What causes inflation?  That question is often answered in a way that sneakily avoids answering the question “What IS inflation”?

Like a lot of people, I first heard about “inflation” in the late 1970′s.  That’s why the prices are going up, we were told.  We were told that oil prices had increased, which meant that gas prices

What causes inflation

had gone up, and because everything depends on gas to be manufactured and shipped, the prices of everything went up.

But wait a second.  If people are paying more for gas, and paying more for everything else because the price of gas has gone up, doesn’t that mean we must actually have more money to be spending on everything that costs more money?  The simple and amazing answer turns out to be: YES!

Inflation, by definition, is an increase in the money supply.  At least, it used to be.  Nowadays, the people who increase the money supply would prefer you use the term “monetary inflation” to describe the process.  And now that “monetary inflation” sounds like some meaningless, academic, esoteric concept that doesn’t really matter, we can get back to making up reasons why the prices of EVERYTHING go up, that have nothing to do with the fact that there is a whole heck of a lot more money in circulation than there was a few years ago.

A friend of mine recently told me of an oversimplified microcosm that shows the obvious, and the not-so-obvious, effects of inflating the money supply.

On an island are a very small group of people who use coconuts to shop for fish.  There are 10 coconuts, and 10 fish.  The price of a fish is one coconut.  As fish and coconuts are consumed, another is harvested to replace it.  One day, one of the inhabitants “sneaks” an extra 5 coconuts onto the island and buys 5 fish.  The obvious effect is that there are now 15 coconuts in circulation – the less obvious effect is that there are now only 5 fish left to buy.  The people with the original 10 coconuts are now faced with a much higher price for fish – they will bid the price of the remaining fish up to 2 coconuts each, lest they get stuck with coconuts that can’t buy anything.

Of course this is a gross oversimplification, but it does point out a few things – increasing the money supply at a greater rate than the supply of goods causes the money to lose purchasing power, and, most amazingly, it is those parties who do the increasing of the money supply who also remove goods from the economy, causing demand for those goods to rise, even as they cause demand for the currency to fall.

Nice scam, eh?