Price increases for only a few items do not constitute inflation. Keep that in mind when considering news of price hikes for specific goods such as milk or gasoline.
Remember also that inflation results from excessive growth in the money supply, not because there are fewer cows going to slaughter or Middle East petroleum production is in turmoil. The effects of money growth — rather than what is happening to prices of specific consumer goods — are the key consideration whenever the Federal Reserve’s Open Market Committee meets, as it did Tuesday.
Prices go up and down constantly in market economies as the supply of and demand for different goods and services fluctuate. Prices fill an economic function. They tell producers and consumers to change their behavior. A rising price signals producers to produce more of an item and tells consumers to buy less. A falling price does the opposite.
Increases in the prices of several items, even highly visible ones such as meat or gasoline, do not constitute inflation. Likewise, price decreases for these items do not constitute deflation. Inflation occurs whenever there is a broad increase in the general price level. Deflation is a similar broad-based decrease in prices.
When the U.S. Bureau of Labor Statistics measures general price level changes by tabulating the Consumer Price Index, it checks the prices of some 80,000 different items from more than 20,000 different sellers each month.
This breadth of change is what we mean by changes in the “general level of prices.” The CPI is not a perfect measure of price changes, but it is a darned good one.
If a household on a fixed budget pays significantly more for gas, milk or children’s clothing, it has less to spend on other items. When millions of other households face the same predicament, the prices of less important items get bid down. The overall price level need not change, however.
Only if households have the cash to pay more for higher priced items and, at the same time, keep on buying usual quantities of other goods, will the overall price level go up.
That is most likely to happen if the nation’s central bank pumps out new money faster than the underlying production of goods and services grows. Then more money sloshes around an economy through easier credit. Households can keep on buying just as before even though prices of key items have increased.
Thus, the overall price level rises only when there is excessive money supply growth and falls only when there is insufficient money growth.
Yes, economies are complex, with many factors at work at any given moment. This one-to-one correspondence between money growth and the price level is not exactly true in any particular week or month.
But except in the very short run, the relationship between monetary growth and inflation is of overwhelming importance. It is the Fed, not drought, OPEC or dairy cow numbers, that is responsible when overall prices go up.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.