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All posts by Dan Whalen,
Providence, RI (resume)

Thursday, March 22, 2012

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!

7 comments:

  1. So, is inflation a good thing? I have vaguely heard arguments that inflation is necessary in a growing economy because there is an increased demand for 'dollars' essentially, such as when population increases. I'm not certain what to make of such arguments.

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  2. yeah you basically got it. if the pop increases - or even if it stays the same, but economic activity increases, and the money supply stays fixed - people might end up hording cash. or prices might crash. or interest rates would go up a lot (if money is relatively "rare", i'm going to ask a lot in interest from you when you ask me for a loan) and no one could afford to borrow money to go to school, to buy a house, to finance a town...

    but it gets even more complex the harder you look at it.

    for example: even if the money supply stays constant, you actually will see some MILD inflation if your economy is strong. this is because producers find that they can utz their prices up slowly in good economies. when everyone's incomes are growing, prices kind of naturally creep upward as producers realize they can charge higher and higher prices every year without losing customers. so it can be A SIGN OF something positive

    however, the govt sometimes just prints more money (ie "increases the money supply") independently. this is usually done to achieve one of two end goals:

    1) just to have some quick raw cash to work with - like in the bank bailouts.
    2) (and this is the most common scenario) upping the money supply to bring down interest rates in the economy at large. this concept is a little unintuitive, I know. but the idea is that if there's more loose cash just out there circulating in the country, banks, states, cities, individuals and businesses will be wind up with a lot more money stockpiled. they just can't spend EVERY penny they get (you ever see "Brewster's Millions"). they all will be desperate to lend that money out (cuz its just sitting around doing nothing for them), so they'll lend it out at low interest rates. end result of it all: people who want a mortgage, business loan, bond issuance, credit card, whatever, will find it suddenly more affordable right after the govt injects a little more cash into the system

    the second strategy is a move they pull whenever they think there isnt "enough" borrowing going on in the country (how much is enough? ask the fed chairman, or the sec of treasury, its their job to divine that for the rest of us), and is one of the VERY FEW ways that a government can directly enact any active influence on an economy

    the thing that sucks about inflation is that it erodes people's savings over time. if I had $1000 set aside in 1960, that would have been enough money to skate on for a year! Now, its enough probably half of one at best. so is it fair to someone who worked hard and long to save up $1000 50 years ago, to inflate prices so much that all those hours worked wind up being for barely anything?

    It would take a lot of work to save $10,000 up in 2013. I bet you'd be proud if you could...but by 2050, $10,000 will probably be enough to pay just a month or two of rent! inflation will eat your savings!

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  3. Isn't that more of a statement that 'savings' (low risk, low interest usage of funds) is only a good idea on very short time-spans in any real economy? One cannot get rewarded for having money: the effort that created that money itself becomes less valuable with time, unless you find ways to put that money to work.

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  4. But do keep in mind, that your money is not idle when you save it at the bank. Unless you're saving money by burring it as cash in a box in the backyard, you can't stop your money from being spent.

    When you deposit your money at the bank, they immediately are lending it out as mortgages, credit cards, business credit, etc. Depositing money at a bank authorizes the bank to let other people spend it. You don't really have to find a way to put your money to work, that's what the bank does for you.

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  5. Yeah...but normal savings is like letting your money work part-time at a grocery store being a register monkey for two hours a week. It's not hard at work, it's hardly working.

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  6. I agree with your statement, "The circulation of wealth is what an "economy" actually is!". We are now in the state of inflation. If the president decisions would be pro business, everything would be alright.

    _____________
    Inflation Nation by Ed Butowsky

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  7. Hi, Economystified,
    What a great blog. I love the way you do the story telling.
    I am wondering if you can explain the scenario where the distribution of doubling money is skewed to certain people.

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