If you haven’t read the first installment of “Economics for the Layman,” I’ll give you a brief summary. Gross Domestic Product is the estimated amount of economic activity which took place with in the borders of the United States. As this number goes up, we assume our economy has grown and if it goes down we assume it is shrinking. Moreover, if the GDP shows no growth for two or more quarters we call this a recession.

In this installment we’ll cover ‘inflation.’ So, what is inflation?

Inflation is the overall increase of prices in any given economy. For example, if prices of all goods in the United States suddenly increased by 2%, we then would say we had 2% inflation. All goods, on average, are 2% more expensive. .

Conventional wisdom tells us there are many sources of inflation including: too much consumer activity, too much investing/rising resource prices (see my speculators article), or an increase in the money supply. Ironically enough, economists debate endlessly about the first two sources of inflation. The argument is, those sources are market driven; therefore do not qualify as inflation.

Allow me to explain. As an economy grows, people spend more money. This increase in spending, some argue, ‘bids up’ the prices of goods. More people want SUV’s and therefore are willing to pay more than the listed price, as demand increased so does price. The process of bidding up overall prices is called ‘demand pull’ inflation and is usually the excuse politicians give for raising taxes.

On the other hand, if resource prices increase for any reason; and it finds its way to the check out isle through increased shipping or construction costs it’s called, ‘cost push’ inflation. Politicians will use this as an excuse for resource subsidies or social welfare programs.

The Austrian school of economics does not consider these markets driven factors inflation. They argue that people cannot bid prices higher then they are willing to pay. Meaning, the increase in the cost of lettuce didn’t happen because everyone started dieting. Or, if by some chance, increased demand did actually raise the price; the new price isn’t any higher than the consumer is willing to pay. In other words, if you don’t want to pay five dollars per head of lettuce, you’d never offer to buy for that price. As a result, your demand for lettuce will not inflate the price beyond what you find reasonable.

In conclusion, inflation (regardless of its source) is the overall increase of prices of consumer goods. Inflation is a real problem and has crippled many nations such as the Romans, Great Brittan, and the Soviet Union. In every situation inflation was out of control, and in every situation we saw dramatic increases in the money supply.

The next time you look at GDP figures, you must compare these to our inflation figures. We’ll discuss the relationship between GDP and Inflation in the next installment covering the consumer index (a.k.a the GDP deflator). This is where your real economic analysis will begin.




By: Phillip Mabry