Inflation: Definition & Effects on Rates

[Kyoma]

What is the definition of 'inflation'? Will an increase in the demand for goods and services cause an increase in the inflation rate?

 

[talk2glenn]

What is the definition of 'inflation'? Will an increase in the demand for goods and services cause an increase in the inflation rate?

Inflation is defined as a positive change in the price of a good as measured in a currency of interest.

Yes, all things being equal a change in demand for a good will cause a change in its price in the same direction.

 

[WhoWee]

Inflation is defined as a positive change in the price of a good as measured in a currency of interest.

Yes, all things being equal a change in demand for a good will cause a change in its price in the same direction.

However, in the real world, the downward adjustment may not be as responsive as the upward increase.

 

[BilPrestonEsq]

Lets say your playing monopoly and you all start out with the same amount of money, say 500 bucks. Let's also say there are 3 others playing the game, so 4 including yourself, that's 2000 bucks in your little micro economy. Now say the banker prints out some more money and loans it out to one of the other players maybe another 500 bucks. Now there is 2500 bucks in your little economic world. So now your 500 bucks isn't worth quite as much as it used to because there is now 2500 bucks floating around. Thats inflation, that's why bread isn't 50 cents anymore. That first guy, the guy that got the loan, he is fine because when he got the loan that 500 bucks was worth 500 bucks but you and the other players got screwed. And that's how are system works!

 

[WhoWee]

Lets say your playing monopoly and you all start out with the same amount of money, say 500 bucks. Let's also say there are 3 others playing the game, so 4 including yourself, that's 2000 bucks in your little micro economy. Now say the banker prints out some more money and loans it out to one of the other players maybe another 500 bucks. Now there is 2500 bucks in your little economic world. So now your 500 bucks isn't worth quite as much as it used to because there is now 2500 bucks floating around. Thats inflation, that's why bread isn't 50 cents anymore. That first guy, the guy that got the loan, he is fine because when he got the loan that 500 bucks was worth 500 bucks but you and the other players got screwed. And that's how are system works!

Would a real world example be QE-2 leading to higher oil prices?

 

[BilPrestonEsq]

What is QE-2? Inflation equals higher oil prices and demand equals higher oil prices, also an oil company is a private entity so they can do whatever they want, there is no telling what oil prices are going to do.

 

[WhoWee]

What is QE-2? Inflation equals higher oil prices and demand equals higher oil prices, also an oil company is a private entity so they can do whatever they want, there is no telling what oil prices are going to do.

Quantitative Easing

http://www.npr.org/blogs/money/2010/10/07/130408926/quantitative-easing-explained

"It works like this.

A big bank — Bank of America, say — has $50 billion in government bonds. They'd sell those bonds if anyone would pay enough for them, but nobody is willing to pay that much. So the bank just holds on to them.

With quantitative easing, the Fed comes along and says, "Hey, Bank of America, we'll buy those bonds for a little more than anyone else is willing to pay." Bank of America says, "OK, great, send us the money."

This is where the Fed gets to use central-bank magic. They pay for that $50 billion purchase in new money. They just invent it. That's what the Fed — but nobody else — gets to do.
So now Bank of America has $50 billion they need to do something with. The Fed is hoping that Bank of America will decide to lend that $50 billion to companies and people to invest or spend. That stimulates the whole economy.

It sounds great. Create new money, get it out there, everyone wins. But — of course there's a but.

Nobody really knows if this works. It's still really controversial among economists. It's only been tried a few times and, as in the case of Japan, hasn't had the greatest results."

my bolds

http://money.cnn.com/2010/11/03/news/economy/fed_decision/index.htm
"The central bank will buy $600 billion in long-term Treasuries over the next eight months, the Fed said Wednesday. The Fed also announced it will reinvest an additional $250 billion to $300 billion in Treasuries with the proceeds of its earlier investments.

