They can't wrap their heads around the concepts of rising relative prices and inflation.
Inflation Is a Misused Word
Inflation is one of the most misused words in economics. As economist Michael Bryan carefully explained a few years back, the word originally described currency and money, not prices. It referred to a rise in the amount of paper currency in circulation relative to the precious metal (or money) that backed it. Later, the term referred to the amount of money in circulation relative to the amount actually needed for trade. Today, however, people typically use the word to refer a rise in some set of prices or even in a single price, with no necessary connection to money at all. So now we have countless types of inflation: oil-price inflation, healthcare inflation, wage inflation. The unfortunate outcome of this evolution is that the public no longer distinguishes between two very different types of price pressure.
Strictly speaking, inflation refers only to a drop in the purchasing power of money that results when a central bank creates more money than its public wants to hold. Inflation manifests itself as a rise in all prices and wages—not just some subset of prices. People, of course, use money to conduct their day-to-day transactions, and their demand for money generally expands as the economy grows. If the public’s demand for money grows at, say, 3 percent per year, but the central bank creates money at 5 percent per year, then all prices and wages will eventually rise at 2 percent per year. Prices will keep climbing as long as the disparity between the supply and demand for money continues.
Inflation, as Milton Friedman pointed out, always results from a monetary mismatch. It has nothing to do with dwindling supplies of oil or the effects of a terrible hurricane or the wage demands of workers. And, as a monetary phenomenon, it is always under the control of a central bank. That said, the speed with which an inflationary monetary impulse filters through to all wages and prices depends on many things. Most importantly, it depends on the state of people’s expectations and the degree of slack in an economy. In times when the public generally anticipates inflation or when an economy is operating at full bore, monetary excesses can quickly translate into higher prices and wages.
Relative Price Changes Are Not Inflation
Relative-price changes, like inflation, can cause price pressure in an economy. We experience them every day much like we experience inflation, and they cause changes in standard price indexes. But there the similarity ends. Relative-price changes are not a monetary phenomenon. They arise in market economies as individual prices adjust to the ebb and flow of the supply and demand for various goods. Relative-price movements convey important information about the scarcity of particular goods and services. A rising relative price indicates that demand is outstripping supply (or that supply is falling behind demand), while a falling relative price denotes just the opposite. A rising relative price induces consumers to conserve on the good in question and to look for substitutes. A rising relative price also, by increasing profit opportunities, entices producers to bring more of the good in question to market.
By
Highmark ·
