Basics of U.S. Inflation

 

Basics of U.S. Inflation

In recent years, the subject of inflation has received a good deal of press coverage and is often a topic of peoples’ conversations. Unfortunately, the public educational system in the U.S. does little to equip people with an understanding of the causes and effects of inflation.

Economists disagree about many things and offer competing theories to explain their views -- classical, laissez-faire, Marxist, efficient market, Friedman’s monetarism, Keynesian, prospect theory, game theory, etc. (as an aside, U.S. government policies tend to follow Keynesian theory).

Theory is one thing; reality is another. What the “ordinary citizen” needs to understand is the basics of what causes inflation, what actions can be taken to try to control it, and the results of such actions. Certain basic principles apply irrespective of which economic theory may be popular.

Here are 10 basic principles of inflation as it occurs in the U.S. economy:

1. Inflation is caused by an increase in the money supply. This can be described as “an imbalance between money resources and money uses” or “too many dollars compared to the items available for purchase.”

2. The U.S. money supply is controlled by the Federal Reserve, which is a central bank owned by its member banks and managed by a government-appointed Board of Governors (the government does not own the central bank, which is unusual).

3. The Federal Reserve (the Fed) controls the money supply by buying and selling US treasury bills on the open market. By buying Tbills from financial institutions the Fed adds funds to existing bank reserves, thus increasing the supply of money available. The effect is the same as “printing money.”

4. Tbills are the federal government’s primary way of borrowing money to finance deficit spending. Thus, more federal spending requires issuance of more Tbills, which (when purchased) increase the money supply.

5. An increase in the money supply allows producers/sellers to raise prices, resulting in inflation*. The more Tbills the Fed buys, the greater the money supply, the higher the rate of inflation, and the greater the negative impact on the consumer.

6. The Federal Reserve’s primary tool to attempt to cool inflation is changing the federal funds rate (the interest rate on money it loans to member banks). The idea is that higher interest charged to banks is passed on to consumers, which decreases their spending. This, in effect, takes money out of circulation.

Example: an increase in interest rates causes a potential homebuyer to forgo purchase, thus not taking out a mortgage, thus decreasing the money loaned out by their bank. This reduces the bank’s borrowing from the Fed, which reduces the quantity of Tbills purchased by the Fed.

7. The federal government could play a role in controlling inflation by reducing spending, thus reducing the volume of Tbills issued to finance its deficit. But continued deficit spending requires more borrowing via Tbills, which feeds inflation. As the fed raises interest rates to combat inflation, the federal government’s borrowing costs also increase.

8. As inflation erodes consumers’ purchasing power, political pressure increases the likelihood that federal government spending on assistance programs will increase. As more spending increases the federal deficit, more Tbills will be issued, thus further increasing the money supply.

9. An alternative action available to the federal government is to avoid a growth in deficit spending by increasing taxes. This is unattractive not only for the obvious reason (voter reaction) but also because high tax rates may make a country less competitive in the global economy, stunting longer term economic growth.

10. The Federal Reserve, as well as most macro-economists, support the idea that a “normal” rate of inflation of 2-3% is acceptable and conducive to a healthy economy. This assumption is arguable, but generally accepted. However, any rate of inflation erodes consumers’ purchasing power.

* Sellers/producers may publicly justify price increases by citing increased costs (e.g., increase in wages paid). But consumers can pay higher prices for the same goods only when the money supply is sufficient to do so.
Typically, wage pressure is driven by (a) a desire to receive a greater share of the income realized by profitable sellers/producers, and/or (b) a desire to recoup the increased cost of living caused by an inflationary period.