Inflation Matters summary

We’ve just outlined the definition of inflation. To recap: it’s a persistent increase in the prices of goods or services, or a persistent decline in the purchasing power of money. 

How can we envision this? A lot of introductory economics textbooks would illustrate it through an example like the following.

Say you have five bakers and five brewers. Respectively, they each sell a loaf of bread and a pint of beer every day. The loaves of bread and the pints of beer cost one gold coin each. There are ten gold coins total in the whole world. One day, someone finds another ten gold coins. These are split evenly among the ten people. However, the number of bread loaves and beer pints remains the same – five and five. Because people feel that they have more money, they start trying to outbid each other to get extra bread and beer. As a result, the price of bread and beer both increase. Now each loaf and each pint costs two gold coins instead of one.

In real life, inflation follows a much slower and more complex route than this. But as the example shows, inflation is tightly connected to the money supply –⁠ that is, the total amount of money in an economy. If the money supply is greater, prices will go up as everyone tries to outbid one another to buy a limited amount of goods. 

In the bread and beer example, the money supply increased because someone discovered a bunch of gold coins. In real life, increases in the money supply are typically caused by two different factors: central banks printing new money and private banks making loans to individuals or companies. 

An extreme and famous example of the first situation happened during the Weimar Republic in Germany in the early 1920s. In the post-World War I period, Germany’s government was in extreme debt. In order to finance that debt, it decided to print more money –⁠ lots of it. This worked, of course, and all of the debt was swiftly repaid. However, in the process, the government created hyperinflation –⁠ basically, an extreme case of inflation. Ultimately, this resulted in prices having risen by a massive 29,500 percent by 1923. Large swaths of the population saw their material wealth –⁠ at least, that of it in cash –⁠ wiped out in an instant.

Fortunately, hyperinflation doesn’t happen often. Much more frequently, increases in the money supply happen when private banks make loans –⁠ because, of course, banks loan out money they don’t actually possess. 

What’s most important to remember is that the size of the money supply impacts inflation. But we do need to add in an extra wrinkle: this effect is only apparent in the medium term. In the short and long terms, the money supply has a weak connection with inflation. Let’s explore that a little further.