Making Sense of Inflation – Vega

I’d like to start a discussion about inflation; hopefully Alpha will join me in struggling with the myriad complexities of inflation and we can gain a deeper understanding.

First, it’s important to define what we mean by “inflation.” Economists generally define inflation as a persistent and broad increase in prices. By this definition, an increase in the prices of precious metals and crude oil does not represent inflation unless it’s accompanied by costlier consumer goods.

The greatest authority on inflation is probably Milton Friedman who famously wrote, “inflation is always and everywhere a monetary phenomenon.” Friedman argued that in the quantity theory of money, P = M*V/Q (price = quantity of money * velocity / quantity of goods produced), by far the most important part is the M (quantity of money). Friedman felt that the velocity of money and the quantity of goods produced were generally stable. He also felt that we can focus on just the supply of money since the demand for money is relatively stable.

Friedman argued that the quantity of goods produced and the demand for money are generally more stable than the supply of money, and therefore it is the supply of money (i.e. the central bank’s printing press) that is the cause of inflation. Friedman explained that as the newly printed money enters the economy, there is too much money chasing too few goods, so buyers bid up prices, producers then increase production by hiring more workers, which causes salaries to rise and creates an inflationary cycle. Anecdotally, Friedman noted it generally takes about 2 years from the date the central bank prints money until inflation is felt.

One problem with this simple model is that it relies on relatively fixed output capacity. If producers can quickly and easily increase output, prices won’t necessarily rise very much as demand increases. For example, many factories in China are currently running on just 1 shift a day. If demand for their goods increases, they don’t need to buy any new machinery or open a new facility, they can just stay open longer each day. Similarly, the large number of unemployed workers in China means that wages won’t need to rise very much for factories to add second and third shifts.

Another problem with Friedman’s supply driven model is that it neglects changes in the demand for money. While demand is usually stable, there are occasional turning points when the savings rate changes dramatically. From the end of 2007 until the beginning of 2009, the US personal savings rate rose from about 0% to over 4%. In other words, the demand for money increased quickly and dramatically.

I’ll try to lay out various ways of thinking about inflation over the next couple of posts and try to put them together into a framework with predictive power for our current circumstances.

Originally published at Risk Over Reward blog and reproduced here with the author’s permission.