Welcome to the Deep Dive, the only show that
takes a huge stack of research material you wish
you had time to read and, well, distills it into
immediate structured knowledge. We don't just
skim the headlines. We give you the foundations.
Today, we are deep diving into inflation. And
I mean, it is the single most important concept
in macroeconomics. It's the force that governs
everything from your retirement savings and the
price of oil to. geopolitical stability and national
elections. Absolutely. It is the universal signal
for the health of any modern economy. It really
is. Inflation dominates the news, yet the underlying
mechanisms, the history, the conflicts over how
we measure it, the intellectual battles over
what causes it, all of that is often lost in
the noise. Our listeners ask for a thorough,
a rapid understanding that moves way beyond simple
definitions. And that's our mission today. We
have to establish the core concept right away.
Inflation is defined as a sustained increase
in the average price of goods and services over
time. OK, the average price is a key distinction.
It's the critical takeaway. This doesn't mean
everything costs more. It means the currency
itself has lost purchasing power. Each dollar
or pound or euro just buys less than it did yesterday.
OK, so let's unpack this and set the stage for
our journey. We've analyzed a really comprehensive
body of source material spanning centuries of
economic thought. A lot to get through. A lot.
We'll tackle three major areas. First, the surprising
ancient roots of this, of currency devaluation
and why the terminology itself has shifted. Second,
the contentious debate about how we measure this
force and, you know, what competing theories
claim causes it. And that's where the real intellectual
fights are. Exactly. Right. And third, the double
-edged sword. The dramatic negative effects contrasted.
with the surprising upsides that make central
banks actively target moderate price increases.
Our goal is to move you past simply knowing that
prices are rising. We want to give you the intellectual
tools to understand the crucial why and the how.
This means grasping the foundational theories
from classical quantity theory all the way up
to the modern synthesis and understanding where
economists genuinely disagree about the levers
of control. Let's start by tightening up the
language because even economists and Definitely
politicians misuse the term inflation all the
time. That's essential. We have to be clear that
inflation is the general trend of prices, which
signals a change in the value of the currency
itself. OK. It is not, for example, when the
price of gasoline goes up because a refinery
shuts down. Or avocados get more expensive because
of a drought in one region. Exactly. Those are
specific price shifts. They're driven by very
localized supply and demand imbalances. They
might nudge the overall average, sure, but they
are not the... general systemic devaluation of
the dollar. So the inflation we're talking about
is when the currency itself, kind of like a commodity,
just becomes less valuable relative to everything
else. Precisely. And if we trace the word back,
it comes from the Latin inflare, which means
to blow into or to inflate. But the economic
meaning, it went through this fascinating historical
shift in the 19th century. Oh, really? Initially,
in places like the United States, inflation referred
strictly to currency depreciation. So it wasn't
about the price of bread going up. It was about
the dollar, or I guess in the context of the
American Civil War, the various private banknotes
losing its value. You've got it. It was because
the supply of those notes exceeded the redeemable
metal backing, like gold or silver. Oh, I see.
During periods like the Civil War, private banks
would often issue bank notes far beyond their
metallic reserves. The term inflation was used
to describe this swelling, this inflation of
the money supply relative to its hard backing.
So the rising prices of goods was seen as a symptom
of that currency problem. Exactly. Not the problem
itself. And this original view, it aligns very
closely with classical economists like David
Ricardo, who really stressed the importance of
backing your currency with real assets. That
relationship, that the volume of money relative
to its value is the core issue, is ancient. But
the language keeps evolving. Okay, so let's quickly
equip our listener with the essential vocabulary
they'll need to follow any macro debate. Certainly.
We know inflation is the general rise. Its precise
opposite is deflation. A sustained fall in the
general price level. Right. And that's often
viewed very negatively by economists, and we'll
definitely explore why later. Then there's disinflation.
This is a term we hear a lot when central banks
are trying to claim a victory. Yes. And disinflation
is crucial for distinguishing effective policy.
It is not a price reversal. Prices are still
rising, but the rate of that rise is slowing
down. So if inflation goes from, say, 7 % down
to 3%, that's disinflation. That's disinflation.
If it goes from 3 % to minus 1%, that's deflation.
