# How is inflation logically possible?

I am a total lay man on economics, but I find inflation to be an impossible phenomena. Here is my arguement for it,

We have that every year that more people are born (reduces labour price), and also that the means of production is cheaper due to technology. This would mean that production would become cheaper with respect to time.

However, we are finding that prices are rising day by day for even basic food stuffs in many countries. How on earth is this possible?

1. more people being born does not necessary mean that price of labor will fall. In fact in most countries you will see that wages (even adjusted for inflation) raise over time. Wages depend primarily on marginal product of labor, as people get more educated value of that marginal product increases.

2. Inflation is typically not caused by items becoming more expensive to produce, although sometimes possible, that is quite rare. Inflation, is typically caused by money becoming less valuable over time.

Hence even if goods or services become cheaper (e.g. you need to work less hours to get them, they can be build with less time and resources), the price tag of these might increase because money itself lost value. A money is just a numeraire good that is used to facilitate transaction. Value of money as of any good or service itself can fluctuate over time.

For example, price level (change of which leads to inflation and which can be considered inverse of price level), can be described via money market model (LM curve) as (see Blanchard Macroeconomics):

$$P=M/L(Y,i)$$

Where $$M$$ is money supply and and $$L$$ is money demand that depends on interest rate $$i$$ and real output $$Y$$. If economy gets more productive (Y increases) prices do go down as money demand increases and if everything stays constant prices decline. However, changes in money supply or interest rate can have stronger effect than expansion in real output. In addition, something that is not captured by the simple textbook model above is that what matters is also expectations of future changes in $$Y$$, $$i$$ and $$M$$.

1. If you are talking about present inflation, especially food inflation, that there is nothing perplexing or mysterious about it. First, there was a supply chain issue caused by war and covid19 lockdowns (see this and this report by Deloitte and McKinsey respectively), and in addition there was also large expansion in money supply (data here) and interest rates were also kept at their lowest historical levels (data here) until very recently (and even though interest rates increased and money supply declined very recently it takes time till price level is affected).

So, $$M$$ was up, $$Y$$ was down, $$i$$ was down. That is literally a textbook recipe for increase in $$P$$ (that is inflation), and by extension decrease in value of money (1/P). Hence, there is nothing that unusual about current inflation. Hence, not only it is logically possible its what you would expect following logic of even basic textbook macro models.

• Your point 2 provides zero information.
– Mick
Mar 12 at 8:20
• it obviously does by definition of information as it provides facts about inflation, rather your comment seems lacking in it
– 1muflon1
Mar 12 at 11:17
• I see you have now edited point 2 for the better, so my comment was worthwhile.
– Mick
Mar 12 at 13:22

Inflation is usually result of too much money chasing too little goods. Prices in economy adjust in such a way that effective money supply (money supply times velocity of money) will be equal to the number of transactions at current prices. The number of transactions is proportional to how much goods there are in economy. If there is more money chasing the same number of goods you will see inflation.

Just to make sure we are talking about the same thing, inflation is usually defined as a sustained increase in the price level, which is a composite index created out of goods and services.

1. We have that every year that more people are born (reduces labour price)
If the population grows, demand for things such as food, housing, clothing, haircuts, etc. probably also grows. Thus even if production is cheaper due to more labor where the new equilibrium lands is not clear. Though there are many "truths" espoused in econ 101, it is best to take these with a grain of salt, or at least pay very careful attention to the listed assumptions/caveats.
2. production is cheaper due to technology. This would mean that production would become cheaper with respect to time
Costs alone do not determine prices. For example, market power also plays a role; when there are less companies competing, their profit margins are usually greater.
The global logistic chains also became stressed recently due to mid-term decisions during the early years of the pandemic (not well-modelled by econ 101, which mostly uses comparative statics), and this also increases costs/decreases supply.

Bonus:
Inflational phenomena are (IMO) not well understood, but it is usually agreed that expectations about future prices play a role. Suppose you want to lend money/make an investment, so that you can buy some goods/a house the next year. (Warning, this is a theoretical anecdote, a poor reasoning tool!) If you expect prices to increase by 1%, you would be willing to lend the money at a lower interest rate, than if you expected the prices to rise by 10%. Similarly, if you were looking to sell your house, but you expected housing prices to rise by 20% in the next year, you might put off selling your house by a year and take out a loan for now instead, as long as the interest rate was below 20%. Thus expectations about prices affect consumer/investment decisions, which may in turn affect future prices.

• Pundits might not understand inflation but macroeconomists actually understand inflation well nowadays Mar 12 at 11:57
• I'm curious why you say that. I get the impression that inflation is rather ill understood.
– Mick
Mar 12 at 13:25
• you likely have that impression because you just read news by pundits instead of actually reading published peer-reviewed literature in good journals or following courses from some serious universities. If you get all your info from pundits from fox news then even climate change looks like ill understood issue. Of course, real climate scientists have good understanding of climate change, but commentators that don't make it seem like climate science is not crystal clear, same with vaccines or inflation if you do not follow serious scientists it might look like ill understood issue Mar 12 at 14:46
• @csilvia Please do elaborate here! Mar 12 at 17:37
• @csilva: I am getting my information from the words of senior central bankers, not pundits.
– Mick
Mar 12 at 19:21

Inflation is logically possible because the spending of money is not limited to the amount of money that is earned. Spending can be greater than income, like when money is borrowed from banks. Things can be bought without first earning what is required to pay the price. People do this with houses, cars, furniture, overseas travel etc. They are financed with borrowed money, as long as the cost of borrowed money (the interest rate) is not too high.

Businesses use borrowed money to buy capital goods, and governments use borrowed money to finance budget deficits. If it wasn't for borrowed money, there would be much less economic activity, much slower economic growth, perhaps high unemployment, but no inflation.

Monetary policy is used to ensure that spending exceeds income. It is good for the economy. There is sustained economic growth and low unemployment. Inflation is an unfortunate side effect. Inflation is evidence that demand is greater than supply and the economy is growing.