What Causes Inflation?

by John | Jul 31, 2016 | Geopolitical Risk Protection, Liquidity, Preservation of Purchasing Power

I remember hearing about inflation as a kid and I remember asking “Why are my savings worth less each year?” What I was really asking was “What causes inflation?”

I might have gotten an answer about rising prices or more dollars in circulation but I didn’t understand. When I got older I did my own research and now understand the mechanics and causes of inflation.

Today I Explain What Causes Inflation

But before I do I want to make sure we’re on the same page regarding what Inflation is.

Inflation and Price Inflation are often used interchangeably, but it makes more sense to separate them out because one is the cause and the other is the effect.

Let’s define some terms:

Inflation: An increase in the money supply. An increase in the money supply is a fancy way of saying there are more dollars in existence than before.

Price Inflation: Rising prices as result of an increase in the money supply.

Inflating the money supply causes rising prices

An Example of the Effects of Inflation

Imagine everyone woke up one morning to find their bank account balances had doubled. The money supply had been inflated by a factor of 2!

Some people would choose to buy goods and services with their new-found “wealth”. But there aren’t more goods and services in the economy. Thus, consumers will bid up prices.

Basic laws of economics tell us that when demand increases and supply does not, prices rise.

Prices would then be higher as a result of the increase in the money supply in what is properly called Price Inflation.

What Causes Inflation?

Inflation is caused by creating new dollars. But who is creating these new dollars and how do they do it?

New dollars are created by banks.

The main bank responsible for inflation is the US Federal Reserve. But virtually all other banks also cause inflation via Fractional Reserve Banking.

The Federal Reserve Inflates the Money Supply

The US government spends much more than it brings in via taxes. To make up the difference the US treasury borrows money by issuing debt in the form of bonds.

This debt, these bonds, are then bought by investors, foreign governments, pension funds, and the central bank of the United States called the Federal Reserve.

If the debt was purchased with existing money this would not be inflationary. However, the US Federal Reserve conjures money out of thin air to buy US bonds. How do they conjure money?

They simply create deposits in the Federal Reserve accounts. Imagine if you could go into your bank account and type in that you now had 1 million more dollars. You’d be creating money out of thin air! That is what the Federal Reserve does.

The Fed has inflated the money supply. The Fed caused inflation by creating new dollars.

Using this this freshly minted money the Fed buys US government bonds. The US government then takes the dollars it got from the bonds it sold and spends it on tanks, government employee salaries, national parks, welfare, social security payments, you name it.

This new money that was created out of thin air by the Fed flows through the government into the economy and bids up the prices of goods and services for everyone else.

This resultant rise in prices is one of the effects of inflation.

A Second Cause of Inflation: Fractional Reserve Banking

Another cause of inflation is fraction reserve banking.

Fractional reserve banking means that banks do not have to keep all of their depositor’s funds available for withdrawal. Banks only have to keep a fraction (or portion) of their clients funds in reserve.

When you despot $100 into your checking account it doesn’t go into a vault and sit there. The bank loans that money out to other people or uses it to buy stocks, or bonds, or other investments.

Now banks aren’t allowed to loan out and invest all of their depositors money. After all, if you were to go to an ATM, you need to be able to withdraw cash, or when you write a check to pay your mortgage, the bank needs to send that money to your landlady.

Banks estimate how much money people will spend and withdraw over a given time and they keep that amount in reserve.

There are also regulations in place that dictate the amount of liquid dollars a bank must have in reserve. This is known as the reserve requirement. The reserve requirement is set by the Fed.

If the reserve requirement is 10%, that means that for every $100 in deposits, a bank can loan out $90. So, if you deposit a $100 bill into your checking account, the bank will loan out $90.

The person who received that $90 might spend it on a new pair of shoes. So they give $90 to the cobbler (shoemaker). The cobbler then deposits the $90 back into the bank, which can then be loaned out again. So the bank could make an additional $81 loan. This process repeats itself again and again and that $100 deposit, with a 10% reserve requirement, could become nearly $900 floating around the economy with only $100 in reserves in the bank.

So that little $100 bill has now become $1,000.

If you’re a more visual person you can check out this handy fractional reserve calculator.

So by not holding 100% of deposits in reserve, banks increase the money supply and cause inflation.

Do you have a better understanding of Inflation now?

The actions of the Federal Reserve and Banks cause inflation. I personally don’t like that my dollars are worth less each year because banks only hold fractional reserves and because the Fed prints money out of thin air.

This knowledge has led me to hold some money in gold. Unlike dollars banks can’t create gold by typing in numbers into a computer.

It also goes to show that if everyone were to try to withdraw their money from the bank at once the system would collapse. Don’t count on the FDIC, which is supposed to back up the banks, because it is undercapitalized. This knowledge leads me to hold some money in physical cash.

As I mentioned in a previous article the increase in money supply has caused dollars to be worth half a much since the year 2000.

Another one of the effects of inflation is the creation of bubbles (like the housing bubble of 2008) and the misallocation of resources. But that is a topic for another article.