There is a wonderful game some children play called Monopoly. There are four players, and each gets “pretend” money, and as they go around a square board, they can buy “properties” (identified with a particular square on the board) and then charge rent when other players land on those properties (squares). If initially there is a total of Rs. 10,000 available for all the players, then the total value of all the properties cannot exceed this amount. There would be no extra “notes” for a higher value. Imagine now that in the middle of the game, each player was given an additional Rs. 2,500. Thus the total money available to buy properties would suddenly double. The price of each property could then easily also double. This is called inflation.
In the real world, inflation is a situation of rising prices – it results in a higher cost of living. Under inflation, the price of every product or service we need increases over time.
As in the example of monopoly money, The economist Milton Friedman said that “Inflation is always and everywhere a monetary phenomenon (he means the amount of money notes available) in the sense that it is and can be produced only by a more rapid increase in the quantity of money (notes) than in output (the available products and services).”
The Discovery of South American Silver
History provides interesting examples of inflation. When European countries discovered the Americas, Portugal took over Brazil, but it was Spain who conquered the rest of central and southern America. The Spanish found massive sources of silver in today’s Peru and Mexico and mined more than 300 tons of silver per year for decades.
When this silver survived the still dangerous sea voyages back to Europe, the silver was used by Spain to buy more products and wage wars in Europe. Many economists say this was the reason why between 1520 and 1650, Spain’s economy suffered the most terribly high inflation (called the “Price Revolution”).
While there may have been some other reasons for Spain’s inflation, money supply via silver was probably a significant cause.
Devastating effects of High Inflation
High inflation can have devastating effects. In Weimar Germany (before World War II) a loaf of bread in Berlin that cost around 160 Marks at the end of 1922 cost 200,000,000,000 Marks by late 1923. The hardships Germans faced because of inflation was one of the causes for the rise of the evil Nazis.
In modern-day Zimbabwe, inflation has crippled the country and caused widespread poverty. In 2005 one U.S. dollar was worth 10,000 Zimbabwe dollars. Inflation resulted in a vast increase such that in 2008 one U.S. dollar was worth over 2.6 trillion Zimbabwe dollars. Even today, the mismanagement of the Zimbabwe economy means that inflation was over 500 percent in 2020.
High inflation is worse than penal taxes. It east up and destroys everything we work hard for. For millions, it means less food and malnutrition. It is a disease that literally kills. Thus understanding inflation and preventing it is of paramount importance to us all.
Long Term and Short Term Effects
Economists agree that in the long term, Friedman is correct and that the supply of money has a strong connection with inflation. Economists disagree, however, about the short-term consequences of an increase in the money supply. For example, during the subprime crises (2008-9) and now during the covid pandemic, governments have substantially increased the amount of money available. Governments have effectively printed money and given away large amounts as aid or benefits to people. Yet inflation has not yet expanded to very high levels. So what is happening?
The great economist John Maynard Keynes argued that goods and services could remain very subdued in the short term. This is because in the short term, inflation is mainly affected by “real” variables such as the unemployment rate. During 2008/9 and now under the covid pandemic, millions are out of work. Thus even though the government has pumped a lot of paper money into the economy, demand for products and services is still low.
These findings about inflation are summarized by economist Adrià Morron Salmeron. Salmeron wrote, “findings are consistent with the consensus that in the short term real economic activity is a significant determining factor for inflation, but in the long term this will ultimately depend on the trend in the money supply. It is natural that changes in the money supply should take some time to appear in inflation.”
Risks to our future
Salmeron writes the following words of caution, “Although today we do not have higher inflation in response to the large injections of liquidity by central banks, this is due to short-term factors so that the monetary authorities need to remember that, eventually, inflation will be determined by the trend in the money supply.”
However, governments are rarely as wise as we need them to be. Nearly all governments have borrowed heavily to finance the printing of more money. To pay these debts, it is in the interests of governments to have inflation. It makes it easier to repay these loans. On the other hand, inflation can destroy an ordinary person’s livelihood.
We may soon reach a challenging tipping point. The covid pandemic is keeping prices in check as there is so much suffering. Yet once the pandemic ends, the world will be left with a lot of excess money. Already some signs are emerging that inflation may become a significant risk. The latest figures from the U.S. are that the annual inflation rate is 4.2% for the 12 months ended April 2021 after rising 2.6% previously. This is an unexpectedly sharp rise. We all need to be on our guard in India and elsewhere that the monster of inflation does not come back to haunt us.