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Sunday, June 14, 2009

What is inflation?

I read this article, "Stocks in the Black on Gusher of Cash" in last Saturday's Wall Street Journal. The thesis posited in the article is that the recent surge in global stock markets is largely due to the money that has been created by the Federal Reserve finding its way into stock markets. This is what I have been saying; that the Federal Reserve is purposely trying to raise prices (i.e. cause inflation) by creating money.

Since I read this article last weekend, I have come across numerous other articles discussing the topic of inflation and Fed policies. Obviously, this is a hot topic right now. It also happens to be an area in which I have a great interest. One of my favorite economist of all time (yes, I have favorite economists, which didn't help me get dates in high school) is Milton Friedman, who is the grandfather of modern monetary and inflation theory. Dr. Friedman defined inflation as:


It is this definition that leads directly to the premise that, if the Fed is creating money, then there will be more money. If we keep the amount of goods constant, then, by definition, we will have more money chasing the same amount goods, so prices will go up.

The actual functioning of this process is much more nuanced than my simple explanation, and this is where the confusion starts. What I find fascinating is the number of articles I'm reading which seem to doubt or misinterpret the basic underlying definition of inflation. Here's an example, in which the article discusses the role of excess capacity in the economy. The main idea is that having excess capacity subdues the inflationary affects of printing money, because producers are unable, or unwilling, to raise prices when they are trying to unload inventory.

It is not that this argument does not add value to the discussion, but the problem is that it places the impetus for inflation on the producer's incentive to raise prices. The massive increase in money supply, which is presently occurring, changes the playing field in and of itself, and it is the volume of money that starts the inflationary ball rolling. For me, the question is not whether we will have inflation. The question is, will we be able to stop the ball rolling to far or too fast?