Got it. And what about the worst case scenario,
the one that defines monetary catastrophe? That
is hyperinflation, an out -of -control inflationary
spiral. Our sources highlight Venezuela, which,
as of October 2018, experienced an annual inflation
rate of 833 ,997%. That number is just, it's
hard to even comprehend. It is essentially a
total collapse of faith in the currency. Money
loses all utility as a store of value or a medium
of exchange. And then there's the dreaded combination
that haunted the 1970s. Stagflation. This is
arguably the most challenging economic environment
for policymakers. Why is that? Because it combines
high inflation with two symptoms of a recession.
Slow economic growth and high unemployment. The
traditional tools just don't work. So the tools
you'd use to fight a recession like stimulating
demand would just make inflation worse. And the
tools you'd use to fight inflation like raising
interest rates would just make unemployment worse.
You're stuck. We also need to distinguish between
that core inflation and price changes in specific
sectors, right? Right. We have... Asset price
inflation, where the prices of financial assets
like stocks, bonds, real estate, they're all
increasing rapidly. Often because there's a lot
of liquidity, a lot of cash in the system. Exactly.
But the prices of everyday consumer goods, the
stuff in the CPI, they don't necessarily follow
immediately. And then you have terms like agflation.
Agflation. Which describes a disproportionate
increase in the price of food and agricultural
crops compared to the general rate of inflation.
Okay, so... If the concept of currency devaluation
is that old, let's trace its historical mechanisms.
The earliest forms of inflation weren't about
central banks or monetary policy. They were about,
well, the physical governmental manipulation
of currency. Indeed. The earliest documented
inflation, it occurred in Alexander the Great's
empire around 330 B .C. driven by his massive
expansion and this sheer volume of coins he minted.
But the Roman Empire, that provides the classic
crystal clear example of how the mechanism works,
debasement. Okay, tell us how the Roman government
effectively manufactured inflation and funded
its operations through the coin itself. It was
a simple, profitable, and ultimately disastrous
cycle. When the Roman government needed more
money to fund its army or its bureaucracy, it
would recall silver coins. The ones already in
circulation. Yes. They'd melt them down and then
mix the silver with cheaper metals like copper
or lead. Then they would reissue a greater number
of coins at the same face value. So the government
was secretly reducing the real metallic content
of the currency while telling everyone it was
worth the same. The citizens still had a coin
called a denarius, but the intrinsic value of
that coin had just plummeted. Exactly. When Nero
was emperor around AD 54, the... Denarius was
more than 90 % silver. By the 270s, during all
the military crises and internal chaos, the coin
contained hardly any silver at all. Wow. By that
point, citizens needed exponentially more of
these worthless coins to purchase the same amount
of grain or oil. And the profit the government
made from this process is called seniorage, right?
Could you clarify that term for our listener?
Seniorage is the difference between the face
value of the currency and the cost to produce
it. When a coin was 90 % silver, the seniorage
profit was pretty small. Right. But when they
diluted that silver content down to 5%, the cost
of production dropped dramatically and the government's
profit, the seniorage, exploded. This was effectively
a hidden tax. A non -interest -bearing loan extracted
from the populace just by manipulating the money
supply itself. It's a pure state -driven increase
in the money supply that led directly to a rapid
loss of purchasing power millennia before we
had modern fiat currencies. And we see the inverse
effect with commodity money supply changes, too.
You have to consider the gold shock of 1324.
Ah, Mansa Musa. Exactly. When the Malian king
embarked on his famous Hajj to Mecca, he traveled
with this vast retinue and quite literally gave
away and spent enormous quantities of gold. So
much gold in Cairo that its price was significantly
depressed for over a decade. That's a perfect
real -world example of a sudden, rapid increase
in the supply of a commodity money leading to
immediate inflation. Or, in this case, a dramatic
reduction in the purchasing power of gold itself.
The historian who observed it noted the value
of the gold myth quell fell significantly and
it just stayed cheap afterward. And this leads
us to the most significant inflationary cycle
of early modern Europe. the price revolution
between the 15th and 17th centuries. Over a period
of 150 years, prices in Western Europe rose sixfold.
