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Letter: Where does inflation come from?

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Inflation is a rise in the aggregate prices of goods and services across the entire economy. Different sectors of the economy each have their own reasons for their prices; some sectors go up while others may go down. The inflation rate tries to take the entirety of all these factors and lump them together into a single statistic.

The most common cause of inflation comes from an increase in aggregate demand, this can be thought of as total spending. Increased spending in one area usually corresponds to a decrease in spending in other areas because people’s budgets are limited, so total spending in that case is unchanged. For total spending to increase overall, either the speed at which people spend money must increase or the total amount of money cycling in the economy must increase. Over the last 100 years, increasing the total money supply has been the number one cause of inflation. This is very simply because if more money exists, more money gets spent.

But how does this mechanism work? In the US, the Federal Reserve Bank (aka “the Fed”) manages the money supply by manipulating the loanable funds market. This is the market where individuals, businesses and governments borrow money on credit from a bank. The Fed creates new money out of nothing and gives it to banks who then loan it out for cheap credit. This is step one. People take advantage of these low-interest loans and buy stuff such as a mortgage, college education, factory equipment, or a flood-diversion construction project. This initial spending is how it flows into the broader economy, step two.

This initial spending becomes income for other people who then spend their money on whatever they want. Now that there is more total money in the economy, businesses realize they have more customers, so they place orders for their suppliers to try and satisfy this new demand. Businesses similarly try to hire more workers to get these new jobs done. Business is booming, step three.

But suppliers eventually become strained because there’s not enough materials to go around. This extra competition for scarce materials leads to an increase in cost to the business. There are similarly not enough workers to fill all the job openings. Employers have to increase wages to attract workers if they want the job to get done, which likewise increases the cost of business. The economy becomes overheated, step four. Faced with this increased cost of production, retailers have no choice but to increase their own prices, step five.

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With higher prices, consumers slow back down and don’t demand as much. Businesses don’t see as much demand for their products. In turn suppliers aren’t as strained and the job openings go away. The level of production in the economy is now back where it started, but now everything is more expensive, step six. This is where inflation comes from.

Look out your window right now. There is a labor shortage; I’m sure you’ve heard about it on the news. Talk to local business owners; the prices of supplies have gone up: lumber, oil, beef, freight and international shipping. The symptoms of inflation are all there; you can see it everywhere you look. But what about the cause?

In the two years since January 2020, immediately before the pandemic, the total money supply, what economists call “M2” which includes physical cash, electronic deposits and liquid short-term savings such as CDs, all of that has increased by 40%. The amount of new money creation in recent months is unprecedented. The news just broke that inflation in 2021 hit 7%, the highest in 40 years.

Who could have seen this coming?

Everybody, that’s who.

Why is the Fed creating so much money? Because they want to keep the interest rate low to help businesses get through the pandemic, but the interest rate doesn’t stay low when the federal government is spending several trillions of dollars every year, money it doesn’t have. If we want our stable economy back, either the Fed has to let interest rates rise, which would cause its own problems, or the federal government has to stop spending money, which would also cause problems.

But make no mistake, the inflation we are seeing is caused by our incompetent government.

P.S. - No, I do not believe increased unemployment benefits caused the labor shortage.

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William Smith lives in Fargo.

This letter does not necessarily reflect the opinion of The Forum's editorial board nor Forum ownership.

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