The lead story this morning on CBC Newsworld was that inflation in Canada ticks up to 1.6% in December on higher food prices. The explanation given was the cost of imported food in the “consumer’s basket of goods” increased more than the decrease in the price of gasoline.
The CBC journalists and many economists incorrectly use the term “inflation” to describe rising prices. Properly understood inflation is an increase in the money supply. Inflation increases the exchange ratio of money for goods and services. With an increase in the quantity of money relative to the quantity of goods and services, each unit money becomes relatively less scarce. It therefore takes more units of money to actuate an exchange with a seller of a good or service. In other words, the purchasing ability of each dollar falls.
If the money supply and the quantity available of goods and services is constant, it is impossible for all prices to rise simultaneously. As consumer tastes and preferences change, the prices of goods for which consumers’ demand has increased will rise while the prices of goods for which consumers’ demand has decreased will fall.
If the money supply and consumer demand is constant and the quantity available of goods and services increases, the prices of all goods and services will fall. Note that this is not deflation. Rather, it reflects the natural tendency of prices to decrease as technology improves the physical productivity of inputs and gives rise to opportunities for alert entrepreneurs to combine resources in even more effective and efficient ways. In other words, the same number of dollars is chasing an ever increasing amount of goods and services.
If the money supply is constant, the quantity of goods and services is increasing and consumer demand is changing, the prices for goods and services in relatively greater demand will increase while the prices will fall for goods and services in relatively lower demand. However, the purchasing power of each unit of money in circulation has increased. The quantity of money in existence (fixed) is relatively scarcer than the quantity of goods and services (increasing).
It is only when the money supply increases (inflation) and consumer demand and the quantity of goods and services is constant that all prices rise. This is a critical insight. What individuals are actually measuring using the consumer price index are not the causes, but the effects of inflation. And the unfortunate result is misunderstanding and misplaced blame for rising prices.
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