Sixfold. What were the key drivers of such a
massive, sustained inflation? Well, the sources
cite two dominant and compounding factors. The
first and the most famous was the massive influx
of silver and gold from the New World into Habsburg,
Spain. And from Spain, it spread into the rest
of Europe. Yes, it literally flooded a previously
cash -starved continent with precious metal,
expanding the monetary base significantly. So
a pretty straightforward quantity theory of money
explanation seems to hold true there. More money
chasing the same amount of goods. It does, but
the second factor complicates the picture. The
European population was rebounding robustly after
the devastation of the Black Death. So more people.
A rebounding population means dramatically increased
aggregate demand, particularly for essential
goods like food and land. This demand pull inflation
combined powerfully with the monetary shock from
the New World silver, making the overall price
rise even worse in the 16th century. So even
in pre -industrial history, inflation was already
a multi -factor problem. It was a mix of money
supply shocks and real economic activity shocks.
That's right. So if that's how the historical
route set the stage, the... challenge now in
our fiat currency world is how we accurately
measure this ever -changing force. Moving into
the modern era, the first requirement of any
central bank is accurate measurement. Inflation
is defined by the annualized percentage change
in a general price index, and the most common
one is a consumer price index, or CPI. The CPI
is designed to approximate the price changes
for an average urban consumer. Let's make that
calculation tangible using the U .S. CPI numbers
from 2007 -2008 that our research provided. Okay,
so if the index starts at 2802 .416 the beginning
of the year, and it rises to 211 .080 by the
end of the year, the calculation involves finding
the percentage change. You take the difference,
which is 8 .664, and divide it by the starting
number. 2 over 2 .416, then multiply by 100.
And that gives us 4 .28%. The takeaway for you
is that this 4 .28 % is the official measure
of how much the purchasing power of the dollar
declined for a typical consumer in that 12 -month
period based on their hypothetical basket of
goods. But central bankers need more than just
the historical CPI, don't they? They use a whole
suite of tools, leading and lagging indicators.
That's right. The CPI is a lagging indicator.
It tells you what happened to the consumer in
the past month or year. Exactly. Which is why
the producer price indices, PPIs, are so closely
watched they're considered a leading indicator
for inflation. Why leading? The PPI measures
the change in prices received by domestic producers
for their output. So think of it as measuring
the cost of raw materials, intermediate inputs,
wholesale components, if the cost of those inputs
surged. That's a supply shock. It's the definition
of a supply shock, creating immense cost pressure
on manufacturers. And eventually, those manufacturers
have to pass those costs along to the consumer
to maintain their margins. Precisely. There is
a time lag. So a surge in the PPI suggests that
consumer prices, the CPI, are likely to follow
suit in the coming months. It gives the central
bank an early warning. Then we have the metric
that really dominates the internal discussions
at central banks. Core inflation. Why is the
Federal Reserve, for instance, willing to exclude
crucial everyday expenses like food and energy?
This goes back to their goal of long term stability.
Food and energy prices are notoriously volatile.
They're affected by specific, often temporary
shocks, a hurricane in the Gulf, a cartel decision
on oil supply, a crop failure. So they move sharply,
but they don't necessarily reflect the underlying
generalized monetary pressure in the economy.
Exactly. So by stripping out that noise, the
Fed believes it gets a clearer picture of the
persistent long term future inflation trend.
The trend driven by things like expectations.
and overall aggregate demand. So core inflation
is seen as a better predictor of where inflation
will settle over the next year or two. That's
the goal, making it the preferred target for
policy adjustments like interest rate hikes.
Now here is where we get into the real intellectual
friction. Despite all these sophisticated tools,
virtually all economists agree on one thing.
Measuring true inflation is exceptionally difficult.
It really is. And research consistently suggests
that the official rate, while it's the best we
have, often contains significant biases. The
problem lies in the design of that basket of
goods. It contains weighted prices reflecting
typical consumer purchases. But this fixed basket
introduces two major sources of bias that can
distort the official rate. And the first one
is the substitution effect. Explain why that
might make the official rate overstated. OK,
so when statisticians calculate the index, they
track the price of a fixed quantity of items.
If the price of gasoline spikes, the average
consumer doesn't just keep buying the same amount
of gas. Of course not. They drive less. They
take the train. They substitute. They substitute
the expensive good for a cheaper alternative.
But the index assumes they continue buying that
now expensive gas at the same weight. So their
actual cost of living rises, but not as quickly
as the fixed basket index suggests it does. Exactly.
