Inflation (part 1)

          High in the mountains, far from view, lies the tiny village of Anytown.  Anytown is an isolated location that does not trade with any other community in the world.  It has the means to produce any item or service that the residents would want. 

          It's a completely self-sufficient economy.  A closed system.

          The Anypeople even have their own currency: the anydollar.

          Right now, there are exactly 100 anydollars in circulation.  These anydollars are dispersed among the villagers, in bank accounts, wallets, shoe boxes buried in back yards.

          There's a bakery in Anytown, and the baker charges 1 anydollar for bread.  That's 1% of the total circulating currency, in exchange for one loaf.  The baker uses this revenue to pay for his flour, ovens and licenses, and to pay himself and his employees a wage.

          Everyday, an Anyperon by the name of Mr. Customer comes by the bakery and dutifully purchases a freshly baked loaf of bread.  He munches on it on his daily commute, to his job that pays him a salary of 10 anydollars a week.

          Simple so far, right?  Ok, here comes the twist.

          One day, a magical fairy godmother waltzes into town, and exactly doubles the amount of money each of the Anypeople has.  She stops everyone in the street and looks in their wallets.  If there's 5 bucks in there, she gives them 5 more.  If you're carrying a 20 when she stops you, you'll be carrying 40 when she sends you back on your way.

          She goes to the bank and doubles everyone's account balance.  She digs up the hidden cash stashes, counts it, and tosses an equivalent amount in the shoe box.  With a wave of her wand, all incomes are doubled - Mr. Customer now pulls down a cool 20 per week.  

          When she's done, there's now a total of 200 anydollars in circulation throughout Anytown.

          Fairy godmother figures she's made all the Anypeople "richer" than they were before.  Pleased by all the good she's done, she flitters away on shimmering wings. 

          Now, here's my question.  Has she actually done what she thinks she's done?  Are any of the Anypeople truly richer than they were before?

          Mr. Customer finds out first hand the next morning. 

          After the fairy godmother's magic, Mr. Customer starts to thinks he's a very well to do man.  With a doubling of his income, he figures he'll be eating two loaves of bread on his way to work from here on out.  He strolls through the baker's door...and is shocked at what he finds.

          - Any budding economic minds want to guess what he sees?

          A big new sign at the counter: "Bread - 2 anydollars per loaf"

          You see, after the fairy godmother's magic, the baker thinks he's become a very well to do man as well.  His store is suddenly located in an "affluent neighborhood" full of wealthy shoppers!  People around here make 20 anydollars a week!  

          Knowing that every one of his customers now has twice the income they did before, he is ready and willing to charge twice the price for his goods!  Why?  Well...

          First, he knows there's not reason not too.  He won't loose his customer base by asking wealthier people to pay more for bread!  He's asking for the same proportion of the Anypeople's income that he always has, so his bread isn't any more cost prohibitive then it ever was.  He knows that the bread won't actually feel more expensive to the villagers, so there's no reason to expect they'd buy less at the higer price level.

          Second, if he refused to charge 2 anydollars for bread out of principle, and kept his price at 1, some other Anyperson with and oven and some entrepreneurial spirit will open a bakery asking for 2 anydollars/bread - and find the newly "affluent" villagers would be willing to pay it.  He's likely to steal the other baker's business.  The new player in town could then open multiple locations, expand to offer donuts and muffins as well, afford more advertising - and would ultimately knock our baker completely out of business.  The baker knows this, and could be seen even as raising his prices "defensively."  (And if he didn't, either way, the 2 dollar price would eventually become the norm - after he's business is replaced by the new guy's.)

          Third - and most importantly - the cost of producing bread will have doubled as well.  This is happening on two fronts:

A)  The baker must now pay twice the wages.  If he doesn't, he'll lose his workers to another employer who'll pay more.  Remember, after the fairy godmother's magic, incomes across town have all doubled, and workers expect to get paid "the going rate," or they'll find gigs elsewhere.  Besides they have to double their wages!  The prices of everything they buy, from rent to shoes to bread to TVs, has doubled today.

