What We All Missed About Inflation

Many try to use relative value stories, to look at prices. Because prices are relative, the saying goes, only a monetary expansion can lead to continuous price hikes. Any relative value story will get adjusted for, and then prices would stabilize at the new relative values.

There are many things to consider here. When relative values change, that also changes the weights of different items in a basket.

Consider the scenario with a basket of two items: apples and carrots. At the start, each is worth one dollar.

A basket of one apple and one carrot would cost $2.

Now, consider what happens if the price of apples doubles, and the price of carrots cuts in half. The carrots cost $0.50, but the apple now costs $2.00. The total cost of the basket has risen by $0.50 cents, even though only the ratio of the costs has changed.

If carrots and apples were substitutes for each other, than you could simply switch to a basket of two carrots, saving $1. But more often than not, items in a CPI basket are selected because they are imperfect substitutes.

The more extreme the relative prices become, the higher the total cost of the basket.

This may seem like a mathematical mystery, but anytime your production gets out of balance with your consumption needs, the costs of living will rise. So until the economy rebalances, or consumption rebalances, the cost of living will simply rise. Everyone needs the entire basket to survive, and one item quickly becomes the limiting factor.

So when people say that relative price changes cannot lead to inflation or continuous price rises, you can safely ignore them.

If the ratio between apples and carrots goes from a factor of 4 to a factor of 10, then the total cost of our basket will rise to $5.20, just from a supposedly "relative value" story.

Resources CAN get scarcer across time.

Surprisingly, it is in fact not necessary to even consider relative prices, for prices to rise. 3 apples from yesterday may actually only be worth an apple today. And this happens whenever consumption outpaces production. If yesterday we produced more apples than today, than the proceeds of selling 3 apples yesterday may only buy one apple today.

When people talk about relative prices and inflation, this is what we all missed, that even looking at a single item, with no money and no other items or relative prices, it can get more expensive across time. You can use the proceeds of an item sold yesterday to try to buy that same item today, and if the production of the item does not keep pace with its production, then this "intertemporal value" can do nothing but rise.

In each of these discussion, you may note, the money stock did not matter, relative price changes were not necessary, and neither did any "cost for money" or borrowing, come into the equation. Quite simply, all that was needed, was for consumption to outpace production.

This is a very simple and understandable scenario, that perfectly describes most inflationary episodes, without a reference to a price for money, without a reference to relative prices, exchange rates, or any of that. I think it's fair to say, that either we all missed this fact(unlikely), or simply that the way we talk about inflation lacks clarity and specificity.

Intertemporal Exchange

Relative prices cannot be assumed to involve exchanges at a fixed point of time, but rather there is a delay between production and consumption, and during that period, the price for even the same item can rise.

This is a much more coherent view of most inflation episodes, that does not depend on a money stock, velocity, etc. This intertemporal value story is key to a correct and nuanced view of inflation.