A Brief Word About Governments And Inflation

Politicians from both sides keep telling us about their plans for dealing with inflation, while all the time ignoring the fact that they are the main cause of the problems. You see, inflation is one of those things we think we observe when we look at rising prices, but in reality, the world is more complex, because price differentials and inflation are not the same thing, despite being connected. A relative price change can occur distinctly from inflation, but affect inflationary rates. A relative price change is the distinction between an observed price change (linked to currency rates) and the inflation rate. For example, if the inflation rate is 4%, and the pound sterling price of sandals rises by 2%, then there's been a 2% decrease in the relative price of sandals.

Inflation is observed by the naked eye as a general increase in prices, and it’s folly to cite individual price changes without factoring in relative price changes occurring independently of inflation. Prices can change without inflation affecting the change, and inflation can occur independently of the relative price changes of individual goods.

When we talk about inflation, what is often meant is the combined effects of relative price changes and inflationary effects. The amount a price of something changes should not be just attributed to ‘inflation’, as most people do, because the effects being observed are really inflation plus the relative price change. Put it this way; Alice may have a clean car (z) by applying soap (x) and water (y) to the process, but while x and y contribute to z, it wouldn’t make much sense to say that z contributes to x.

So, here’s why the governments are largely to blame for the ‘inflation’ problems they are trying to help alleviate by, in their words, dealing with the ‘cost of living crisis’. Aside from supply side shocks caused by things like pandemics and wars, there are two main ways that our purchasing power is negatively affected; 1) no change in the money supply, but fewer goods to obtain, or 2), no change in the goods to obtain, but new money supplied with which to purchase these goods.

When the governments restrict the acquisition of goods, either by over-regulation, distincentivising investment and production, price fixing, or artificially starving the supply, prices go up and shortages occur, negatively affecting living standards. When the governments increase the money supply over and above public demand, there will be a drop in the purchasing power of that money, and citizens will feel the effects of inflation. If you increase the money supply, then you increase nominal prices of goods and services, and you reduce people’s purchasing power, negatively affecting living standards.

The next time you meet a politician who tells you what they are trying to do to combat inflation, tell them you already know what they should do; they should cut taxes, and stop increasing the money supply and saddling us with more and more debt.