For government institutions tasked with ‘officially’ collecting the numbers, let alone for people trying to buy their daily essentials, understanding and monitoring inflation is difficult. One ‘fallacy’ regarding inflation seeping through the gaps has been recognized by economists, but it’s actually a handy rule of thumb for common people.
The inflation fallacy is the mistaken belief that a rise in prices equals a loss in purchasing power. Many economists argue that every purchase represents the income of someone else, so this can’t be accurate. It is, nonetheless, a sensible rule of thumb for anyone living on a salary.
This mistake continues because it conceals an unpleasant truth about inflation. When we look at the economy as a whole, we can see that every dollar spent represents someone else’s income. This, however, falls short of understanding how inflation truly works in the real world. Unfortunately, the current structure of inflation has a significant impact on society’s winners and losers.
What is a good illustration of the inflation fallacy?
The inflation fallacy is a fallacy that claims inflation is bad. Now and again, a false conclusion can emerge from an incorrect argument. Perhaps inflation is a bad thing. Perhaps inflation lowers our real incomes. However, it is still a fallacious argument. It provides no compelling evidence that inflation is harmful or affects our real incomes.
The inflation fallacy is often believed by non-economists. I’m an expert in non-economists’ perspectives on economics. That’s because I’ve been attempting to teach non-economists how to think about economics for the past 30 years.
“So, why is inflation a bad thing?” I’ll ask my ECON1000 students somewhere in February.
I can see their expressions coming. Some will give me that sympathetic look, which is usually reserved for folks who aren’t very bright. Others would assume this is a trick question, because I wouldn’t ask anything so clear. Finally, someone will respond.
“Because if all prices increase by 10%, we will only be able to afford to buy 10% less. Duh!” Except the “Duh!” is deafeningly quiet.
You could try to dispute the inflation myth by bringing up the concept of monetary neutrality. However, this is the incorrect method. Sure, if money is neutral and has no effect on real variables like real income, the inflation fallacy’s conclusion is wrong. That, however, is missing the point. The inflation fallacy is an error in logic. It is logically and philosophically perplexing. Even if the conclusion were correct, the argument would still be incorrect. Even if inflation did cause real incomes to decrease, the inflation fallacy would not be a good reason to believe that inflation would cause real incomes to fall.
Apples purchased must be equivalent to apples sold. What is an expense for the apple customer is a source of income for the apple vendor. The customer is $1 poorer and the seller is $1 richer for every $1 increase in the price of an apple. That holds true whether we buy and sell a single apple or a billion apples. Whether we include bananas, carrots, dates, or eggs, this is true. It holds true whether all prices increase by the same amount (or percentage), or by different amounts. It holds true whether we use money, gold, or venus dust to calculate pricing.
It’s just as reasonable to say that a 10% increase in pricing is a positive thing because it means we’ll earn 10% more money from selling goods and so be able to buy 10% more stuff. Let’s refer to this as the inflation fallacy number two. It is the polar opposite of the first inflation fallacy.
Why is it that the inflation fallacy mark 1 is so widely used, yet the inflation fallacy mark 2 is so uncommon? I’m not sure, but I’ll make some educated guesses.
1. We live in a specialisation and division of labor-based economy. We sell one item and purchase hundreds of others. Naturally, we know a lot more about the one product we offer than we do about the hundreds of products we buy. We are aware of the forces that influence the pricing of the one product we sell. We have no idea what forces affect the prices of the hundreds of items we purchase. So we coined the term “inflation” to describe our ignorance.
The term “inflation” refers to a rise in the cost of the items we buy. The cost of the product we sell is established in a unique method. As a result, if we think in this way, inflation will seem to make us worse off.
Inflation occurs when others raise their prices, not when I raise mine.
2. The majority of us get money by selling our labor. And we believe that others are similar to ourselves. We think of ourselves when we think of the representative person. The cost of labor has a unique term in our culture. We don’t refer to it as a “price,” but rather as a “wage.” And we conceive of inflation in terms of price increases rather than pay increases. We believe that inflation reduces real wages and makes people worse off since there is no evident one-to-one relationship between price and wage inflation, and we know that wages rise faster or slower than prices at times. Even if it did, we must remember that capitalists are also individuals. They are referred to as “the other.”
