Why does inflation happen?

[aes1]

This may be economics 101, just wanting to check my facts on the phenomenon...

Does inflation, in case of dollars for example, simply come from the fact that the government introduces more money into the system, which causes the value of existing dollar? Or are there other factors in play?

How about banks creating money out of thin air, does it have any role in inflation? (As I understand it, they invent money that they loan  to customers, expecting an interest - correct me if I'm wrong!)

[antimattercrusader]

All the factors you mention has a impact on inflation... you can think of it as a hidden and huge tax. There are a ton of other factors as well... just depends on how deep you want to get...

[Sage]

Not just the money supply...

Any of these cause inflation:

The demand for goods/services goes up faster then the supply increases.
The supply for goods/services goes down faster then the demand decreases.
The supply of dollars chasing those good goes up faster then the supply/demand differential.

With innovation and efficiency the cost of goods/services should overall be going down (factoring out the temporary boom/bust cycles) IF the money supply was honest and fixed.

5% inflation in no way means a simple 5% increase in the money supply.  Factoring in innovation and efficiency increases it could be multiple times that.

Central banks have been stealing that efficiency increase on top of inflation since the invention of fiat.

[odolvlobo]

Also, keep in mind that the term "inflation" is ambiguous.

In economics, it means an increase in the money supply, which may or may not result in rising prices (as we have seen).

In common usage, it means rising prices, which may or may not be caused by an increase in the money supply.

[Vladimir]

When private central bankers (not governments) need some money for any reason it magically appears on credit side of banksters' balance sheets and on debit side of balance sheets of all the other market participants . Normally, banksters are content with improving their balance sheets at expense of suckers (whose balance sheets get decimated) to the tune of 3-5% of GDP/M1/some_other_huge_amount per year.  Sometimes, when all the leveraged bets of banksters blow into their face they magic onto credit side of their balance sheets a few extra trillions here and a few extra trillions there. The euphemism for this process is inflation.

Then they also get interest on top of that, the interest is normally covered by income taxes on population. But it is another story.

Trivial stuff.

[aes1]

Also, keep in mind that the term "inflation" is ambiguous.

Yes, good point. What is meant is the common usage, or the value of dollar decreasing in relation to everything else.

(Technically the bitcoin economy is inflating, with new bitcoins being introduced, but the value is going up - so it's somewhat confusing to talk about inflation.)

All the factors you mention has a impact on inflation... you can think of it as a hidden and huge tax. There are a ton of other factors as well... just depends on how deep you want to get...

This is a really good point. The devaluation of dollar caused by printing new money can be seen as a form of tax, which is interesting since as far as taxes go, it's probably the fairest and most efficient kind of taxation there is: everyone loses exactly the same percentage, and the amount of bureaucracy and effort used to collect the tax is probably a lot lower than with traditional taxation.

Now I wonder where this tax goes - who gains? The central banks? Those who they lend the money to? Governments? Where is this newly collected "tax" used, and are politicians / public sector in control of them in similar way than other taxes?

[Adrian-x]

1) over supply of money
2) under supply of goods and services
3) increase in consumers

And use the search for a weeks worth of debate reading on the topic.

[Adrian-x]

Now I wonder where this tax goes - who gains? The central banks? Those who they lend the money to? Governments? Where is this newly collected "tax" used, and are politicians / public sector in control of them in similar way than other taxes?

The tax is called the Cantillon Effect - it goes to the spenders of new money - mainly huge government contacts, corporations and bankers. At the experience of the producers in an economy.

[nobbynobbynoob]

The inflation tax benefits the first users of the new money, i.e. major banks. It is also used to underwrite (monetize) government deficits. How else could they continue ad infinitum to spend far more money than they actually collect?

[Elwar]

Imagine it this way. Jack has a poker game at his house. Each person puts in $30 and gets 30 chips. 4 players, $120 120 chips. The pot will go to the winner.

After playing for a while, Jack loses all of his money equally to the other players. Now those players each have 40 chips.

Jack decides he wants to keep playing. He goes into the other room, grabs 40 more chips for himself. He drops an IOU for 40 chips to the winner of the game.