The official CPI overstates the true impact of
those price rises on a consumer who rationally
changes their purchasing habits. The second major
issue is the challenge of quality. or unobserved
quality improvements? This is a tricky one. If
a laptop costs 5 % more this year, but it has
twice the memory, a better screen, and a faster
processor, has the real price of that functionality
gone up or down? That's a great question. Statisticians
struggle mightily to fully account for these
quality improvements in existing products and
the introduction of entirely new valuable goods.
And the sources suggest this leads to an overestimation
of the price rise because the index just registers
a higher nominal cost without fully adjusting
for the massive increase in utility the consumer
is getting. And that's before you even consider
brand new products. Think of a life -saving medicine
or some revolutionary software. If it wasn't
available last year at any price, its introduction
is like an infinite improvement in quality at
a finite price. It's almost impossible to fully
quantify in an index. So we have minimum issues
and we have perception issues. Yeah. There's
a clear divide between the official rate and
what people feel in their wallets, the perceived
inflation gap. Why do people generally feel that
inflation is higher than the government reports?
There are a couple of major psychological factors
at play. First is frequency bias. People focus
overwhelmingly on the prices of things they buy
all the time, like food and fuel. The volatile
stuff. The most volatile stuff. They buy a refrigerator
maybe once a decade and forget the price, but
they remember the price of eggs from last week.
And second, it's the compound effect. We often
think of 2 % inflation as modest. But we forget
what happens over time. A low, steady 2 percent
inflation rate for, say, 35 years. A typical
career span results in prices nearly doubling.
People deeply feel that cumulative inflation,
the compound pain of the erosion of purchasing
power over decades, even if the annual rate itself
has been stable. To wrap up our discussion on
measurement, it's worth noting the more whimsical
indices that show how tailored price tracking
can be. They really demonstrate the complexity
of translating these abstract economic concepts
into lived reality. Right, like the globally
recognized Big Mac Index. It's used to compare
the relative purchasing power of currencies by
tracking the price of an identical standardized
product, the Big Mac, across dozens of countries.
Or the hyper -local ones like the Jollof Index
in West Africa or the Two Dishes, One Soup Index
in Hong Kong. These measure the true cost of
living and eating for specific populations, which
can feel much more relevant than a centralized
CPI. And of course, the famous Lipstick Index.
was popularized after the 9 -11 downturn. The
idea that when people can't afford big luxuries,
they turn to small affordable ones like lipstick.
Exactly. It's an indicator of consumer sentiment
and substitution behavior during tough times.
So if that's how we track the value of the currency,
the next monumental question for economists is
figuring out what actually moves that needle.
This is where the real battle of ideas begins.
Historically, the debate over the cause of inflation
has been dominated by one central question. Is
inflation primarily a monetary phenomenon driven
by the supply of money, or is it a real phenomenon
driven by the supply and demand for goods and
services? And the oldest and perhaps most elegant
answer comes from the quantity theory of money,
QTM. This theory, revived and championed by the
monetarist school, led by Milton Friedman, gave
us that famous assertion. Inflation is always
and everywhere a monetary phenomenon. QTM is
rooted in the equation of exchange. MV equals
PQ. M is the nominal quantity of money circulating
in the economy. V is the velocity of money, how
often money changes hands. P is the general price
level, what we measure with CPI. And Q is the
real economic output, or GDP. So if the total
amount spent, MV, must equal the total value
of goods sold, PQ, What are the assumptions that
make QTM so powerful in saying that money supply
growth causes inflation? Well, monetarists assume
that in the long run, both V velocity and Q output
are stable or determined independently of the
money supply. Velocity tends to be relatively
stable and real output Q is determined by the
economy's productive capacity, technology, labor,
capital. So if you increase M, the money supply,
substantially faster than the economy can grow
Q. its output. Then P, prices, must increase
proportionally to balance the equation. It's
money chasing too few goods. The rival approach
historically was the real bills doctrine, RBD,
also known as the backing theory. Adam Smith
and many 19th century thinkers laid out this
idea. It argues that inflation only results if
the money issued is not backed by sufficient
real assets or real bills of value. So if a bank
issues a loan creating money against a tangible
asset that is short term and valuable, that new
money is legitimate and won't cause inflation
even if the quantity of money goes up. Correct.
The RBD supporters believed that money should
be issued based on the legitimate needs of trade.
