Tuesday, May 22, 2012

Hyperinflation and Expectations

Yesterday, I wrote a piece giving three reasons why I think hyperinflation is unlikely.  Today, I want to add a key point about the subject.

Hyperinflation (or even inflation) is not all about the money supply, when we define it in terms of prices.  Supply and demand affect each individual price in the market.  For the overall general price level, it is affected by just a few things.

First, productivity and technology play a role in the overall price level.  We can see this in the computer and electronic industry today.  You can have falling prices, even in the face of monetary inflation.  In a world with a stable money supply, prices would most likely decline gradually as production increases.

Second, the overall price level is obviously affected by the money supply.  If you increase the money supply, then the overall price level will increase, assuming other factors stay the same.

Third, the overall price level is affected by the banks and lending, particularly in a fractional reserve environment.  Prices will tend to go up with more fractional reserve lending.

Fourth, and this is the main point I wanted to touch on, is that prices are affected by the demand for money.  This is also called velocity, which is the speed at which money changes hands.

The demand for money changes based on people's thoughts and actions.  If people spend more, then velocity will increase (the demand for money goes down) and prices will tend to rise.  If people save more, then prices are not bid up as much and prices will tend not to rise or even go down.

One thing that affects the demand for money is people's expectations.  This ties in with the subject of hyperinflation.  If people expect that the Fed (or any other central bank) will continue to inflate, then people may be more anxious to spend their money quickly before prices go higher.  This can just trigger even more expectations of higher prices and cause them to go up even faster.

In a hyperinflation type environment, the money in use can be destroyed quickly.  Prices will often go up faster than the money supply is increasing due to people's expectations.

On the other hand, prices can also go up slower than monetary inflation.  If people expect that the increasing money supply will slow down, stop, or even go down, then more people are likely to save their money.  This will cause prices to go down, or at least go up slower.

If we hit a scenario where there is high price inflation, the Fed can most likely slow it down very quickly. The Fed just needs to tell everyone that it will stop monetizing debt.  If people believe the statement is credible, then price inflation will most likely slow down quickly.  You could have 50% price inflation go down very quickly if the Fed makes a credible statement that it will halt its increasing of the money supply.

Keep these thoughts in mind, particularly if we hit a scenario of high price inflation.  Things can change quickly, depending on the actions of the Fed and also the actions of millions of people in the marketplace.  Price inflation is not just about the money supply.  It is also about the future expectations of the money supply.

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