Wednesday, May 6, 2009

Understanding Inflation - Alpha

I'm trying to figure out the very basic question, "What causes inflation?"

Three easy answers:

1) In a fiat money system, if the govt. just prints/creates more money at a rate much faster than economic growth.
2) A supply side shock, like the price of a super-central commodity like oil rising rapidly, which affects everything else.
3) A demand side shift, where people just want to consume more, but the number of goods is limited (so they deplete savings to chase after goods, causing prices to rise in the short-run).

The much more sophisticated answer can be found here:
Milton Friedman, Monetary Mischief (chapters 1-3).

Incidentally, I think we're far off from inflation. With the velocity of money so far down, the Fed can print as much money as its wants, but if people need to save and pay off debts (so output is below capacity), prices will stay low.

The best paper to read about the current debt deleveraging process is:
Irving Fisher, "The Debt Deflation Theory of Great Depressions" (1933)

1 comment:

  1. Fully agree with the above points and that the disinflationary effect of deleveraging and spare capacity won't cause meaningful inflation. The only major factor that remains and which can indeed cause inflation is FX depreciation. These are of course all thoughts on the actual inflation, not the expectations which as we have all seen can change from day to day pretty much given all the confusion people have on the printing...

    PS: Congrats for the very good blog and posts