But now there are 160 chips in the game making each chip worth 75 cents. At the end of the game he owes the winner for a quarter of the chips and a quarter of the winnings, $30. Even though when the game started a chip was worth $1 each.



When the Federal Reserve prints money they lend it out to the big banks who lend to the big corporations. They are getting money for an IOU in the same way that Jack got 40 chips in exchange for an IOU. They pay it back after the money has circulated and lost value. And they get to spend it when the value is still high, until it trickles down to the average person.


The poker game would be a lot different if instead of chips they used dollar bills, or if each chip was tied to the dollar. Then Jack bringing 40 new chips to the table would mean that he would owe $40 at the end of the game. Until 1971 the dollar was tied to gold in this way. But then they went off of the gold standard and we have had more and more inflation since then.

[nobbynobbynoob]

The poker chip analogy is a good one.

+bitcointip Elwar BTC0,001

[doobadoo]

This may be economics 101, just wanting to check my facts on the phenomenon...

Does inflation, in case of dollars for example, simply come from the fact that the government introduces more money into the system, which causes the value of existing dollar? Or are there other factors in play?

How about banks creating money out of thin air, does it have any role in inflation? (As I understand it, they invent money that they loan  to customers, expecting an interest - correct me if I'm wrong!)

The "Austrian" school of economics would say that the definition of inflation is an increase in the supply of money and credit, the result is a general rise in the price level.  Mainstream economics teaches that inflation IS a rise in the price level, and usually mentions the silly "phillips" model which claims that inflation occurs due to economic growth (even though graphs of inflation vs nominal gpd growth show no correlation whatsoever).

Let me prove the austrians by introducing you to simple math equation governing money and goods/services: Its called the Quantitative Theory of Money:

M * V = P * Q

Where M is the amount of issued currency in the economy
V is the "velocity" of money (how many times the average dollar changes hands in transactions for good/services over a period of time)

P is the average price of a good or service in the economy
Q is the quantity of goods/services

When you think about it, the supply of money (M), multiplied the number of times the money changes hands (V) represents all the economic activity for the year.   Also, the Prices of everything traded, multiplied by the number of those things traded should equal M * V.

So, any increase of P is, by definition a rise in the overall price level.  

Now what causes a rise in P over the long run?  In the long run Velocity is just a constant, because money can't habitually change hands faster and faster and faster (or slower slower and slower) over long periods of time (not in a normally functioning economy anyway).  So you might as well consider V a constant over longer periods of time.

Now, if Q (Quantity of Goods sold) stays the same from one year to another because of a lack of economic growth, the whole rise in the price level is must be caused by and increase in Money Suppy (M).

Interestingly as an economy Grows (Q gets bigger), were there to be no change in the supply of Money (M), Prices would HAVE to decline.

Thus, when the general price level rise, that is and indication of the size of the Money supply increase, net of real economic growth.  So if the economy is said to grow 2% in a year, and price inflation was 3%, it meas that money probably grew about 5%.

Now just to introduce another concept M or money supply also includes fractional credit.  This is the phenomenon created by the banking system, which will take a deposit of $100 dollars of currency, then lend say $95 to a borrower, who in term buys something from some one who goes ahead and deposits the money somewhere else.  A portion of the redeposited $95 then gets lent out AGAIN and thus the same currency starts occupying many places.  

This is why all the money that The Federal Reserve has been aggressively printing as part of "quantitative easing" has not cause a big jump in prices (yet).  During this time banks have been collapsing their loan portfolios (both due to loan losses, and poor economic prospects reducing lending).  If and when lending starts expanding we will see much sharper inflation if the Fed doesn't quickly raise interest rates and collapse the amount of currency its issued.

Its a lot to understand, hope this helps.

[doobadoo]

Not just the money supply...

Any of these cause inflation:

The demand for goods/services goes up faster then the supply increases.
The supply for goods/services goes down faster then the demand decreases.

