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Can you explain the mechanism of money inflation in simple words, understandable by non-professional? Where does it come from?

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The mechanism of supply and demand is imperfect. Producers don't know exactly how many purchasers/consumers for a good there are. Some goods, by their nature, are in short supply, and some are plentiful.

The process of price discovery is one where (in a nominally free market) producers and purchasers make offers and counter-offers to assess what the price should be. As they do this the historical price changes, usually floating around some long-term average. As it goes up, we experience inflation. As it goes down, deflation.

However, there isn't a fixed supply of producers and purchasers, so as new ones arrive and old ones leave, this too has an impact on supply and prices.

Money (either in electronic or physical form) needs to be available to reflect the transactions and underpin the economy.

Most central banks (at least in more established economies) aim for inflation of 2-4% by controlling the availability of money and the cost of borrowing new money. There are numerous ways they can do this (printing, issuing bonds, etc.).

The reason one wants some degree of inflation is because employees will never accept a pay cut even when one would significantly improve the overall economy. Companies often decrease their prices in order to match lower demand, but employees don't usually accept decreased wages for decreased labour demand.

A nominal degree of overall money inflation therefore solves this problem. Employees who get a below-inflation wage increase are actually getting a wage cut.

Supply and demand must be matched and some inflation is the inevitable consequence of this.

  • It should also be noted that inflation can also be caused by expectations of inflation: If inflation has been 3% for the last 5 years, companies may start to build in a 3% price increase into their products (causing inflation to be sustained even in the absence of any other factor) – serakfalcon Sep 4 '14 at 4:55
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Assuming constant velocity, inflation is caused by the difference between the growth in the money supply and growth in real output. In other words, this means that the money supply growing faster than output is expanding causes inflation to arise.

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In simple terms, inflation is a result of too much money chasing too few goods, i.e. there is an imbalance between demand and supply. The demand exceeds the supply. With all other things being constant it leads to increase in price, i.e. inflation.

  • 1
    This is probably the best explanation, but a bit light on the details. I would add that the inflation mechanism is due to the fact that buyers collectively bid on goods. In general, if somebody suddenly has more money to spend but the same number of goods to buy, they become willing to bid more to buy those goods. For instance, in the housing market, bidding more for a house to outbid the next highest bidder. – Michael Aug 24 '15 at 22:28
  • @Michael Agreed. Please feel free to edit. – Dheer Aug 25 '15 at 0:11
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I don't think this can be explained in too simple a manner, but I'll try to keep it simple, organized, and concise.

We need to start with a basic understanding of inflation. Inflation is the devaluing of currency (in this context) over time. It is used to explain that a $1 today is worth more than a $1 tomorrow.

Inflation is explained by straight forward Supply = Demand economics. The value of currency is set at the point where supply (M1 in currency speak) = demand (actual spending). Increasing the supply of currency without increasing the demand will create a surplus of currency and in turn weaken the currency as there is more than is needed (inflation).

Now that we understand what inflation is we can understand how it is created. The US Central Bank has set a target of around 2% for inflation annually. Meaning they aim to introduce 2% of M1 into the economy per year.

This is where the answer gets complicated. M1 (currency) has a far reaching effect on secondary M2+ (credit) currency that can increase or decrease inflation just as much as M1 can...

For example, if you were given $100 (M1) in new money from the Fed you would then deposit that $100 in the bank. The bank would then store 10% (the reserve ratio) in the Fed and lend out $90 (M2) to me on via a personal loan. I would then take that loan and buy a new car. The car dealer will deposit the $90 from my car loan into the bank who would then deposit 10% with The Fed and his bank would lend out $81... And the cycle will repeat...

Any change to the amount of liquid currency (be it M1 or M2+) can cause inflation to increase or decrease. So if a nation decides to reduce its US Dollar Reserves that can inject new currency into the market (although the currency has already been printed it wasn't in the market).

The currency markets aim to profit on currency imbalances and in reality momentary inflation/deflation between currencies.

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Your question asks about the mechanism of money inflation - not price inflation. Money inflation occurs when new money is introduced into an economy. The value of money is subject to supply and demand like other items in the economy. The effects of new money can be difficult to predict. One of the results of additional money can be rising prices. These rising prices can be concentrated in one particular area - stocks, homes, food - or they can be spread out over many items. This is true regardless of the form of money being inflated - gold, silver, or paper money. There were times in history when large discoveries of gold and silver were found that caused prices to rise as a result. Of course, the large discoveries of gold and silver pale in comparison to the gigantic discoveries by central banks of new fiat currency.

  • Can you tell me how exactly introducing new money affects prices? None knows how much money were printed, I suppose. Or at least this is not broadcasted on all corners. – Vladislav Rastrusny Apr 19 '11 at 18:48
  • Prices are affected by how the initial recipients of the new money decide to spend the new money. The prices of the items that are initially purchased with the new money will begin to rise - all other things held constant - as it appears as if there is increased demand for these items. If these items are all of the same type - stock, homes, etc - then the prices of these items will rise more dramatically. Other items will feel the inflationary affect later as the money is spent. – Muro Apr 19 '11 at 19:24
  • Is "money inflation" a correct technical term? – Patience Apr 20 '11 at 2:50
  • @Beatrice I don't know, I'm not a native speaker. My dictionary says, yes, though. – Vladislav Rastrusny Apr 20 '11 at 6:35
  • @Muro how do initial recipients of the new money know that they are ones? I think for them these new money are as good as old money. – Vladislav Rastrusny Apr 20 '11 at 6:47
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An economy produces goods and services and people use money to pay for those goods and services.

Money has value because people believe that they can buy and sell goods and services with it in that economy.

How much the value of money is, is determined by how much money there is in comparison to goods and services (supply and demand).

In most economies it is the job of the federal/national reserve bank to ensure that prices stay stable (ie the relationship of goods and services to how much money there is is stable); as this is necessary for a well running economy.

The federal reserve bank does so by making more (printing, decreasing interest rates) or less (increasing interest rates) available to the economy. To determine how much money needs to be in the economy to keep prices stable is incredibly hard as many factors have an impact:

  • How much does the economy grow/shrink (ie how much more goods and services are there compared to last year).
  • How much money has been removed from the economy (lost, destroyed in accidents, stashed as cash saving under people's pillows, ...)
  • How much money is not available for other reasons? E.g. other economies with unstable currencies might use your currency instead, removing this cash from your economy. Especially a problem for currencies such as US$ or euro which is used as in-official currency in many countries.

If the reserve bank gets it wrong and there is more money compared to goods and services than previous, prices will rise to compensate; this is inflation If it's the other way round is deflation. Since it is commonly regarded that deflation is much more destabilizing to an economy than inflation the reserve banks tend to err on the side of inflation.

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