The bond purchases aimed at stimulating the economy -- a policy known as quantitative easing -- will total up to $900 billion and be completed by the end of the third quarter of 2011. "

 

[WhoWee]

A few links to concern about QE-2 and oil prices - IMO it is a real concern.

http://www.google.com/search?source...rlz=1T4SKPT_enUS404US404&q=qe2+and+oil+prices

IMO - This one hits the nail on the head:
http://seekingalpha.com/article/236176-qe2-lower-usd-higher-oil-prices-more-economic-pain

"So, what are we doing? The best solution our policymakers can come up with is QE2. How can our foreign oil import problem be solved by the Fed printing more money via QE2 or any other financial tom-foolery? I am an engineer by training, but let me offer an equation for U.S. economic policymakers to consider:

QE2 --> lower dollar --> higher oil prices -> more economic pain for the U.S.

It's really that simple. It's the equivalent of economic "thermal runaway"."

 

[BilPrestonEsq]

Yea that is exactly my analogy

 

[BilPrestonEsq]

The way people talk about this stuff makes it sound so complicated and its not

 

[BilPrestonEsq]

Bankers and economist talk in a language that makes the average american think that the subject of economics is just too difficult for them to understand. Really they are stealing out of everyones savings account.

 

[WhoWee]

There is an old saying "he who has the gold - makes the rules". We can print money - gold (including black gold) is another story.

 

[BilPrestonEsq]

I really suggest reading "the creature at jekyll island". This book gives a history of banking and the creation of the fed and many other interesting historical tidbits relating to banking and how the fed and our banking system works today. Though it sounds like a sci fi novel its given that title because Andrew Jackson referred to the fed as a 'creature' and its been said that the fed was designed by many of the powerful bankers and industrialist at the time on jekyll island. Very interesting read. I think everyone should read this book.

 

[BilPrestonEsq]

There is an old saying "he who has the gold - makes the rules". We can print money - gold (including black gold) is another story.

Sad but true. Not that I believe there is no hope but we have a lot of work to do

 

[talk2glenn]

Lets say your playing monopoly and you all start out with the same amount of money, say 500 bucks. Let's also say there are 3 others playing the game, so 4 including yourself, that's 2000 bucks in your little micro economy. Now say the banker prints out some more money and loans it out to one of the other players maybe another 500 bucks. Now there is 2500 bucks in your little economic world. So now your 500 bucks isn't worth quite as much as it used to because there is now 2500 bucks floating around. Thats inflation, that's why bread isn't 50 cents anymore. That first guy, the guy that got the loan, he is fine because when he got the loan that 500 bucks was worth 500 bucks but you and the other players got screwed. And that's how are system works!

Technically, what you are describing here is currency price deflation, not price inflation. That is, the price consumers are willing to pay for dollars is dependent on the number of dollars in circulation, and in your case, that number has gone up, implying a decrease in price (assuming no change in demand).

The relationship between prices and demand is direct - an increase in demand will lead to an increase in prices, and vice versa.

The relationship between prices and supply is inverse - an increase in supply will lead to a decrease in prices, and vice versa. Again, all things being equal.

In your example, the supply of dollars has gone up with no change in the demand. The result is a reduction in the market clearing price for dollars (currency deflation). This can lead to an inflation in the price for goods and services traded in dollars, but such a development is not necessary and must be considered independent of the effect on currency markets.

The original poster was asking about the effect of a change in demand on prices, however, not the effect of a change in supply. Turning this into an anti-fed rant is inappropriate; keep it in the politics forums please.

 

[BilPrestonEsq]

In response to talk2glenn:

INFLATION 1. economics higher prices: an increase in the supply of currency or credit relative to the availability of goods and services, resulting in higher prices and a decrease in the purchasing power of money

That is what I described in my monopoly analogy. There was $2000 then after adding $500 there is $2500. Thats an increase in the supply of currency relative to the availability of goods, which have not changed.

The OPs question was: 1.What is inflation? 2.Will an increase in the demand for goods and services cause an increase in the inflation rate?

