors that companies weigh when setting prices, including steady profit margins and overall inflation.
That means a business can essentially set prices as high as it wants, as long as they aren’t so high that they drive away the customer base. In other words, it’s Econ 101: Good, old-fashioned supply and demand.
More than 82% of businesses surveyed said demand factored into their pricing decisions, while only 52% of businesses said they take the overall rate of inflation into account when setting prices.
CNN went on to ask ‘Are customers too willing to pay higher prices?’ but the relevant question is ‘How are consumers able to pay higher prices?’
Think of that business that “can essentially set prices as high as it wants, as long as they aren’t so high that they drive away the customer base.” That business is raising prices now, and that, we are told, is driving inflation.
But, as I’ve asked previously: Why didn’t it do so before? Businesses are always looking to to maximize their profits, that isn’t a new thing. If raising prices would do that, why didn’t they do it in 2019? What changed?
The phenomenon we are faced with is one where the restaurant can raise prices without losing customers, and that happens because the customers have more money to spend. Here we approach the real cause of inflation: the creation of extra money.
With a fixed supply of money in the economy, the rise of one price will cause consumers to scale back consumption of either that good or some other good (or a mix of both). Whichever it is, the quantity demanded will simply fall until equilibrium is achieved: there is no spiral.
If the amount of money the consumer has to spend increases, on the other hand, they can pay the higher price without cutting back elsewhere. But the key is where they got that extra money from. If the total supply of money in the economy is fixed, then someone else’s holdings of money must have fallen and, with it, their capacity to spend. Their demand will decrease, which means there is no general increase in prices. Once again, there is no spiral.
But if the amount of money the consumer has to spend increases and so does everybody else’s—or many people’s, at any rate—then their increase in spending does not correspond with an offsetting decrease somewhere else. Indeed, everyone can increase spending together. Now we have a spiral.
This newly printed money – those “various US economic policies” – is the source of the “customer demand” which is driving inflation. This demand drives up prices, which drives up profits. Eventually, however, the prices of inputs, like labor, get bid up, and those profits get squeezed. That is what is happening now.
Last week I offered two explanations for why people swallow ridiculous theories like greedflation as an explanation for inflation. I’d like to add a third.
In the United States, and in Britain, also, this bout of money printing was undertaken to help fund massive government spending in response to the Covid-19 pandemic: shutting down an economy and paying everyone to sit at home doesn’t come cheap. If you supported those policies you have to own the resulting inflation. You can argue that it was worth it in the face of a pandemic, a price worth paying, but you still have to accept some measure of responsibility for it. I actually commend those who are willing to do so.
Few people will do so. They want to believe, or make you believe, that a government can borrow and spend vast sums of money and print vast sums to cover this and that inflation won’t result. This means that they have to come up with another explanation for the inflation, and that is where fantasies like greedflation come in’. For the most part, the people peddling greedflation as an explanation for inflation are those who supported Covid-19 shutdowns and all the accompanying spending and now want to shift the blame for the inflation that has resulted.