To put it as simply as possible: if the only goods in the world were four pencils and the total money supply was four dollars, each of the pencils would cost 1 dollar. If the central bank would then create another 4 dollars and the amount of pencils does not increase – how much would the pencil cost now? Exactly – 2 dollars. Monetary inflation is an increase in the quantity of money. Monetary inflation is not the same as rising prices, though the two are related. The popular definition of inflation as an increase in a general price level is not complete and doesn’t tell us the main cause of rising prices. We see the general rise in prices when the money supply increases faster than the demand for money. Price inflation then is often a consequence of monetary inflation. We can also have monetary inflation without increase in prices. This can happen if the number of dollars and the number of pencils increase by the same amount, at the same time. We can also have rising prices without inflation, if the amount of money remains unchanged, and a natural disaster or a war destroys two pencils. Most often, however, monetary inflation is accompanied by an increase in prices, although the process is not immediate. So why is monetary inflation and, in effect, price inflation bad for us?
First of all, because it diminishes the purchasing power of our savings and salaries. Inflation is a hidden tax. It is hidden because you see the same amount of money in your account, but with a 10% increase in a price level, you will be able to buy 10% less stuff. Debtors, however, benefit from the inflation. The value of their debt falls as much as the value of savings. Most governments in the world is heavily indebted, and this means that inflation is convenient for them. At the time of borrowing, the money is worth more, or buys more than at the time of repayment. Inflation, therefore, discourages savings and promotes consumption, because it is better to buy today if tomorrow everything would be more expensive. Another effect of inflation is an increase in the wealth inequality. Newly created money is not distributed equally through the economy. Those, who get the money first, have the advantage, because they can buy before the price inflation. People who get the money last are in the worst situation, because they are most affected by its falling purchasing power.
Monetary deflation is the opposite phenomenon. It’s a reduction of the money supply. Using the pencil example – if a bank takes out two dollars, each pencil would cost 50 cents. Monetary deflation results in falling prices. It rewards people with savings, because the purchasing power of those savings grows over time. It is a problem for debtors, however, because they have to give back money that is worth more than the money they borrowed. It also causes a decrease in liquidity, which results in more cautious investment decisions. Deflation is therefore advantageous for people that manage their money in a conservative way.
Price deflation, may also occur without monetary deflation. For example, if the money supply remains the same, and the number of pencils increases because of the increase in productivity. Is such a decline in prices a bad thing for anybody? After all, we want everything to be cheaper. Perhaps this phenomenon is good for consumers, but not for producers? Let’s have a look then, at the manufacturers of computers, cell phones and cars. When production was less effective, only rich elite could afford such inventions. Thanks to an increase in productivity, due to the introduction of new technologies, manufacturers were able to produce these things faster, cheaper and in greater quantities. Now many more can afford a computer, a phone or a car. Not only are these things more accessible, but they also are much higher quality than at the beginning. Can we say that the manufacturers of cars, computers and cell phones are poorer because of that? Of course not.
So maybe a continuous decline in prices is bad for the economy? Will people indefinitely put off the decision to buy something, because in the future it will be cheaper? Will the demand for everything completely disappear? Think about it. We know that every year computers can be bought cheaper or at least much higher quality for the same price. Does this mean that we will not buy a computer if we need one? Of course we will buy one because we need it now, and not a year from now. Will we indefinitely put off a decision to buy food, knowing that next year it will be cheaper? For obvious reasons – no.
For the economy, and the people, the best solution is a stable amount of money. The amount that cannot be increased or decreased in a sudden manner by the whims of central bankers. The money available on the market should be controlled naturally, by how much we spend and how much we save, and thus how much money is actually available to finance investments. Market mechanisms will then force commercial banks to determine the appropriate, market, interest rates. Also, decreases in price level, due to the an increase in productivity, should be a natural and welcomed consequence of economic growth. We would have steady deflation, if the central banks wouldn’t increase the money supply.