Inflation 2 (March, 2010)

This is the second installment of my three part series about inflation. Last month, I spoke generally about the basics of inflation. I mentioned that inflation is the gradual increase of prices over time. It leads to an erosion of wealth, since your dollars will buy smaller and smaller amounts of goods and services. This month, I will talk about the main theories about why inflation occurs.

Economists have several different views about the causes of inflation. I will be covering the ideas that fall in the Keynesian and Monetarist schools of thought. Keynesian economics is attributed to John Maynard Keynes. He was an economist in the early 1900's who had a major influence on modern economic thought and theory. Keynes believed that the supply of money in the system does not directly affect inflation, but that inflation is driven by other pressures in the economy. He was a proponent of government intervention into markets to smooth the effects of business cycles. He has several different theories about the cause of inflation.

The first is the so called "demand-pull inflation." As citizens and governments buy more goods and demand more goods, the price of those goods goes up. This causes the government to increase spending when the economy is sagging in hopes of "inflating" economic activity. Demand-pull proponents tend to see fiscal policy, government spending, as the solution to controlling inflation.

"Cost-push" is another inflation theory. This theory assumes that as the price of an input increases, a firm will raise the final price of the good to cover costs. An example is a beet farm. If the cost of fertilizer goes up, the farmer will raise the final price of beets. While the previous theory called for an increase in demand to push inflation, this one deals with a decrease in supply causing prices to go up. When those two forces work together, prices can sky rocket. We experienced something similar to this here in Georgia after Hurricane Katrina hit the Gulf Coast, our number one supplier of gasoline. Expecting shortages, people bought as much gas as possible and hoarded it (demand went up). These two complimentary forces shot prices up as high at $10+ a gallon in some areas.

The final Keynesian theory is called "built-in" inflation. This theory is similar to cost-push, but is much more cyclical. Workers demand more money in wages, therefore firms raise the price of the goods they sell to cover the increases. As more firms do this, workers can no longer afford the goods they normally buy (since the prices are all going up), so they demand more wage money. As you can see, this is a never ending cycle; workers think they are getting richer, but price increases negate their raises.

The last major theory about the causes of inflation is attributed to the "monetarist" point of view. Monetarists believe that monetary policy (actions by the Federal Reserve) is the most effective way to fight inflation The monetarist theory suggests that inflation is caused by the easing of credit, which in turn increases the amount of money in the economy. The more money there is available, the easier it should be to obtain credit. However, the increase in money also leads to increases in inflation. In the 1950's, Milton Friedman became the main opponent to Keynesianism and the main advocate of monetarism, influencing individuals such as Federal Reserve Chairman Ben Bernanke. Currently, the American Federal Reserve follows a modified form of monetarism.

Economists have been debating the cause of inflation for decades (and longer!). These are the most prevalent theories from the last 100 years or so, but it is surely only a matter of time until the next new theory comes around. Like many other things in science and academic fields, there is a continual search for evidence that clearly points to one cause over the others.

Next month, I will be wrapping up this series with a few ideas about the impact inflation has in a practical sense on an investor's portfolio. I will also include some strategies that are used to mitigate the effects of inflation.