If money creation is backed by real value, it
holds its value regardless of the sheer quantity.
Whereas the QTM supporters were all about the
quantity. They said the sheer quantity mattered
most, not the quality of the backing. This conflict
was the first great monetary debate. This debate
then shifted dramatically with the rise of Keynesian
economics in the mid -20th century. Right. John
Maynard Keynes' crucial insight was that in the
short run, that QTM assumption that prices, P,
will adjust quickly, is false. He emphasized
sticky wages and prices. So when demand falls,
firms don't immediately cut wages or prices.
No. They first cut production and employment.
Therefore, demand shocks affect output. Q first,
not prices P. This led to the empirical observation
in 1958 of the Phillips curve, which showed an
inverse relationship between inflation and unemployment.
And early Keynesians interpreted this as a stable,
exploitable tradeoff. They believed policymakers
could literally choose a point on the curve.
a little more inflation for a lot less unemployment
or vice versa. This informed policy all through
the 1960s. But the stable Phillips curve was
demolished by the monitor's challenge in the
late 1960s, led by Friedman and Edmund Phelps.
They argued that tradeoff was only temporary
because it ignored the crucial role of human
expectation. Expectations. If the government
consistently stimulates demand to keep unemployment
low, the resulting higher inflation eventually
becomes built in. Firms and workers aren't fooled
forever. They start to expect it. So workers
demand higher nominal wages to maintain their
purchasing power. And firms raise prices to cover
those labor costs, leading to a self -fulfilling
wage price spiral. The consequence of this realization
was the introduction of two transformative concepts
in modern macroeconomics, NARU and rational expectations
theory. NARU stands for the non -accelerating
inflation rate of unemployment. It is the lowest
level of unemployment the economy can sustain
without causing inflation to continually accelerate.
So if you try to push unemployment below NRU.
You'll just get perpetually higher inflation
as people constantly raise their expectations.
This is what explained the stagflation of the
1970s high inflation and high unemployment at
the same time. And rational expectations theory
reinforced the importance of central bank behavior.
It posits that economic agents look rationally
into the future and use all available information
to predict what policy will do. This is why central
bank credibility is absolutely key. If a central
bank has a reputation for being soft, for being
willing to tolerate inflation to boost short
-term employment. People just expect high inflation.
And they'll build that expectation into contracts,
making the bank's job harder. Conversely, a tough
reputation allows the bank to manage expectations
quickly and lower inflation with much less economic
pain. The 1970s show that neither pure Keynesianism
nor pure monetarism provided a complete answer.
The solution adopted by the mainstream came to
be known as the modern synthesis, epitomized
by Robert J. Gordon's triangle model. This model
asserts that inflation is almost always caused
by a dynamic mix of three interwoven factors.
First, demand shocks or demand pull inflation.
This is where aggregate demand exceeds the economy's
capacity. Classic too much money chasing too
few goods, often caused by expansionary monetary
or fiscal policy. Second, supply shocks or cost
push inflation. This is where aggregate supply
suddenly drops or the cost of key inputs skyrockets.
Like the OPEC oil crisis in the 70s or more recently
global shipping bottlenecks. And the third factor,
connecting back to that monetarist insight. Expectations.
Inflation expectations. Even if there are no
immediate shocks to demand or supply, if consumers
and firms believe inflation will be high, they
act on that belief workers demand higher wages,
firms raise prices, and that expectation feeds
the wage. price spiral, embedding inflation into
the economy. The modern consensus also cites
several structural real economy factors complicating
the picture in the 21st century. Things like.
chronic housing shortages, shifts in immigration
affecting labor supply, and climate change. Climate
change is increasingly cited as a driver because
recurring extreme weather events translate directly
into supply shocks for agriculture and commodities,
causing unpredictable spikes in food and input
prices that then feed into the broader CPI. The
2021 -2022 inflation spike provides a perfect
case study for this triangle model synthesis.
