It is almost impossible to turn on a radio, read a blog, or thumb through newspaper business pages without a strong forewarning of inflation.  In this column I have worried about inflation as far back as mid-2009.  Since then inflation has been very tame.  Some have even worried about the specter of deflation – a far more troubling phenomenon that has likewise been absent.  It may be worth explaining how all this works.

All economists know that, at its core, inflation is solely caused by too much money chasing too few goods.  But unless you’ve been steeled to think of the world in terms of simultaneous equations, this is a pretty abstract notion.  Let me use an easier example:

Suppose there were two villages that made goods and traded them with each other, each using its own distinct currency.  Initially, the value of each village’s currency is identical, but one day, the monetary authority in one village decided to print a great deal of money and distribute it to citizens. At first, the villagers with the new cash would be pleased to spend the money in the other village, but it wouldn’t take long until the denizens of the second village got wise and raised the price of their goods in terms of the first village’s currency.  Saddened, the holders of the devalued money would return home to buy goods – but there also, merchants would sense the extra demand for their goods and raise prices.  This is inflation.

 Please don’t think this example is meant to be condescending.  It is actually a fine model for both exchange rate variability and inflation and something like this is the basis for many more sophisticated models.  But as long as you understand that concept, it is what is absent from the example that is really fascinating.

Suppose the printing of money in the first village was done to compensate for a terrible drought’s effect on harvest.  The idea was to cause some villagers in both locations to produce more goods to fill the gap in demand.  This would work to some degree, but certainly not in the long run, and only as long as workers make more goods instead of simply raising prices.  The extra money would also reduce the costs of borrowing money (there is more in supply) so could boost demand for capital goods (like irrigation ditches) – so far, so good.  The problem arises as villagers can no longer produce more goods to fill the gap and instead raise prices. 

In the U.S., and to a lesser extent elsewhere, we’ve increased the money supply significantly, and it looks like it is boosting demand, rather than causing prices to rise.  The depth of the recession has lessened the ability of firms to raise prices. As the economy recovers, this will end – prices will rise and we will have inflation.  Experience tells us that while inflation may be delayed once it starts, it is apt to accelerate dangerously. When and how much are matters of great supposing.