This is incorrect.  Demand cannot outstrip the supply of all goods and services.  The demand for a particular good, like oil, can outstrip supply and price rises till the demand peters off and some people stop buying as much.  But if there were OVERALL demand increasing, the economy would just supply it.  The result, with a steady supply of money would be a decrease in prices.  The simple way to understand this is that EVERYONE can't pay more unless....wait for it, wait for it....there were more overall money/fractional credit available.

Keynesians always deny the true reasons for price inflation, so they put up these red herrings about aggregate demand outstripping supply.

With innovation and efficiency the cost of goods/services should overall be going down (factoring out the temporary boom/bust cycles) IF the money supply was honest and fixed.

5% inflation in no way means a simple 5% increase in the money supply.  Factoring in innovation and efficiency increases it could be multiple times that.

Central banks have been stealing that efficiency increase on top of inflation since the invention of fiat.

Now THAT is 100% correct.  The impact of money printing exceeds that show by just the price inflation statistic.  But these inflations not only rob productivity, but they cause boom/bust cycles because they incentivize speculation and investment in silly things during the boom, and rob the economy of the savings needed to invest during the bust. 

Keynesian inflationist manipulate interest rates down.  The deters saving and encourages borrowing.  In essence they try to cause the supply of savings in an economy to finance more than it could otherwise.  Then the bust comes and people bitch about "over capacity" in the economy, well thats because there never were enough savings to finance the investment (borrowing) boom, and not enough savings to follow thru to allow savers to afford buying the new products the overbuilt production capacity builds.

[doobadoo]

...The devaluation of dollar caused by printing new money can be seen as a form of tax, which is interesting since as far as taxes go, it's probably the fairest and most efficient kind of taxation there is: everyone loses exactly the same percentage, and the amount of bureaucracy and effort used to collect the tax is probably a lot lower than with traditional taxation.

Not true, taxing by printing money causes interests on saving deposits and saving bonds to drop, because the new money enters the system as newly created bank deposits.  The people running the banks go, great, we got more money to lend and start expanding lending.  However, in reality the savings rate is dropping because people see lower savings rates.  The borrowers see lower rates and borrow more.

The causes and investment bubble and things are built that would not be built if one had to finance it with more costly loans.  And consumers might initially be able to afford more, but it is coming at the expense of real savings.  Eventually the bubble pops when the money printing stops, or banks wind up lending well beyond what they should and borrows start going bust.  The busted borrowers cause the banks to pull back their lending and consumers relying on debt to spend beyond their means get cut off.  This causes more stagnation and more loans to go bad. 

Just what happened in '07.  Remember the banking crisis started when people started walking away from the 0 down loans when housing finally turned.  Then they bitched about how "frozen" the credit system was.  Oh my something is wrong banks aren't lending.  They simply over extended themselves and the base of savings wasn't there to finance the loans, or the new investments.  POP!

[bubblesort]

To answer OP's question...

The amount of stuff people can buy with a unit of currency depends on the supply of money and the speed at which it circulates through the economy (which is the formula doobadoo posted above:  MV == PQ).

The velocity of money is easy to understand.  I pay you a dollar for a cheese burger, you give that dollar to your kid who buys a comic book, the comic book shop owner spends that money on gas, the gas station gives it to the bank who loans it out, an entrepaneur spends it on physical capital to start a company, and so on...  Money with a higher velocity does more work than money with a lower velocity.

This is a chart of M1 (cash) velocity in the US:
http://research.stlouisfed.org/fred2/series/M1V?cid=32242

The supply of money changes based on Federal Reserve's actions, but the Fed doesn't literally print money.  Money is created when loans are repayed.  This is how that works:

Money sitting at the Federal Reserve is not money.  It looks like money, feels like money, tastes like money, but it has zero velocity, so it is not money.  When the Fed wants to inject more money into the economy they purchase bonds by giving this not-money to the banks, which circulates it, turning it into money.  The banks take this money and loan it out at interest.  When the loans are repaid with interest more money is created.  In other words, if you take out $100 and pay back $110 you just generated $10.

When the Fed wants to take money out of the economy they sell bonds.  People give the Fed money and the money sits in their vault, not circulating, which destroys the velocity of it, reducing it to something that looks and tastes like money but is not money.

