Inflation: Why We're In Store For Some

Approximately last week I was talking about how moderate inflation is not, usually, a bad thing, and is actually necessary for a healthy and growing economy to continue functioning.

This week, I'm going to talk about the extremes of inflation and, more specifically, why America is in store for a bit more than the planned amount of inflation.

Obviously, lots of inflation is bad. It punishes people who save and invest money, an important economic service. It adds uncertainty and instability to pricing. It also tends to lead to a loss of the value of a currency in relation to other currencies. While these may seem like minor problems, they have a major impact on the economy.

However, I'm going to assume that you all either know that large amounts of inflation either cause or are indicative of poor economic situations, and move on.

If you look back a while, I discussed the Quantity Theory of Money and used it to show why small amounts of inflation (approximately equivalent to growth) are necessary for long-term price stability in a growing economy. Now I am going to use that theory and another concept to explain why American is going to experience some inflationary pressures in the next few years.

(Before I get into anything else, I'd like to say that I'm not a macroeconomic expert, and that this explanation simply shows that inflationary pressures will exist beyond the norm, not that there will necessarily be inflation or, more importantly, that there will be a lot of inflation.)

Now for our new idea - when consumers buy something, they send a signal to producers. This is often described mathematically using a demand curve. A demand curve is a temporally static way of looking at how much of a certain product an individual or market will purchase at a specific price.

Holding the price constant and looking at the demand over time yields more interesting results. When looking at things temporally, a specific signal can be sent by consumers to producers that they should invest in additional productive capacity. They do so without knowing, and the producer often intakes the signal without much analysis.

Regardless, when consumers are constantly consuming more and more, producers begin to invest in more and more productive capacity. This seems fairly obvious, but when combined with the idea of credit it has some interesting effects.

When interest rates are low, people are more likely to borrow money. Currently, interest rates in America are about as close to zero as possible, and loans are available easily with little in the way of application process via credit card and other processes.

This naturally leads to consumers purchasing more and saving less. In America, consumers often purchase more than they can actually afford, and the savings rate for many individuals and families is well below zero.

Spending in this way sends a specific signal to producers - they need to raise productive capacity to meet future expanded demand. However, when spending is artificially inflated by low interest rates and easy access to credit, that future demand does not necessarily exist and, in most cases, will not.

This causes a problem, one that occurred in the Great Depression - there will be capacity to produce goods that simply are not in demand as a result of false signals from consumers to producers, and this capacity will either not be used or will be used to produce goods that will not be sold at an economically optimal price - or any price at all. The problem will be further exacerbated the longer the current credit glut continues.

Unused resources are misallocated, and this is an economic problem. The degree of the problem is not something I can comment on, but the results are fairly straightforward - depending on the average elasticity of demand for goods in America, we will have either massive inflationary pressure, deflationary price, or no pressure in either direction. If demand is largely elastic, we will have a great deal of inflation, while deflation will occur if demand is largely inelastic. As the majority of goods have elastic demand curves, we will almost certainly have inflationary pressure.

(As this is getting fairly long, I'm going to skip over the idea of elasticity and direct you here if you're really interested in what it is: Elasticity. If anything around this is unclear, please leave a comment below.)

There isn't really any solution to this problem other than to be prepared for the coming inflationary pressures and, on the part of the government, to raise the interest rate immediately and begin implementing a contractionary monetary policy.

And I'm sure, to many of you, that above paragraph was largely meaningless. For now, I'm done, and I hope you learned a little something wandering through my thoughts for the day. If you have any questions or, possibly, arguments, please leave them in the comment section.