Thursday, February 21, 2013

Intimidation by Confusion: The Case of Inflation

One of the common sins of media commentators and pundits of all colours is what I will call intimidation by confusion. This is a situation when a phenomenon is made incomprehensible by the use of unclear terminology and by invoking even less clear relationships. This makes the audience reluctant to ask for clarification because they assume the commentator’s explanation is confusing not because it is wrong but because it is too complicated to be understood by someone with “non-technical” knowledge.

One such case of intimidation by confusion is the recently often heard explanation of the general rise in prices, popularly called—inflation. The popular assertion made by many commentators is that increases in prices result from an increased “cost of production” of goods and services. Most people at that point would feel like asking: Well, yes, I see my bills rising over time, but where does this increase in the "cost of production" come from; what's causing it? Most people, however, do not ask this question fearing it is a stupid question. It is not, and I'll explain why.

The Cost of Production Fallacy

Note first that the concept of money supply is nowhere to be found in this "cost of production" argument. While it is true that there is a logical link between the price consumers are willing to pay for the final product and the total expenditure producers are willing to incur to produce that product, careful examination shows two key points.

First, the logical direction of this link between input and output prices runs from final consumer goods to inputs used to produce those final goods. It does not run from inputs to final products. Inputs are only valued insofar as they can be used to produce goods that someone is willing to buy. The producer's willingness to pay for inputs is limited by the amount of money consumers are willing to pay for the final product.

For example, the amount of money a baker is willing to pay for a pound of flour is limited by how much consumers are willing to pay for a loaf of bread. The baker cannot simply start charging $500 for a loaf of bread and justify this to his customers by claiming that his flour supplier is asking $400 for a pound of flour. At that price of bread, most or all consumers would stop buying bread. Thus, it is not "cost of production" that drives prices of consumer goods. It is the willingness of consumers to pay for different consumer goods that determines how much money producers can spend on inputs.

The second point that becomes evident from this is that the link between the final product prices and the producers' expenditures on inputs  is established through the process of exchange of goods and services and money. In most simple terms, our willingness to pay for goods and services will depend on how much money we actually have and how much of that money we are willing to exchange for goods and services. The portion of all the money within an economy that people are willing to exchange for goods and services at any point in time is key for understanding inflation. Let us call this portion—the money supply.

The Money Supply and Prices

The link between the money supply, the demand for goods and services and the expenditure producers are willing to incur to produce those goods and services is established through the process of market exchange and competition. At any point in time, there are some individuals offering money in exchange for goods and services, and there are other individuals offering goods and services in exchange for money. The shortcut label economists use for the first group is the consumers, while they label the latter group as the producers.

Imagine now you are a consumer that have had a monthly income of $3000 for the last two years, and your income increases to $3500. You will have $500 more to spend on things you could not have bought before. You may decide to save a portion of those $500, say $200, and spend the remaining $300.

Now imagine the government decided to add $500 to the paycheque of every public service employee in your country. For this purpose governments generally use the central national bank whereby the bank adds new currency (i.e., money) into the government's budget. If most of these public service employees are like you and I, they will want to spend a portion of that new money.

Now we have hundreds of thousands or millions of people wanting to buy more goods and services than before. But, if the quantity of goods and services available on the market did not increase compared to the last two years, we will have millions of people competing to buy the goods and services they were not buying before.

This will lead to a faster emptying of the producers' stocks of goods and longer line-ups for different services. The producers will interpret this as a signal that their prices are too low—a signal that they can increase their profit by increasing prices since so many people want to buy their products. Thus, this increase in the frequency of market exchanges will prompt the producers to increase their prices.

As the producers' shelves are being emptied faster than before, they will want to replenish them faster, so they will try to buy more inputs than before. This will signal the input suppliers to increase their prices as their stocks are being depleted faster than before. Finally, as the prices of inputs and final products rise, the increase in the frequency of exchanges will slow down until we end up with the frequency of exchanges similar to the one before the increase in the money supply and with prices of final products and inputs higher than before. At this point, the new money created by the central bank will be circulating within the economy.

This is the basic mechanism of the percolation of new money into the market economy. The more money your central bank creates in a given period of time, the faster will the prices of most or all products rise if most people decide to use this money in market exchanges rather than accumulate it.


This brings us to the conclusion that, if we see money prices of all or most goods rising over time, this rise is a symptom of the money supply rising faster that the available stock of goods and services. People are offering more money per unit of goods and services purchased in a given period of time.

Now that we understand the mechanism behind the general increase in prices, we can no longer allow various commentators confuse us with buzz-phrases  like "rising cost of production" or "rising input costs" or, worse, "rising costs of living". In my experience, the best way of fighting intimidation by confusion is by actually asking the "stupid" question that is brewing at the back of your mind while someone is "explaining" to you how the world works. Thus, I encourage you to do the same after reading this article.

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