How does inflation work in real life?

Question

So when the government prints more money, then it is said the people will have more money in general and as a result the prices of goods and services will also increase. So in the end, we will end up buying the same amount of goods, but by paying more. So its the concept that the more the things is available the less value it has. I do not understand how this works in real life. When the government prints more money, how does this extra money end up in the hands of the people, they still are being paid the same amount of salary annually by their employers. The income of people is fixed. Secondly, why does the price of the goods increase? If rice is worth 1$ per kilo, then just because people are richer why does the cost of rice increase ?

I have recently started studying economics.

Answer 1

When the government prints more money, then how does this extra money end up in the hands of the people, they still are being paid the same amount of salary annually by their employers.

This is really two questions:

How does the money get into the economy? The US government increases the money supply by having the Fed buy things with dollars that did not previously exist. Typically they buy financial assets, pushing their price up and putting new money into the hands of the previous owners of those securities (often the US treasury, which means it is injected into the economy in the form of government spending).

How do individuals get this money if their incomes are fixed? For a given individual, their income may be fixed in the short run. However, across the economy there are many people whose incomes fluctuate with sales or who are up for raises that depend on sales or profit. Or who get a higher wage when they change jobs. As the money supply increases, consumers have more money in hand and spend more money, raising wages for those whose wages can go up using these mechanisms. Your intuition is right about people with truly fixed wages, though: in the short run, they do not participate in the money supply increase. This is why people on a fixed income (like elderly people living on a pension) hate inflation.

Overall inflation shifts wealth from lenders to debtors and from those with fixed incomes to those with adjustable incomes.

why does the price of the goods increase?

The price of a good is the equilibrium between the people buying and the people selling. A change in the money supply does not change how many goods there are to sell but it does change how many dollars the people buying them have. If people have more money, they will be willing to pay more, so the price goes up.

Answer 2

Very good question. Let me use your rice price as an example.

At the beginning, rice is worth of 1 dollar/kg when every one in the society holds $10. One kg of rice is worth of 10% of each individual's asset or fortune (1/10=10%)

Now, the government issues extra $10 to each person in society by printing "free" paper bills. Everyone ends up holding 20 dollars in hand. The 10% worth of rice still holds the same since everyone has the same amount of cash in hand and every one has the same purchasing power. Guess what, now the price of 1kg of rice is 20 dollar * 10% = 2 dollar /kg

Above is an explanation in "ideal" world. It is true that the "free" printed money do not directly end up in our hands but the amount of currency circulated in the society does increase. Think about this, those with more currency in hand can afford to buy more rice with more money and this just increase the overall demand of rice. From simple micro-economics, higher demand leads to higher price equilibrium, thus, inflated price.

Hope this helps you understand the concept of inflation. Once again, not all printed money leads to inflation. The growth of society wealth depends, more or less, on inflation. That's why US government's been issuing several rounds of Quantitative Easing (a.k.a printing money) in order to stimulate economy

Answer 3

Actual inflation is about chain of effects, depends on the magnitude of money entering the market and how fast it is consumed by goods and services, according to the price accepted by the market, it is not about affordability nor rationality of individual. And impact of inflation is all about essential goods/services/rents price paid by the individual against their saving.

In a market with limited choice (i.e. protection policy that curb alternative) and fix demands, suppliers that monopolize the market can increase the price anytime they want to a level that the market accept till they see a sales drop. The hypes price increase bubble will burst when alternative (cheaper and better due to increase of efficiency on production, or innovation) introduced to gain of share of the profit; or in worst scenario, the people income diminished when all their saving is depleted to acquire the required goods.

Any country that suffered significant inflation impact, there is a significant roles play by government protectionism towards its cronies related to particular industries.

This is proven by USA Quantitative Easing(QE) begin in year 2008, which sometimes is called "exporting USA inflation to third world country". Because US market is pretty open and competitive, there is little for the QE money able to play significant roles on rent seeking speculation.

However, most third world country run by corrupted government with favourism is a easy target for such price rent seeking. When third world country start increase money supplies to cope for the "inflow hot money", those countries policies just promote speculation of price than help increase efficiency. (p/s: don't expect a neo-libralism "free market" is going to help those 3rd world country with corrupted institution.)

Answer 4

Your question assumes that it is the government (or perhaps the central bank) that "prints more money" this is mostly untrue. The vast majority of new money in our economy is created by private banks when they make loans (and destroyed when the loans are repaid). This is very surprising to many people including some with degrees in economics! The process is called fractional reserve banking and it is often misunderstood, or described incorrectly. A good explanation is given here.

Most new money is created in the process of lending for real estate, so any surge in the money supply often has its impact on house prices. I.e. more people being given ever larger loans for buying houses means that house sellers can put ever larger selling prices on their homes. So this is where new money arrives into an economy, into the hands of house sellers.

So to part two of your question, why the cost of consumer goods will rise. People's propensity to purchase goods at price X depends on how much money they have. There will always be people just on the verge of buying a product at price X, but that refuse. These people, when armed with just a bit more money, will go ahead and buy a product at price X. This means that when some people have more money than before, a shopkeeper will see that an item is selling faster than before, they will consider raising the price.