I answered his first question about what inflation is in my analogy in a very clear way. Here is your answer: "Inflation is defined as a positive change in the price of a good as measured in a currency of interest" That means: "the price goes up" in a lot more words. You never actually explained inflation. Then you said: "Yes, all things being equal a change in demand for a good will cause a change in its price in the same direction" Which is only relating to supply and demand. Demand goes up prices go up. We get it.

I don't see how I was ranting in anyway. That is how inflation works and this forum is, including other things is about economics and the Fed.

 

[WhoWee]

talk2glenn is correct - Devaluation of currency is not necessary for inflation to occur. A cut in production combined with constant or increasing demand can cause inflation. Likewise, a constant supply with increased demand can also lead to inflation.

 

[WhoWee]

Worth noting in the context of oil, there are other factors that can effect supply. These factors can include distribution (supply) restrictions - a few years ago the distribution pipeline was shut down and supply was restricted to a region that included Atlanta - the result was constant demand, limited supply, & a price increase. Refinery slow downs can also have this outcome - even if adequate supply is available to be processed. Another factor that can effect supply and demand of oil is reserve management. All of these forces can inflate prices.

 

[BilPrestonEsq]

Really guys? Thats right devaluation of currency isn't needed for prices to inflate. I am talking about the definition of inflation that I posted from the dictionary. The one the the OP was referring to!

 

[BilPrestonEsq]

What is the definition of 'inflation'? Will an increase in the demand for goods and services cause an increase in the inflation rate?

Remember? The OP was confused about the DEFINITION OF INFLATION. I am not arguing that an increase in demand will 'inflate' the price of whatever is in demand. Also he accused me of ranting and asked me to take my comments on economics to the politics forum. I am the only one that actually answered the OPs question! Ridiculous

 

[hamster143]

an increase in the supply of currency relative to the availability of goods, which have not changed.

By currency, presumably you mean money. (Since the amount of physical currency in the world is not affected by QE2. Besides, the great bulk of that physical currency sits in suitcases in Latin American drug dealers' mansions.)

But the problem is that there's money and there's money. In the modern world, there are multiple possible ways to define "money" and the boundaries of different definitions are getting increasingly vague.

The take-home lesson for now is that "money" directly inflated by QE2 is very different from "money" that affects oil demand.

Would a real world example be QE-2 leading to higher oil prices?

it would be, if QE2 led to the depreciation of the dollar with respect to other currencies and therefore to higher dollar-denominated oil prices, while, say, euro-denominated oil prices stayed constant.

In addition, all else equal, higher domestic oil demand has to lead to higher consumption as well as higher prices:

http://www.eia.doe.gov/dnav/pet/pet_move_impcus_a2_nus_ep00_im0_mbblpd_m.htm

but it looks like consumption is down since the announcement of QE2, not up.

Inflation is defined as a positive change in the price of a good as measured in a currency of interest.

Yes, all things being equal a change in demand for a good will cause a change in its price in the same direction.

Inflation can also be defined as the change of the overall price level. In this case, all things (in particular, money supply) being equal, changes in demand for any particular good do not necessarily lead to changes in overall inflation. At constant money supply, higher demand and higher prices of this good lead to lower demand and lower prices of all other goods.

 

[BilPrestonEsq]

I just wanted to add that whowee's example of quantitative easing was a quality addition to this thread as he gave a real life example of one way that the banking system adds to currency devaluation, which is the definition of inflation.

I'm not sure how you (hamster143) can say that the definition of money is vague. It's not it is the medium of exchange for goods and services plain and simple. I also don't understand how you can say that money that's 'on the books' has no effect on physical money. Whether it's a number in your bank account or money in your hand it is the same thing.

"The take-home lesson for now is that "money" directly inflated by QE2 is very different from "money" that affects oil demand."HAMSTER143.

