I’ve been reading about inflation lately and wanted to write a quick post about what inflation is. How the government reports inflation is grossly inaccurate, so I attempt to provide a clear example of how inflation is a cause of higher prices and not the other way around.

To understand the effect that inflation has on prices, we need to understand three relationships:

• an item and its value

• supply and demand and prices

• dollars and prices

Once these three relationships are understood, the overall effect of inflation on prices will be apparent.

What’s the Real Value of Something?

This question is almost always left out of a discussion of inflation and prices, but it is essential to understand that there is a difference between value and price. If there were a world without money, the value of an orange would be expressed in terms of how great it tastes or the nutritional benefits of the vitamins it provides. Similarly, the value of a gallon of gas would be measured in the number of miles that can be driven in your car when that gallon is poured into the tank. If that gallon of gas allows you to get to your job for a few days, then the value would be pretty high.

While the value of an orange or a gallon of gas could be different for every person, it is essential to see that value is not based on or even related to money. If there was no money, things still have value.

Supply and Demand and Prices

Before we understand the relationship between inflation and prices, we need to understand supply and demand.

From our example above, if there is a frost and the orange crop is damaged, the price of oranges will go up. It’s important to note that this price rise is not inflation. It is a common misunderstanding that inflation results from rising prices, but this is false. Inflation can cause prices to grow, but so can many other factors — the most notable of which are supply and demand.

The way governments measure and report inflation is flawed for this reason. If the Consumer Price Index (CPI) goes up due to the price of oranges or other products, the government reports inflation. Still, it would be more accurate to say prices are increasing, which may or may not be causing inflation.

Dollars and Prices

Finally, we can look at the relationship between the cost of an item and the number of dollars available in the economy. To create a manageable example, we’ll take our orange and imagine eating it on an island country where the total of all money available is only 100 dollars.

If we go back to the “value” of orange in this economy, we could express that value (based on the benefit derived from eating the orange) as 1/100th of the total value of all the goods available on the island. This is just an arbitrary figure, but in reality, since our money is finite, the principle is sound. Everything has a price that reflects its value, which can be expressed as a fraction of all the money available to spend on any possible item for sale.

Now let’s double the amount of money available on the island due to the island government creating a stimulus package.

Now there is a total of 200 dollars available on the island, but the value of oranges has not changed. It still has the same great taste and health benefits. Therefore still has a value when expressed as a percentage of all available money or 1/100th.

But now there are 200 dollars, so 1/100th of 200 dollars is $2. The price of an orange, due to the government stimulus package, which doubled the amount of money available, has also doubled from $1 to $2.

This is the essence of inflation as a result of the money supply.

Thank you for reading, and I hope you have a good rest of the day!

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