Economics for Life – #1: INFLATIONMay 2, 2011
I am not an economist, but I am a voracious reader and I have two courses in Economics in my learning pedigree. At the same time, I have one primary ability: I am good at taking complex subjects and breaking them down into understandable chunks.
During May, I am devoting this space to explaining to my friends and readers the basics of the world economic situation. We are in dire straits, much worse than most people think. We are actually within a decade of total world collapse. Even as I say that, I know most of you will be scoffing. If it was that bad, I would have heard it on Good Morning America, or certainly from someone on Facebook.
So make up your own mind. But how will you do that unless you are well informed.
So to help you understand why we are in such a mess, let me take a week or two to give you the basics of all economic theory. One concept each day for now and then for the rest of the month, I will put it all together into our current situation.
There is a committee in our country called the Federal Reserve. They are in charge of three things. First, they print our money. Second, they set the interest rates that banks pay to get the money that will be circulating as dollar bills. Currently, that interest rate is effectively zero. That means that banks don’t have to pay the Federal Reserve anything for the money they borrow. Then, they lend it out to people, banks, businesses for more than zero.
They make lots of money. Don’t believe me? Look at the profits many of our leading banks are making at the moment. I will address the third thing they are in charge of a few days from now.
But, back to inflation. The Federal Reserve (called “The Fed“) prints money and lends it to big banks for a certain interest rate. The more money the Fed prints and lends out, the more money is in circulation. The more money in circulation, the more inflation.
Wait, Mike. I thought that inflation was prices going up? I mean, the big problem with inflation is when I go to buy a loaf of bread and it costs way more than last month, right?
What you are describing is higher prices. Higher prices are the result of inflation. The word “inflation” means to make something bigger. In Economic terms, inflation is the result of making the money supply bigger. When the Fed prints more money, there is inflation. We associate inflation with higher prices because that is the logical result of printing more money.
Let’s say we’re little kids. You want to ride my bike. I tell you that you can ride my bike if you give me a baseball card. Little kids don’t have many cards, so they are precious. I charge you one card. But in the next couple of weeks, we both get hundreds of baseball cards given to us. They no longer seem that valuable because they are no longer that rare. So the next time you want to ride my bike, I figure “he has more cards now, so I can charge him two cards.” And, because you have more cards, you are willing to part with two cards.
That’s inflation. The inflation of the amount of cards has made the value of each one less. It works the same with the American Economy. The value of any given dollar is measured as a simple math formula. The Gross Domestic Product (GDP) is the value of the entire American economy at any time. The GDP divided by the amount of dollars printed by the Fed is the value of each dollar.
If the GDP doesn’t grow, and we print more dollars, then the value of each dollar goes down. In the past three years, our GDP has not grown very much. But, the Fed during those three years has printed 50% more dollars.
That’s called Inflation. So why aren’t the prices going up?
They are! The Fed plays a little trick on all of us. When they figure inflation, they leave out the cost of food. They leave out the cost of health care. They ignore the cost of interest on debts, the cost of gasoline, the cost of heating oil, the cost of insurance, the cost of renting an apartment. They leave out the cost of college.
What do they measure? Most of the things that get measured are items that rarely change price, or do it slowly. Why? The government has all pensions, Medicare, Social Security indexed. If prices go up, then they have to pay more for all those things.
So they stop measuring things that are going up and tell us we don’t have inflation. But we do. Have you looked at your food bill lately, your health insurance or your gas bill?
That’s because the Fed is printing more money. Next time, we’ll talk about the meaning of Money.