How so? How is one dollar different from another. This kind of talk only contributes to making this subject more confusing than it needs to be. There are so many factors that add to the complexity of economics that you don't need to make simple ideas like 'what money is' complex.

 

[hamster143]

"Whether it's a number in your bank account or money in your hand it is the same thing."

Did you make any money directly because of QE2, either in your hand or in your bank account? Me neither. So if we didn't get any money, but money supply got inflated anyway, how could that possibly happen?

The answer is that some "entities" sold some long-term bonds to the Fed and got cash in exchange. These entities are, for the most part, not people. Some of them may be managing people's 401K's, some of them are investment banks like Goldman Sachs, some of them are foreign national banks or sovereign funds.

On the other hand, most of the 'consuming' of the petroleum, especially the elastic kind that responds well to having more money, is done by private individuals.

The effect of changes in the valuation of your 401K on your spending is negligible. Even if your 401K gains $10k in valuation in a short period of time, that probably does not make you more likely to take one extra road trip to Vegas. Savings accounts and brokerage accounts fare better, but the effect is still far from 1:1. (Besides, stocks are disproportionally owned by the wealthiest 20% of the population, and gasoline is uniformly consumed by everyone.) The single biggest factor that affects your spending is your wage income. So unless and until the inflation of money supply by QE2 translates into an increase in incomes and employment via some mechanism, we should not expect any price inflation.

How is one dollar different from another. This kind of talk only contributes to making this subject more confusing than it needs to be.

Quite the contrary. There is a myriad of details, and the biggest mistake you can make is to oversimplify things. You lose sight of important factors and that can lead you to make wrong conclusions from correct data.

 

[WhoWee]

"Whether it's a number in your bank account or money in your hand it is the same thing."

Did you make any money directly because of QE2, either in your hand or in your bank account? Me neither. So if we didn't get any money, but money supply got inflated anyway, how could that possibly happen?

The answer is that some "entities" sold some long-term bonds to the Fed and got cash in exchange. These entities are, for the most part, not people. Some of them may be managing people's 401K's, some of them are investment banks like Goldman Sachs, some of them are foreign national banks or sovereign funds.

On the other hand, most of the 'consuming' of the petroleum, especially the elastic kind that responds well to having more money, is done by private individuals.

The effect of changes in the valuation of your 401K on your spending is negligible. Even if your 401K gains $10k in valuation in a short period of time, that probably does not make you more likely to take one extra road trip to Vegas. Savings accounts and brokerage accounts fare better, but the effect is still far from 1:1. (Besides, stocks are disproportionally owned by the wealthiest 20% of the population, and gasoline is uniformly consumed by everyone.) The single biggest factor that affects your spending is your wage income. So unless and until the inflation of money supply by QE2 translates into an increase in incomes and employment via some mechanism, we should not expect any price inflation.



Quite the contrary. There is a myriad of details, and the biggest mistake you can make is to oversimplify things. You lose sight of important factors and that can lead you to make wrong conclusions from correct data.

On the other hand, a devalued US Dollar will have less purchasing power. Individuals are not purchasing oil from the Middle East. The commodity price increases when the currency loses value.

 

[hamster143]

On the other hand, a devalued US Dollar will have less purchasing power. Individuals are not purchasing oil from the Middle East. The commodity price increases when the currency loses value.

That is true. But once again, what is the mechanism to explain the devaluation of the US dollar as a result of QE2? And is there evidence that such devaluation occurred between today and, say, mid-September, especially on a scale that would explain a 12% jump in dollar-denominated oil prices in the same period of time?

 

[BilPrestonEsq]

That is true. But once again, what is the mechanism to explain the devaluation of the US dollar as a result of QE2? And is there evidence that such devaluation occurred between today and, say, mid-September, especially on a scale that would explain a 12% jump in dollar-denominated oil prices in the same period of time?

The addition of currency 'watering down' the currency in circulation.

is there evidence that such devaluation occurred between today and, say, mid-September, especially on a scale that would explain a 12% jump in dollar-denominated oil prices in the same period of time?

