I don’t understand inflation but here’s what I’ve learned from a few people:
When something happens in the economy, we use money to identify cause, effect and, possibly, remedy. Money is the yardstick.
So what happens if something goes wrong with the yardstick? Very hard to figure out what is happening, is the answer.
Thank goodness only a few things can go wrong with this commodity: we can either have too much or too little.
Forgetting the case of too little for now, what happens if there is suddenly more money?
Money is measured by M1 and M2. If these two aggregates were to suddenly increase, people would feel richer and spend more. This drives up the prices for goods and services, which keep going up, of course, if money keeps expanding.
Ok, yeah, I get that that’s what fires everyone up, but I’m really wondering how M1 and M2 increase.
The key is the banking system. Banks hold money, which counts as M1/M2, but also lends money out which, when it hits the system, also becomes M1/M2.
If the demand for loans increases, banks will lend more money out, which means that the money supply goes up.
More loans means there’s more demand for loaned money. Since loaned money must be repaid, more loans actually means firms expect to be able to spend more on interest.
Time for Scott Sumner, who taught me that expected Nominal GDP is incredibly important.
Expected Nominal GDP is the aggregate of expected income. If firms think their future income has gone up, they’ll expand. We live in a Garett Jones Economy, where CEOs are empire builders that will always pour money back into their businesses if they think profits are going up.
Normally this is great because, normally, CEOs benefit from drastic improvements in supply (dishwashers get cheaper, so we buy more video games or, gulp, health care and education).
But what if we’re tricked? What if all this extra money didn’t come from an improvement in supply? And if we keep getting tricked?
Ah. The trick. Now we’re almost done.
Hm. Well, banks are constrained by reserve ratios, which provides an upper limit on loans. Competition for that limited supply would drive up interest rates, choking inflation off.
Ok, so the fed pumps banks’ reserves, then. They do this by… buying assets from banks, I suppose. Treasuries and the like.
And this process is leveraged, because every dollar of reserves is worth 1/[reserve ratio] of money at its max.
What remains a mystery to me is how this process starts.
How do businesses suddenly convince themselves and banks they’ll be able to afford a bigger interest bill?