Inflation 101

Inflation, Taxes, and Economy Blog Headlines

Written by Brian Farmer

Wednesday, 07 May 2008 13:03

We are witnessing an increasing number of news reports these days highlighting the skyrocketing prices of gasoline, foodstuffs, and other commodities. Some analysts are predicting that we may be returning to a time of high inflation, similar to what we experienced during the late 1970s. Inflation is particularly hard on those with low incomes but it is beneficial to the politicians and to the bankers.

In any discussion of inflation, it helps to make sure that we have a mutual understanding of what we are talking about, by starting with a definition. The dictionary defines inflation as “an increase in the volume of money relative to available goods and services, resulting in a substantial and continuing rise in the general price level and a reduction in the purchasing power of the currency.” The key concept here is that inflation is exclusively a monetary phenomenon and that rising prices are simply a symptom of inflation.

On the other hand, one must be careful to remember that rising prices in some segments of the economy do not necessarily indicate the existence of inflation. Prices can also rise due to a supply shortage of a good or service, relative to the demand for it. For example, the price of crude oil doubling over the past year does not mean that the amount of money has doubled. All it means is that people around the world wanted to buy more crude oil than was immediately available. When the demand for a good or service exceeds the supply, prices rise and prices continue to rise until supply attains equilibrium with demand.

Conversely, house prices have been falling for many months; does that mean that the money supply is shrinking (deflation)? Again, not necessarily. In this case, falling house prices are simply marking the end of a debt-financed speculative mania in the real estate market.

Now that we have an understanding of what inflation is, we also need to have an understanding of what “money supply” means. The definitions that economists and the government use range from narrow to broad, as follows:

M0 is physical currency, namely, all cash held in banks and circulating in the economy.
M1 is M0 plus all demand deposits, which are commonly referred to as checking accounts.
M2 is M1 plus all individual savings accounts, money market accounts, and small certificates of deposit (less than $100,000).
M3 is M2 plus all large certificates of deposit, institutional money market mutual fund balances, eurodollars (U.S. dollars deposited in banks outside the United States), and repurchase agreements (short-term loans — normally for less than two weeks and often for as little as one day).

The different forms of money in government money supply statistics arise from the practice of fractional-reserve banking, in which banks are required to keep only a fraction of their deposits in reserve, with the choice of lending out the remainder, while still operating under the obligation to redeem all deposits upon demand. The Federal Reserve gives the following summary explaining why fractional-reserve banking is used and what its effects are:

The fact that banks are required to keep on hand only a fraction of the funds deposited with them is a function of the banking business. Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money. If banks did not lend out their available funds after meeting their reserve requirements, depositors might have to pay banks to provide safekeeping services for their money. For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to “create” money.

Of course, if all of the depositors of a bank tried to withdraw all of the money in their accounts at the same time, the bank would be in trouble, but this rarely happens. In the rare event that it does happen, a bank can arrange to obtain additional funding from other banks, including the Federal Reserve. Fractional-reserve banking works because:

Withdrawals are usually offset by new deposits.
Only a tiny minority of people will actually choose to withdraw all their money at any given time.
People usually keep their funds in the bank for a long period of time.
There are usually enough cash reserves in the bank to handle occasions when withdrawals exceed new deposits.

The process of fractional-reserve banking leads to a cumulative effect of money creation by commercial banks. This occurs, because the banks are permitted by the Federal Reserve to hold only a small fraction of their deposits in reserve (as little as ten percent). So, for example, if a bank receives $10,000 in deposits, it only needs to keep $1,000 on hand as reserves, which means that the remaining $9,000 are available for lending. That $9,000 moves out into the economy as loans, but eventually works its way back into the banking system as deposits. The process now repeats, with ten percent of the $9,000 (that is, $900) becoming reserves, allowing the remaining $8,100 to be used for lending. This process repeats itself over and over until it reaches its maximum effect, which is that the total amount of money created can be up to ten times the amount of the original deposit.

Now that we have defined the key terms and explained the functional details, we are ready to move on and show how the politicians and the bankers, thanks to the actions of the Federal Reserve, financially exploit the American people in defiance of the U.S. Constitution.

To be continued…

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Author of this article: Brian Farmer

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