Intro: While the explanation of ‘too much money chasing too few goods’ partly explains what drives inflation, it ignores other key factors, most important of which are government debt growth and the demand for money. More accurately, inflation is driven an excess of money or government bonds relative to real goods and services production, and a lack of willingness of individuals to hold these government liabilities as a store of value.
Inflation is perhaps the most misunderstood variable in economics, with the vast majority of mainstream economists a long way off the mark when it comes to what drives price changes. The majority share the mistaken belief that real GDP growth is an inflationary force as they conflate individual demand for a particular good relative to another with overall spending in the economy.
In reality, inflation is driven an excess of money or government bonds relative to real goods and services production, and a lack of willingness of individuals to hold these government liabilities as a store of value. This means there are three main forces that can cause inflation to rise or fall:
- The supply of money and government liabilities.
- The demand to hold money and government liabilities as a store of value.
- The availability of goods and services in the economy.
Money Supply
This should be fairly intuitive. The more money that exists in an economy, the lower its marginal utility. As shown here money supply is intimately related to inflation. There has never been a period of high inflation in history that wasn’t accompanied by high money supply growth.
For most countries the majority of money supply comes from the private banking system in the form of loans, and so if a country has a particularly underdeveloped banking system relative to the size of its economy, it has the potential to see rapid money supply growth as the banking sector expands. In contrast, if a country has a highly-leverage banking system with a high level of private sector indebtedness, money supply growth is likely to be sluggish if not negative, acting as a drag on inflation.
Government Bond Supply
Like money, people hold government bonds and bills as a store of value. If a government runs a fiscal deficit, its impact on inflation is more or less the same whether if finances the deficit with freshly printed pieces of paper that say ‘money’ or freshly printed pieces of paper that say ‘bond’. Bonds compete with cash in the portfolios of individuals, so any increase in bond supply acts to reduce the marginal utility of existing money, raising prices.
Money Demand
The demand for money is an important but often misunderstood inflation driver. Money demand reflects the willingness of individuals to hold money as a store of value. If people think that their money will lose its value over time they will be less likely to hold onto it and more likely to exchange it for goods and services or alternative stores of value such as foreign currencies or precious metals. See ‘The Impact of Money Demand on Inflation‘ for more details.
There are various factors influencing the demand for money; some short term in nature and some long term in nature.
Real interest rates: The lower real interest rates, the lower will be the willingness of individuals to hold the currency as a store of value, reducing the demand for money.
Government debt: The level of a country’s government debt relative to GDP plays an interesting indirect role in determining inflation. The higher the level of government debt, the greater the potential for investors to doubt the willingness that the debt will ever be paid back through means other than monetization. While government debt growth and money supply growth play a similar role in driving inflation, the prospect of debt monetization can lead to a loss of faith in the currency as a store of value, raising the prospect for inflation.
Net International Investment Position: The greater the level of net external assets, the greater the likelihood of the country experiencing net monetary inflows from their investments via the income account. The greater the amount of inflows relative to outflows, the greater the demand for local currency.
Historical Inflation Rate: Because inflation in part is driven by the demand to hold money as a store of value, a country’s historical inflation rate plays a role in future inflation. If people have seen prices rise by 10% most years in the past, they will likely become accustomed to expecting prices to be 10% higher next year, which can become self-fulfilling.
Real GDP Growth
As explained previously, the weaker real GDP growth, all else equal, the greater the marginal utility of goods and services, and the greater the potential for prices to increase. High inflation rates rarely occur during times of strong economic growth.
What About Quantitative Easing?
Quantitative easing has proven to be inflationary in the near term but has failed to come close to the expectations of policymakers regarding its inflationary impact, let alone its critics who feared runaway price pressures. The reason being that QE is in fact just an asset swap where the central bank exchanges one form of paper (cash) with another (bonds). That said, there are two other indirect inflationary consequences of QE which are likely to manifest over the long term. Firstly, it allows the government to continue running large deficits as it reduces the need to raise tax revenues. Secondly, negative real interest rates reduce the demand to hold money as a store of value.
What About Wages?
Generally speaking, wage inflation is closely correlated with overall inflation but is not typically a driver of it. Both inflation and wage growth are driven by the factors outlined above. To argue that rising wages cause rising inflation, we first need to know what causes rising wages. For one company’s product, an increase in the price of labour would lead to an increase in the price of a product, but for prices to rise across the economy, we would need to see a broad based rise in the money supply, a reduction in the demand for money, or a decline in real GDP.
There are crucial exceptions, however, as we currently see in the US. There has been a large amount of money and bond supply growth over the past decade, yet this has failed to translate into higher inflation partly because the money has flowed into the hands of the wealthier members of the economy with a lower propensity to spend the money. In other words, wealthier individuals tend to have a higher demand to hold their money as a store of value. As wages rise the US we are likely to see a rise in inflation as money shifts towards people with a lower demand to hoard it.