We saw all three elements operating at the same
time after the COVID -19 pandemic. It really
was textbook. We had massive demand shocks from
unprecedented fiscal support stimulus checks,
government aid. Combined with highly accommodative
monetary policy, low interest rates, quantitative
easing. And at the same time, we had severe supply
shocks. Lockdowns, logistics bottlenecks, and
later the energy crisis from the Russian invasion
of Ukraine. But during this period, a new critical
argument gained traction. The idea of sellers
inflation. What is this theory asserting? This
argument suggests that the demand and supply
shocks provided cover for highly consolidated
firms to significantly increase their profit
margins to price gouge. contributing disproportionately
to the inflation spike. So they were exploiting
the price inelasticity that resulted from the
supply chain constraints. Right. The argument
goes that when a market has fewer players, those
major corporations can raise prices and consumers
who lack alternatives just have to pay the higher
price. They choose to take increased profits
rather than absorbing the cost increases. That's
the core claim. However, this is where that intellectual
friction is essential. Critics of the seller's
inflation theory argue that high corporate profits
are often just a symptom of supply constraints,
not the primary cause. So how do they distinguish
between those two explanations? They look at
the source of the price change. If prices are
rising primarily because input costs are rising,
that's classic cost push. If prices are rising
and firms profit margin. are also increasing
at an unusual rate, that strengthens the seller's
inflation argument. It remains a very ongoing,
highly political debate. It shows that even with
modern tools, diagnosing the specific cause of
an inflationary surge is incredibly complex.
Finally, let's address the monetarist resurgence
after the pandemic. M2 money supply growth surged
post -COVID, and many linked it directly to the
inflation that followed. Yet we noted former
Fed shares downplayed that link. Why? This is
a sophisticated point about the current state
of monetary transmission. Former Fed leaders
have acknowledged that the one strong direct
link between the money supply, M2, and consumer
price inflation effectively ended about 40 years
ago. Because of financial deregulation and innovation.
So why has the equation changed so much? The
key concept here is the velocity of money, V.
If the money supply M increases, but that money
isn't quickly spent and circulated through the
consumer economy, if velocity is low, its inflationary
impact on consumer goods P is dampened. And where
did all that money go post -COVID if it wasn't
immediately fueling consumer prices? A significant
portion was held in the financial system, in
bank reserves, excess deposits or concentrated
in asset markets like stocks and real estate,
which fueled asset price inflation. It wasn't
circulating rapidly in the hands of the average.
consumer buying groceries, the whole system has
changed. So understanding the cause of inflation
requires us to be economic historians, psychologists,
and systems analysts all at once. Now let's turn
to the critical question. What happens when inflation
is too high and what happens when it's too low?
The general effect of inflation is clear reduced
purchasing power, but the specific consequences
are often uneven, creating winners and losers.
We must first analyze the significant hidden
costs and negative effects of high or unpredictable
inflation. And one of the most insidious effects
is that inflation acts as a powerful redistributor
of wealth and purchasing power. That's right.
Inflation shifts purchasing power from those
who hold financial assets denominated in currency
like cash, savings accounts, fixed nominal incomes
toward those who hold physical assets like property,
gold or inflation index stocks and critically
toward debtors. Precisely. If I took out a fixed
rate 30 -year mortgage 10 years ago and inflation
is suddenly 10%, the real value of the debt I
owe the bank is effectively being inflated away.
I win. The lender loses. And it hurts those on
fixed nominal incomes, like many pensioners whose
benefits aren't perfectly indexed to inflation
as their monthly checks buy less and less. Beyond
redistribution, high inflation gums up the smooth
operation of the economy, leading to economic
inefficiency. How so? Unpredictable inflation
makes long -term investment planning extremely
difficult for businesses. They have to divert
resources and attention away from core activities
like boosting productivity and instead spend
time focusing on managing constant currency profit
and loss fluctuations. It's a severe drag on
growth. And it creates confusion in the marketplace
that leads to a loss of allocative efficiency.
Can you use a conversation? example to explain
that complex idea. Absolutely. When prices are
stable, a change in a specific product's price
sends a clear signal. For instance, if the price
of lumber suddenly jumps 20 percent while everything
else stays the same, that's a signal to consumers
to conserve lumber and to producers to invest
in more logging capacity. That's efficient. But
if general inflation is raging at 15 percent
and lumber rises 20 percent, it's hard to tell
if lumber is genuinely scarce or if its price
is just rising slightly faster than the general
background noise. That confusion leads to misallocating
capital and resources. We mentioned earlier that
inflation is often called a hidden tax. It acts
as a hidden tax on holding currency, just eroding
its value passively. Furthermore, if tax brackets
aren't indexed to inflation, a phenomenon known
as bracket creep. Inflation can push you into
higher marginal income tax rates, even if your
real purchasing power has an increase. A subtle
non -legislated tax increase. Exactly. The sources
also cited a profound, severe consequence, the
direct link between food inflation and social
and political fallout. It's a critical. High
food inflation directly impacts the most vulnerable
populations globally. For instance, high food
costs were cited as a major underlying cause
of the widespread demonstrations and revolts
that fueled the 2010, 2011 Tunisian and Egyptian
revolutions. When people cannot afford basic
sustenance, economic metrics become immediate
drivers of political instability. We also need
to define the two classic microeconomic costs
that illustrate these subtle inefficiencies.