Inflation can increase by increasing the amount of money in the economy or by increasing velocty (increasing consumption).  The interesting thing is, as inflation increases so does consumption, or velocity, because when your money is going to be worth less tomorrow and less the day after that and the day after that then it makes no sense to save money.  The rational thing is to spend it as soon as you possibly can.  Increasing the money supply can increase velocity to counteract low consumption in a down economy.  Decreasing the money supply can reign in consumption if inflation gets too bad.

That is where inflation comes from and how it is manipulated and why it needs to be manipulated.

Interestingly as an economy Grows (Q gets bigger), were there to be no change in the supply of Money (M), Prices would HAVE to decline.

I don't follow that reasoning.  Why couldn't velocity increase instead?

[Fiyasko]

Go to school.
When you loan money, the government creates that money, and puts it in your bank account.
You just caused inflation.

The money you recieve doesnt "leave" someone elses' pocket, they just typed into the computer that $10,000 is now in your account.
Wanna go back before Credit Cards?, Okay. Get ANY KIND OF LOAN, You just caused inflation.

[hashman]

Also, keep in mind that the term "inflation" is ambiguous.

In economics, it means an increase in the money supply, which may or may not result in rising prices (as we have seen).

In common usage, it means rising prices, which may or may not be caused by an increase in the money supply.

+1     I know it's annoying but you are going to need to repeat this again and again for us. 

[Vladimir]

Go to school.
When you loan money, the government creates that money, and puts it in your bank account.
You just caused inflation.

The money you recieve doesnt "leave" someone elses' pocket, they just typed into the computer that $10,000 is now in your account.
Wanna go back before Credit Cards?, Okay. Get ANY KIND OF LOAN, You just caused inflation.

Exactly what I said.

Once a sucker shows up and signs for a entry to be created on debit side of his or her balance sheet (loan/liability) banksters do a shaman dance and create it along with a corresponding entry on credit side of their balance sheet. This creates money and inflation.

After that whatever transaction are done wit that money it travels netween balance sheets of whatever entities and it changes nothing except sometimes generating some extra fees for banks in the process.

Eventually the sucker that asked for money to be created on debit side of his balance sheet defaults, money get destroyed (written off) on corresponding credit side of balance sheet of banksters. This is deflation. It is not big deal as another sucker will come for loan and there are fees and interest that was generated by money while it was in existence. Rinse and repeat.

The trick is to stop considering relationship a specific person and a specific bank but to look at it more generally. There are suckers and there is a parasitic cartel feeding on them.


This is basically our modern monetary system, everything else is smoke and mirrors.

[aes1]

Thanks a bunch. Every day this forum teaches me something new. I had no idea I could be this interested in economics!

Now the only thing I need to figure is how this all applies to bitcoin...

Does a currency with low (or nonexistent) inflation cause the economy to wind down, causing a depression? As that's what everybody seems to be fearing with traditional economies.

Does the amount of inflation have an effect on distribution of wealth, and in which direction? (Earlier I would have assumed that if money never loses its value, it would eventually drift to successful players inside the economy, causing to greater inequality in wealth distribution - but if the new money in an inflationary system goes to the rich, perhaps it's the other way round)

Okay, perhaps it's time to learn to use the search function

[johnyj]

This may be economics 101, just wanting to check my facts on the phenomenon...

Does inflation, in case of dollars for example, simply come from the fact that the government introduces more money into the system, which causes the value of existing dollar? Or are there other factors in play?

How about banks creating money out of thin air, does it have any role in inflation? (As I understand it, they invent money that they loan  to customers, expecting an interest - correct me if I'm wrong!)

It has almost no direct relation with banks creating more money. The root cause is supply and demand, and that in turn is decided by many other factors

For example, after financial crisis, FED created 3 times more money, have you seen the CPI rise by 300%?

Another example, banks print one billion dollar and give it to you, as long as you guarantee that you don't increase your consumption in anything listed in CPI index, there will be no inflation, you can buy gold, buy stocks, buy bitcoin, all these won't cause inflation