B)  Materials needed will have doubled in price as well.  The cost of flour, ovens and licenses will now be twice as high, as the producers who supply the baker double their prices - for all the same reasons that the baker is doubling his.

          The fact of the matter is that the baker never needed "1 anydollar" per loaf to keep his operations afloat.  He needed 1% of Anytown's wealth!  It's not the face value of the notes that were important, it's the power each one had.  The weight those anydollars carried around town is what truly mattered. 

          Before the fairy godmother gifts, 1 anydollar gave a person a claim to 1% of Anytowns economic value.  Now, with 200 anydollars in ciruclation, 1 anydollar only lays claim to .5%.  2 anydollars are therefore needed to capture that 1% the baker needs.

          So Mr. Customer, at first put off by the doubling in price, grudingingly decides to just buy just one loaf and get on with his life.  What does he care anyway?  "I'm making a smashing 20 anydollars a week now," he thinks to himself. "I can afford 2 bucks for bread..."

          Epilogue: Years and years later, Mr. Customer will tell his grandkids: "When I was your age, bread was just 1 anydollar a loaf!" 

          What Mr. Customer is describing to them when he does this, is inflation.  (Specifically a type of inflation called "monetary inflation.")

 

          In the popular discourse, people tend to talk about inflation as if it has something to do with the prices of goods and services themselves increasing.  As in: "the price of bread has "inflated" because bread is harder to come by, or more expensive to produce."

          That reasoning is not really accurate.  Inflation often has nothing to do with cost of items increasing - and everything to do with changes in the available quantity of currency used to transact purchases of those items.  When there's more currency in play, a greater percentage of it is needed to lay claim to what's available for purchase in a given economy.

          Now, yes, the REAL price of bread might go up over time, on top of any price increases due to inflation - or independent of it. 

          For example, maybe flour, or labor, or other inputs for bread production may become unexpectedly scarce.  Maybe the Anytown council puts a cap on the number of bakeries that can operate in town, or quotas on how many loaves each can make.  Maybe the town doctor declares that bread is actually enormously beneficial to one's health, and the Anypeople rush out to buy some. 

          All of these things would create a perceived "bread shortage," by either increasing the demand for bread or decreasing its supply.  The shortage, in turn, would cause the price of bread to go up - whether fairy godmothers tinkered with the quantities of anydollars in circulation or not.

          But in that scenario, the price would be going up in "real terms."  This means that the baker would be capturing 1.1%, 1.5%, 2%, 20%, upwards and upwards, to who-knows-how-much percent (it would depend on how severe the shortage) of Anytown's total wealth, per loaf.  The price is really going up, not just rising along at the pace of inflation.

          BUT! ...in any situation where prices go up, due to nothing more than an increase in the anydollars going around (as in the fairy godmother scenario), the price hike has nothing to do with the supply or demand for bread.  It has everything to do with the supply and demand for anydollars.  And this is what causes prices to "inflate," as opposed to just "increase."

          When my grandfather was a boy, comic books cost 20 cents.  He made 50 cents an hour working in a grocery shop.  When I was younger, comics cost $2.25…but I had a job that paid $5.50.  For both of us, a comic costs about 40% of our hourly wage. 

          So I put it to you that the real price of a comic book hasn't actually changed at all in those years.  It's only "inflated."  There’s simply more dollars per person printed and going around today than there was before, weakening the “purchasing power” of each one. 

          We tend to conceptualize an economy only as it pertains to our own existence.  Without realizing it, we kind of behave as if wealth "appears" as it comes into our possession and is "destroyed" once we've spend it. 

          It doesn't come naturally to see ourselves as part of a larger system: that that wealth is not "coming in and out of being" as we receive it and spend it, but rather its just being passed along from person to person in an endless cycle, with our own pockets representing one tiny stop in an near infinite series of exchanges. 

          But this is actually the correct way of viewing economic activity.  That circulation of wealth is what an "economy" actually is!