If apples were removed from the CPI and given a unique name, “inflation” would be defined as a rise in the price of bananas, carrots, and dates. As a result, we apple dealers are harmed by inflation.
The inflation fallacy is a logical error. It’s a compositional fallacy. It fails to recognize that the axiom “inflation is someone else’s price increase, not mine” does not hold true at the macro level, when all the buyers and sellers are added together. It’s a fallacy of someone who hasn’t encountered the accounting identity “revenue = spending.” It’s a fallacy of someone who doesn’t understand that production, not how much we pay each other, is the ultimate source of our collective income and expenditure.
It’s a fallacy I don’t think we’ll ever be able to get rid of. “Ours is an endless mission,” says the narrator once more.
I sympathize with those Austrians who define “inflation” as a rise in the money supply rather than a rise in prices. However, it is ineffective since both the demand for and supply of money can fluctuate. Even if you prevent them from using the term “inflation,” people will find another way to discuss rising costs. I also sympathize with Scott Sumner’s strategy of attempting to outlaw the usage of the “i-word” in favor of NGDP.
Because it’s a ridiculous question to ask, “Is inflation a good or negative thing?” It does not have a response. Inflation is a naturally occurring variable. It is dependent on the cause. If a harvest failure is the cause of inflation, we will be worse off. But it is not inflation that makes us poorer; it is the failure of the harvest. Our actual income is also reduced as a result of lower goods output. Inflation is merely a symptom of a larger problem. If we weren’t personally involved in the harvest, this is how a bad harvest will present itself to us.
The proper method to ask the question is to bring up the subject of monetary policy. Would the Bank of Canada’s 0 percent or 4 percent inflation targets make us better or worse off than the existing 2 percent inflation target? That’s when we may start debating the neutrality or non-neutrality of money, rather just accounting identities (strictly, super-neutrality of money).
It would also improve people’s minds if we could talk about the effects of a dropping value of money rather than a growing price of items. When we talk about the value of money declining, we’re implying that we’ll obtain more money for the items we sell and give up more money for the goods we buy. It leads us to consider both forms of the inflation fallacy mark 1 and mark 2 at the same time and observe how they balance each other out. Then, and only then, can we begin to consider the true issue.
Surprisingly, the existence of the inflation fallacy as a sociological phenomenon may be one of the greatest solid arguments against setting too high an inflation rate. The fact that so many regular people are perplexed by inflation suggests that it may be harmful.
What is the fallacy of inflation?
Because everyone’s spending is another person’s income, the inflation ‘fallacy’ is a fallacy. Inflation, on the other hand, is reducing the purchasing power of most wage and salary earners’ income and savings.
What are three instances of inflation?
Demand-pull Inflation happens when the demand for goods or services outnumbers the capacity to supply them. Price appreciation is caused by a mismatch between supply and demand (a shortage).
Cost-push Inflation happens when the cost of goods and services rises. The price of the product rises as the price of the inputs (labour, raw materials, etc.) rises.
Built-in Inflation is the result of the expectation of future inflation. Price increases lead to greater earnings in order to cover the increasing cost of living. As a result, high wages raise the cost of production, which has an impact on product pricing. As a result, the circle continues.
What exactly is the problem with inflation?
- Inflation, or the gradual increase in the price of goods and services over time, has a variety of positive and negative consequences.
- Inflation reduces purchasing power, or the amount of something that can be bought with money.
- Because inflation reduces the purchasing power of currency, customers are encouraged to spend and store up on products that depreciate more slowly.
What is the Fisher effect?
The Fisher Effect, coined by economist Irving Fisher, describes the relationship between inflation and both real and nominal interest rates. The real interest rate is equal to the nominal interest rate minus the predicted inflation rate, according to the Fisher Effect. As a result, unless nominal rates rise at the same rate as inflation, real interest rates fall as inflation rises.
What exactly is inflation?
Inflation is defined as the rate at which prices rise over time. Inflation is usually defined as a wide measure of price increases or increases in the cost of living in a country.
