I recently read an interesting article about the true measure of inflation, and given that the official government CPI and RPI figures always seem so unreliable, what with gerrymandering of the basket etc. finding a more fundamental concept of inflation was interesting.
The formula was basically: GDP growth - M4 growth = inflation on the basis that money supply and GDP should go hand in hand if money is to maintain its value and that any deviation in the money supply would result in inflation. The supposition is that prices as such are irrelevant as they are set by what people will pay,and that the value of money as a medium of exchange is what’s of interest.
Its simple and there is some rationale behind it and the resulting figures tally well with my perception of past prices etc. over a long span. but is it a reasonable concept - how legitimate is the theory behind it?
Now I know that this is at odds with traditional measures of inflation invariable based on a ‘basket’ of goods - it seem to me that this is leaving out whole swathes of the economy such as property, investments and paper instruments. This subtractive approach seems to be more in line with aims of politics than measuring the value of money.
It is commonly assumed that inflation comes from over-expansion of the money supply.
But if this was true, it would mean that everyone selling something is measuring exactly
how quickly the money supply is expanding and how much to raise prices.
No.
As people who receive extra money spend it, this increases demand, which raises prices. As some prices go up, this increases some people’s costs, so they have to raise prices or bargain for higher pay. People are reacting to the market conditions they encounter. Even if they aren’t even aware of the expansion of the money supply, inflation happens.
You are assuming that people spend extra money, rather than saving it or investing it.
This is not self-evident as deterministic consumer behavior, nor is it empirically supported.
There will be some spending. How much depends a lot on what sort of people receive the extra money.
Increased saving will, by supply and demand, reduce interest rates and increase borrowing. Much of the borrowed money will be spent on one thing or another.
Increased investing will increase spending on capital improvement.