No, the CEO just wanted a giant train made of gold to get around his mansion. And a monkey conductor of course.

 

[hamster143]

The addition of currency 'watering down' the currency in circulation.

That's precisely the kind of oversimplified reasoning that leads you to wrong results. "Currency due to QE2" does not add to "currency in circulation" in any meaningful way, unless you want to operate with highly idealized, abstract concepts like the M3 money supply.

 

[BilPrestonEsq]

That's precisely the kind of oversimplified reasoning that leads you to wrong results. "Currency due to QE2" does not add to "currency in circulation" in any meaningful way, unless you want to operate with highly idealized, abstract concepts like the M3 money supply.

What is the point of QE2 then? What problem is QE2 intended to fix? What about the stimulus package that was passed not too long ago, what was that intended to fix?

 

[talk2glenn]

What is the point of QE2 then?

Quantitative easing has two primary objectives:

1. Remove debt instruments from the economy. Wealth can be held as either debt or currency. Currency is liquid, and debt is not, but the two are always in equilibrium. For every dollar in currency the Fed injects, it removes a dollar in debt instruments. No new wealth is created, however currency is liquid - the Fed assumes bank liabilities, freeing financial institutions to originate new loans. This process can create new wealth.

2. Protect the yield curve. Buying up financial instruments raises their price, which lowers yield. This is how central banks keep interest rates low (or move them lower) after exhausting other, more conventional mechanisms.

The injection of new currency into an economy is not necessarily inflationary for goods and services traded in that currency (but it will always be deflationary for the manipulated currency, as explained before).

Inflation risk is created only if the pace of new currency injection is greater than the pace of economic expansion. To the extent that the new loans create new wealth at a pace equal to or greater than the rate of currency injection, there will be no inflation. Currency is chasing production, but it is also fueling new production. Too little currency (relative to the demand for goods and services) is deflationary, and too much is inflationary.

Long-run inflation can be loosely defined by M * V = P * Q, where the money supply and its velocity is, by definition, always equal to the price level times real output (people often find the concept of money velocity difficult to grasp, so I will explain - if the amount of money M is less than the amount of real output Q at price level 1, then by definition the money must change hands in proportion to the excess for transactions to occur, yielding a V greater than 1). During a recession, Q tends to fall, and no change in the money supply (M) or the price level (P) requires that V go down to maintain the identity (the velocity of money or the speed at which money changes hands in an economy in a specific period of time, typically a year). The decline in the velocity of money happens because people stop spending, their demand for currency declines, and the demand for bonds goes up.

The Federal Reserve responds by buying bonds, driving down interest rates (reducing the demand for bonds) and increasing M. The identity no longer holds; P or Q must increase. P only increases when there is no capacity for production absorption by the economy, but central banks are gambling that there is idle capacity in the economy that can be turned on immediately and that will absorb the injection.

Sufficient?

 

[hamster143]

What is the point of QE2 then? What problem is QE2 intended to fix? What about the stimulus package that was passed not too long ago, what was that intended to fix?

The stimulus package was intended to increase demand and to decrease unemployment with regard to the trajectory we were on at the time. It did as good a job as anyone could've expected, given its size (seeing how we don't have 15% unemployment right now).

The objective of QE2, in addition to those correctly but somewhat too academically explained by talk2glenn above, was also to stimulate the economy. Unfortunately, dollar for dollar, quantitative easing (monetary policy) is a lot weaker than deficit spending (fiscal policy), for reasons I described. And the government isn't all that willing to engage in deficit spending proactively. If the Fed were to take $300 billion and give it to all taxpayers, directly or via the treasury, that would be quite inflationary. Buying $300 billion of long-term bonds from Goldman Sachs and Bank of China does not have quite the same effect. It lowers the long-term yields, and that's supposed to be good, but that effect is far more indirect.