Saturday, May 21, 2005

The Real Cause of Inflation

While I voted for Bush, I also am disappointed in the Border Issues and with his big spending.

With Bush's big spending comes consequences. One consequence is Deficit Spending.

With deficit spending comes an increase in the money supply. With an increase in the money supply comes Inflation.

A government in deficit, (spends more than it takes in), must either borrow the money or sell bonds to the FED Open Market Committee. It will usually get the extra money by selling bonds. The process is rather complex but suffice it to say, In so doing, it causes an increase in the money supply.

With this it is important to be prepared for the FED to raise interest rates in an effort to do a "Slight of Hand" to appear to try to curb inflation. In order to better explain I will discuss inflation....

The classical definition of Inflation is "Too many dollars chasing too few goods."

Notice how there are only two components to Inflation, First Money, and Second Goods.

Armed with these two components, it becomes possible to construct a mathematical formula for inflation that my Econ professor was very impressed with.... .

...................Delta M2
Delta INF = ------- .
...................Delta GNP

The symbol Delta cannot be published, so I had to use the word instead. Most should recognize that the symbol delta stands for "a change in", so to read the formula, we would say...."A change in Inflation is equal to a change in the M2 money supply, divided by a change in the Gross National Product.

Now with this formula we can apply any situation. If the GNP rises faster than the money supply, then we will see the inflation rate decrease. While on the other hand, if the money supply is increased more than the GNP, we will have inflation.

The typical GNP increase, (If my memory serves me), is around 3 percent per year, so as long as the money supply is held to only increasing 3 percent or less, then we will be in good shape.

Notice that big business cannot cause inflation by increasing their prices.

It is all about disposable income.

If Gas prices go up, then we are left with less money to spend on something else, so overall the price of Goods remains the same.

I could go over a great deal of other scenarios, and many of the myths of what causes inflation would be easily exposed. If labor gets an increase in pay, then the company has less profit to use on things. Neither of the previous examples changes the money supply or the total GNP.

Have fun with the formula. Any questions?


At 9:19 AM, Blogger SactoDan said...

I remember the inflation of the 70's as the cost of goods chased the sudden increases in the price of gas.

Money lost it's value and prices were increasing daily.

We didn't have word proccessors and price sheets were obsolete as soon as you received tham as manufactures tried to keep up with increasing costs.

The inflation rate has been stable for years. Somehow the Fed has kept a lid on riding costs by managing the money supply even in the face of huge deficit spending.

I beleive we may be near the end of a very long run of minimal inflation. Sooner of later the new high cost of energy will be reflected in the goods and services that are produced, they have to.

The drop in costs of goods and labor (cheap products from China, and cheap labor from Mexico)can only take us so far and we may be near the end.

At 11:42 AM, Blogger Free Agency Rules said...

The high cost of energy will be reflected in the cost of goods for sure, but it will not alone cause inflation, because we will just spend less money on something else.

Only increasing the Money Supply or causing a decrease in Productivity (GNP) can cause inflation.

I think we will have inflation because of Deficit Spending though.

At 9:35 PM, Blogger stc said...

Hey FAR - I came to visit your site since you have been so much fun at ours.

Inflation is such an interesting subject. It has changed a bit since we all went to school. The integration of world markets has made a big differnce in how we manage our money in the US. The thing to be worried about now days is how the Chinese spend their money. We need spare cash from somewhere, China has alot of it. So long as they are spending money, we are OK. But watch out when China decides to cut us off, then Bush's deficit spending will become the big dog, can't feed it, can;t control it.

At 5:57 AM, Blogger Free Agency Rules said...


I agree. As I have said, one of my dislikes about Bush is his Deficit Spending. Inflation is right around the corner, and watch out if China stops spending for a lot of reasons.


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