Thursday, March 13, 2008

Inflation vs Dilution

In the context of my recent post on inflation I think it's worth thinking more clearly about what this word means.

While I do not agree with the grim prognostications of this essay, I do think that distinguishing different flavors of price movement is useful.

In general, when most people refer to "inflation" they mean "a general increase in prices". This is seen to be a bad thing. By the same token, when most people refer to "deflation" they mean "a general decrease in prices". This is seen to be an even worse thing, although it is not immediately clear why lower prices are bad. I mean, if Apple announced 10% discounts on all their products, no one would be unhappy. If gasoline dropped back to $2/gallon, the politicians would not admonishing Big Oil to be stingier at the spigot. But somehow price declines across a broader span of goods is really bad.

For a moment, let's separate prices and quantity.

Say there is a fixed amount of dollars in the world, $Q. Say the Fed prints 20% more dollars, there are now 1.2$Q in the world. If the number of goods in the world is the same, then these extra dollars will drive up prices until 1.2$Q buys as much as $Q used to. In other words, any idiot holding $Q can now buy less.

At the same time, suppose there is some dramatic new technology (such as, say, China) that can produce goods at much lower prices. Maybe 20% cheaper. Thanks to this new technology, someone with $Q in their pocket will now be able to buy more (since what used to cost $P now costs 0.8$P).

Now suppose these two things happen at the same time -- the Fed prints more dollars while, at the same time, new technology makes goods much cheaper. The net effect of all of this may be that, although the currency is being dramatically diluted prices are not rising by all that much. This means that measures of inflation, such as CPI (which has lots of problems all by itself) are totally useless because they do not include the opportunity cost of not having money diluted in the first place.

Looking at inflation this way, as dilution, also makes it really easy to understand the old Milton Friedman (U Chicago) aphorism "inflation is always and everywhere a monetary phenomenon" -- if you substitute "inflation" with "dilution" it reads "dilution is always and everywhere a monetary phenomenon" which is so obvious as to be a tautology.

OK. So we have now separated the fuzzy and confusing term "inflation" into the more precise terms "dilution" (referring to an increase or decrease in the monetary base) and "price changes" (which can happen for a variety of reasons). Since the compound term "inflation" conflates both changes in prices due to "dilution" (monetary only) and other "price changes" (lots of reasons), we find that core measures of inflation (like CPI) are useless because they combine price and quantity. More on this later.


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