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Understanding Inflation

What is inflation? Inflation, as generally understood, means rising prices. Or, more money chasing fewer goods. At first glance, this ‘makes sense’. Petrol prices go up all the time. So do prices of staples like rice, wheat etc. When prices increase a lot, we have high inflation. When we don’t notice it much, it’s low inflation.

But this explanation of inflation has one fundamental flaw: we still don’t know what causes inflation. All we see are its effects, manifesting themselves in the form of higher prices paid for every purchase.

So, in order to understand inflation, we need to understand its root cause. Since inflation, at first glance, means rising prices, to understand inflation we must first understand price.

What is a price?

A price is simply a ratio of two quantities. If I pay 3100 worth of rupee, I can purchase one gram worth of gold. Which means, the rupee price of gold is 3100 per gram.

3100 rupees = 1g gold

Price of gold = 3100 rupees/1g

Price of rupees = 1/3100 g gold/1 rupee

A price is simply a ratio of two quantities. Now imagine an economy where there are 20 different items. Pricing each item in terms of all the others, we get 380 different prices! No merchant can trade with so many different prices to consider. So, the people decide to make their lives simpler by considering the price of all items with respect to one single item. They call this item money. Henceforth, every item has only one price. 20 items, 20 prices. Life becomes simple.

But let’s not forget the origin of price. When we use the term price, what we really mean is price of one item in terms of another. The common denominator to all prices is the money commodity, in this case the rupee.

Back to Inflation

So, if inflation is rising prices, what causes prices to rise? And what are its implications?

To answer these questions, we should not only understand what prices are, but also how items are given a particular price.

From general economic theory, we know that prices are determined by the market forces of demand and supply. At a particular price, supply equals demand. If an item is priced higher, there will be more sellers and lesser buyers. Sellers will have to reduce their price to clear out their stock. If an item is priced lower, there will be more buyers and less sellers, leading to shortages. Buyers will bid prices up in order to get what they want. At the equilibrium price, there is exactly enough supply in the market to meet the demand of the buyers.

It follows that as prices rise, more people are eager to sell. And when prices fall, more people are eager to buy.

Further Implications

When prices of all items rise in a particular period, it either means there are more eager buyers willing to bid prices up to get what they want, or less sellers, creating shortages in the market and hence pushing prices up. Could this explain inflation?

Supply and demand are actually two sides of the same coin. In fact, supply is the source of demand. To increase my demand for goods, I should have first earned more in order to fund my increased demand. But to earn more, I should have supplied more in order to make more money. Generalizing, all suppliers should have increased their supply in order to generate enough money to increase their demand. But if all suppliers increased supply, prices would fall, not rise!

Increase in demand is possible only with increase in supply, hence a fall in price, since supply is the source of demand. In the overall economy, we simply cannot have a situation of eager buyers pushing prices up while sellers decrease! It can happen at a smaller level, but definitely not in the overall economy. It is a logical impossibility under the laws of economics.

But, we see it happen daily. Does this mean the laws of economics are wrong? Or, are we forgetting something?

Recall that price is a ratio. Thus far, we have only looked at the numerator. Let us now look at the denominator.

You wake up one day to find that you have exactly half the quantity of money you had yesterday. And it’s the same case with everyone else! Half the quantity of money has simply disappeared from the economy! If you pay yesterday’s prices for your purchases, you can now only satisfy half your demand. What would you do? Prioritize your purchases. Demand for many items at yesterday’s prices would plummet to zero.

What would happen in the market? After an initial period of chaos, prices will adjust to the level where demand equals supply, as we saw earlier. Or, if everyone realizes that nothing has changed except the quantity of money, all prices would simply be halved and life would go on as usual. (This is just a simplistic explanation to prove a basic point that prices will adjust). But the essential thing to note is, all prices would go down.

Now image that instead of the quantity of money becoming half, it has doubled. You feel richer, until you go out into the market and realize that all prices have gone up.

Aha! There’s our inflation. That phenomenon of rising prices all around, or a general increase in prices. Its cause: increase in the supply of money. Effect: all prices have gone up.

At last, we have understood what inflation is. Inflation is an increase in the supply of money.

Why does this happen? How does this happen? These are questions to be addressed in subsequent posts. Thanks for reading.

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