Saturday, January 12, 2008

Causes of Inflation

Inflation is caused by three things:

*An increase in the money supply
*An increase in the speed of circulation of money
*A decrease in the size of the economy

When money supply or money velocity increase, or when the economy produces less, the purchasing power of your money decreases (i.e. prices increase).

prices can be determined by the formula


allowing for

P= price

M= money supply

V= money velocity

Y= GDP output.

If GDP output increases, that means there are more goods for every dollar in circulation. As such, there's a higher demand for every dollar (purchasing power of each dollar increases), and prices decrease.

If money velocity increases, i.e. if money changes hands more quickly, then a smaller number of dollars will be used for a greater number of purchases, leaving a surplus of dollars no longer being used, leading to a decrease in demand for dollars, and prices increasing.

If money supply increases, i.e. if the federal reserve prints more dollars, then there's less demand for each dollar (purchasing power of each dollar decreases), and prices increase.

I hypothesize money velocity is also largely a function of money supply, the reasoning being that an increase in money velocity is a result of people losing faith in their dollars maintaining their value (when every year more money is printed), in other words, an increase in money velocity is a result of people opting to quickly trade in any dollars they may have for other stores of value (e.g. commodities [e.g. gold], real estate, stocks), and only acquiring dollars when they need to pay taxes or make a transaction, thereby creating a situation where people are trading dollars back and forth like hot potatoes.

Therefore, I contend that, given an economy that isn't contracting, only the federal reserve and its decision to expand the money supply can cause inflation, nothing else.

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