First, the shoe leather cost. High inflation
dramatically increases the opportunity cost of
holding cash. The term theoretically references
the energy and time, the shoe leather, spent
by people running back and forth to the bank
to minimize their cash holdings and keep their
money in interest bearing accounts. It's wasted
time and effort managing cash instead of doing
productive activity. And the second is the menu
cost. This is the explicit or implicit cost for
firms that have to constantly change their prices.
A restaurant having to reprint its physical menus
every month is an explicit cost. And the implicit
cost includes time spent updating computer systems,
changing price tags, negotiating with suppliers.
Both costs consume resources that could otherwise
be used to increase output. OK, now we flip the
coin. Why do central banks consistently target
a low but positive inflation rate, typically
2 percent in the developed world? Because inflation
has some powerful upsides. The primary positive
effect is related to greasing the labor market.
This addresses a fundamental truth about human
behavior. Nominal wages are sticky downward People
hate pay cuts Workers strongly resist pay cuts,
even if inflation is zero and a pay cut is economically
rational. So if the economy needs wages to drop
to clear the market, say during a recession,
but workers refuse nominal pay cuts, the result
is prolonged disequilibrium and higher unemployment.
Precisely. Moderate inflation provides a mechanism
to allow real wages, the actual purchasing power
of the paycheck, to fall slowly, even if the
nominal dollar amount of the wage stays the same.
It acts as a necessary lubricant for economic
adjustment. Inflation also grants the central
bank essential policy flexibility or room to
maneuver. This prevents the central bank from
hitting the feared liquidity trap. Right, where
you can't cut interest rates any further because
they're already at zero. Exactly. If moderate
inflation is built into the system, say 2%, then
a zero nominal rate still equates to a negative
2 % real interest rate, providing stimulus and
ensuring the central bank retains its policy
tools. We also have the academic argument for
why moderate inflation might actually spur investment,
known as the Mundell -Tobin effect. The Nobel
laureate Robert Mundell argued that when inflation
is expected, it raises the opportunity cost of
holding non -interest -sparing money. Why hoard
cash that is constantly losing value? It encourages
you to invest it instead. It encourages savers
to substitute money hoarding for capital formation.
They invest in loans, stocks, productive capital.
This substitution leads to a fall in real interest
rates and increased investment, thereby stimulating
long -term growth. And finally, the ultimate
justification for avoiding zero inflation, the
inherent instability that comes with deflation.
This ties back to economist S .C. Chang's compelling
argument. Expected deflation is dangerous because
it encourages money hoarding, as money is constantly
increasing in value. This hoarding euthanizes
financial markets. And Tsang warned that if this
massive pile of hoarded money is suddenly triggered
into circulation by some panic or change in expectation.
The resulting mass movement to spend would become
a tremendous avalanche causing rapid inflation
and severe disruption as the financial system
just cannot cope. So stability is the key. Moderate,
stable inflation prevents that fear of deflation
and provides the necessary mechanism for markets
to operate smoothly and for central banks to
manage employment and demand. The modern objective
of central banks is not just to manage interest
rates, but to manage inflation expectations to
keep the rate low and stable, typically around
2%. And to achieve this, economies have historically
relied on various nominal anchors. The classic
anchor, dominant globally before World War I,
was the gold standard. Under the gold standard,
a country tied its currency to a fixed preset
quantity of gold. The long term inflation rate
for the economy was effectively determined by
the rate of growth of the global gold supply.
