Where does inflation start?
Inflation starts with a trickle.
Introduction
I have written before that the only source of generalized price inflation consists of monetary expansion. The old saying about “too many dollars chasing too few good” does contain an element of truth. It does not, however, seem to contribute to a deeper understanding. The same people who frequently quote the old bromide often follow with misleading comments about tariffs, oil prices, or “supply and demand,” contributing to price inflation.
To fully understand price inflation, one must understand the dynamics of price changes on an individual good in a free market. Do stores increase the offering price of a good to “maximize” profits? Do rising producer prices “force” stores to increase retail prices? Do any of these influences—product-specific or system-wide—cause immediate changes in prices?
Production and Pricing
To illustrate the causes of price increases, I will discuss a typical scenario for the price increase of widgets at Willy’s Widget Emporium. I use widgets in this example because, as we all know, businesses have sold widgets for years, and they come in only one size and one color. They represent a nearly perfectly fungible good. Setting the offering price for widgets should occur nearly automatically.
The sales of widgets at Willy’s Widget Emporium have remained nearly constant for a year: about 50 widgets per month (varying between 47 and 52 widgets) at the constant price of $10 per widget.
Willy says his widget inventory seldom runs out before the end of the month, but any small carryover only covers his sales until the next shipment arrives. Willy has been in this business long enough to know the customer determines his ultimate sale prices. Customers do not care about producer prices or supply and demand “bat curves” in the middle of the night. Customers can purchase from multiple stores at the same price. After all, these are widgets, not decorative bolts supplied only by Willy’s Widget Emporium.
Widget Boom
Surprisingly, one month, Willy runs out of widgets on the 20th of the month. He knew better than to overreact, for he had seen spikes in sales of widgets before. Usually, sales volume would return to its normal level. Willy made a special order to fill the gap, and then placed his normal order at the same time of the month as usual.
The increased sales volume continued for three or four months, and Willy decided to increase his orders and raise his offer prices about 8%. Some reporters complained that Willy wanted to “take advantage” of his customers, but they missed the whole point of market prices.
By raising offer prices, Willy did not have the power to “take advantage” of his customers. Customers made their purchase because they valued the widgets they got more than the $10.80 they now paid for widgets at Willy’s. But Willy raised offering prices for another reason.
To satisfy the apparent increased demand, Willy needed to earn more revenue to maintain a larger inventory. Willy knew that businesses made more money by satisfying increased demand at the same, or slightly higher prices.
Like many people who have actually run businesses, Willy understood that a market sustaining rising prices indicated a need for more supply. Thus, price increases occur one product at a time. Price increases, in a free market, will signal a shift in resource allocation. In order for customers to buy more widgets at higher prices, they would have to buy less of another good (given the same quantity of money). Perhaps the vegans have convinced steak eaters to buy fewer steaks, and they have used the money they saved to buy more widgets.
Monetary Expansion
Willy and the other widget retailers and producers were in for a surprise. Unbeknownst to them, the increase in widget sales had another cause. The formation and funding of the WWA (Widget Welfare Administration) caused a sharp increase in widget demand. Congress funded this program for only one year, and, as with most programs, it funded it with newly created money.
The new widget sales were not the result of shifting resources. Consumers still bought the same amount of other stuff. Increased widget sales resulted from the legalized counterfeiting, known as “deficit spending,” which was funded by money expansion.
Legislators paid no price for this ridiculous program, but Willy and other factors in the widget market paid a heavy price. Customers would no longer pay $10.80 or even $10 for widgets. Many of Willy’s competitors and suppliers closed their doors. Later, because of the reduced orders from widget retailers, producers—who had increase production based on their increase sales—had to lay off workers or close their doors.
The widget boom turned into the widget bust.
Conclusion
With a steady quantity of money, the prices of widgets signaled the true relationship between supply and demand—a determination that the market could only see in retrospect. No supply and demand curve appears to market actors to signal the correct price in advance. Businesses estimate the quantities of products they will need in advance. They use price patterns to help them make those estimates.
In a free market, rising prices signal the existence of relatively unsatisfied demand.
Suppliers cannot distinguish between rising prices due to actual increases in relative demand and those caused by artificial demand resulting from monetary expansion. When monetary expansion fuels price increases, producers make a rational decision to increase production based on a false signal.
Only after the misallocation of resources has worked its way through the economy do the statisticians acknowledge market-wide price increases. By then, the damage has been done.