What were the major criticisms that led to its
abandonment? Critics argue it forced arbitrary
fluctuations in the inflation rate, totally dependent
on gold discoveries, not on the needs of the
domestic economy. And more critically, it made
it incredibly difficult to stabilize employment
and avoid deep recessions because the government
couldn't independently adjust the money supply.
It forced rigidity. A rigidity that was ultimately
abandoned after the Great Depression. After World
War II, many nations adopted a different anchor,
fixed exchange rates under the Bretton Woods
system. This system involves pegging a currency
to a major low inflation currency, historically
the U .S. dollar. Today, only a handful of nations
like Denmark maintain a fixed rate against an
anchor like the euro. The benefit is you import
the anchor country's price stability. But the
cost is the loss of policy independence. Right.
You can't use your own independent domestic monetary
policy setting your own interest rates to manage
local business cycles or unemployment. You sacrifice
domestic control for external stability. A more
drastic and much less popular control mechanism
is wage and price controls. These are temporary
exceptional measures. They can theoretically
be effective at speeding up disinflation and
breaking those entrenched expectations quickly.
But economists generally advise. caution. Because
they create severe market distortions, shortages,
black markets, misallocation of resources. As
seen in the failure of the 1972 U .S. attempt
to impose controls, they only work if the controls
allow the central bank time to tackle the underlying
causes, like excessive demand. Let's look at
another alternative idea that focuses on structural
monetary reform, the de Mirage currency from
Freiberg's Chef Theory. This is a fascinating
theoretical construct. It proposes a currency
designed to inherently decrease in value over
time, a demurrage cost like a storage fee. So
it discourages hoarding. Right. And since it
discourages hoarding, the central bank could
theoretically issue new money at a similar rate
to the demurrage cost to achieve a precise zero
inflation target. The theory posits this also
replaces the need for interest costs to be built
into prices. But the undisputed global standard
today, the framework used by most developed economies.
is inflation targeting. This approach was pioneered
by New Zealand in 1990 and is now prevalent across
the G7. It involves the central bank explicitly
committing to continually adjust its primary
tool, the central bank lending rate, to steer
the country's actual inflation rate toward a
specific published target, typically 2%. And
the mechanism by which those interest rate changes
affect the economy is called the monetary transmission
mechanism. How does that link work in practice?
When a central bank raises its target interest
rate, it raises the cost of borrowing for commercial
banks. This increased cost is then passed on
to consumers and businesses through higher loan
rates, like mortgages and corporate bonds. That
makes borrowing money more expensive, which slows
spending. Exactly. Higher borrowing costs decrease
aggregate demand. Both consumers and businesses
spend less. Lower demand reduces the pressure
on existing supply, which puts downward pressure
on prices, thus influencing the inflation rate
back toward that 2 % target. And lowering rates
does the opposite. stimulating demand. It's all
designed to anchor those crucial inflation expectations.
It truly is incredible, if you step back, to
trace this journey from Nero's crude debasement
of the denarius for quick government profit through
the intellectual battles over the quantity theory
and the Phillips curve. Right up to the highly
sophisticated debate over the NARU and the credibility
of a single announcement from a central banker.
Inflation isn't just an economic metric. It's
a reflection of the trust in the underlying value
of a society's promise of exchange and the competence
of the institutions managing that promise. So
what does this all mean for you, the informed
learner? We've established that unstable inflation
causes enormous social and economic harm from
redistributing wealth and discouraging investment
all the way to fueling revolutions. We also noted
that the instability that comes with deflation
can cause savers to hoard and that a sudden panic
driven movement to spend those hoards could become
a tremendous avalanche. That concept of the Shang
avalanche, a sudden mass realization that money
hoarding is no longer safe, leading to panic
spending, is a powerful warning. It really is.
So given the immediate, highly emotional effects
of inflation on consumers, which we saw vividly
in the social unrest of 2010 and 2011, and the
fact that we now live. a world of instant digital
communication, flash trading and globalized assets.
What happens when this avalanche of money hoarding
and the subsequent rush to trade money for real
goods is amplified and accelerated by social
media narratives and the speed of modern financial
flows? This raises the ultimate question for
contemporary central banks. Is inflation today
as much a psychological and communications challenge,
a battle to manage public narratives and expectations
digitally and instantly, as it is a purely monetary
one, controlled by the relatively slow mechanisms
of interest rate adjustments? The battle for
stable prices may well be won or lost in the
realm of public perception.