Why is inflation so expensive?
Sustained inflation at a rate higher than Bernanke’s ideal long-run inflation rate can stifle economic growth through a variety of processes. One is the monetary cost of inflation, which comes as a result of inflation degrading the purchase power of money, resulting in increased costs for people and businesses to maintain their money balances. Many authors have claimed that such expenses are insignificant. However, Michael Dotsey and Peter Ireland design an example in which the combined impact of a number of modest expenditures is significant. 1 Other experts suggest that the costs of inflation appear low because standard models aren’t rich enough to capture all of the expenses. Otmar Issing, a member of the European Central Bank’s executive board and a former official of Germany’s central bank (the Bundesbank), has claimed that economists’ estimations of the costs of continuous inflation are shaky since they are dependent on model parameters. 2 As an example, he claims that inflation perplexes households and businesses as they try to separate changes in relative prices from changes in the overall price level and distinguish temporary from permanent price changesbut such costs are rarely included in models.
In economics, how much does shoe leather cost?
In a metaphorical sense, the cost of shoe leather is the time and effort (or opportunity costs of time and effort) that people expend by holding less currency in order to lower the inflation tax they pay on cash holdings when inflation is high. These expenses include making multiple bank trips, not being able to make change, and being unable to make unexpected expenditures. The name stems from the fact that going to the bank and getting cash and spending it requires more walking (historically, though the introduction of the Internet has reduced this), thus wearing out shoes more quickly. The additional time and convenience that must be sacrificed to keep less money on hand than would be required if there were less or no inflation is a substantial cost of reducing money holdings.
When the Fed sells government bonds to reduce the money supply, what is it doing?
When the Fed buys bonds on the open market, it expands the economy’s money supply by exchanging bonds for cash to the general public. When the Fed sells bonds, it reduces the money supply by taking cash out of the economy and replacing it with bonds. As a result, OMO has a direct influence on the money supply. OMO has an impact on interest rates because when the Fed buys bonds, prices rise and interest rates fall; when the Fed sells bonds, prices fall and rates rise.
What are the four factors that contribute to inflation?
Inflation is a significant factor in the economy that affects everyone’s finances. Here’s an in-depth look at the five primary reasons of this economic phenomenon so you can comprehend it better.
Growing Economy
Unemployment falls and salaries normally rise in a developing or expanding economy. As a result, more people have more money in their pockets, which they are ready to spend on both luxuries and necessities. This increased demand allows suppliers to raise prices, which leads to more jobs, which leads to more money in circulation, and so on.
In this setting, inflation is viewed as beneficial. The Federal Reserve does, in fact, favor inflation since it is a sign of a healthy economy. The Fed, on the other hand, wants only a small amount of inflation, aiming for a core inflation rate of 2% annually. Many economists concur, estimating yearly inflation to be between 2% and 3%, as measured by the consumer price index. They consider this a good increase as long as it does not significantly surpass the economy’s growth as measured by GDP (GDP).
Demand-pull inflation is defined as a rise in consumer expenditure and demand as a result of an expanding economy.
Expansion of the Money Supply
Demand-pull inflation can also be fueled by a larger money supply. This occurs when the Fed issues money at a faster rate than the economy’s growth rate. Demand rises as more money circulates, and prices rise in response.
Another way to look at it is as follows: Consider a web-based auction. The bigger the number of bids (or the amount of money invested in an object), the higher the price. Remember that money is worth whatever we consider important enough to swap it for.
Government Regulation
The government has the power to enact new regulations or tariffs that make it more expensive for businesses to manufacture or import goods. They pass on the additional costs to customers in the form of higher prices. Cost-push inflation arises as a result of this.
Managing the National Debt
When the national debt becomes unmanageable, the government has two options. One option is to increase taxes in order to make debt payments. If corporation taxes are raised, companies will most likely pass the cost on to consumers in the form of increased pricing. This is a different type of cost-push inflation situation.
The government’s second alternative is to print more money, of course. As previously stated, this can lead to demand-pull inflation. As a result, if the government applies both techniques to address the national debt, demand-pull and cost-push inflation may be affected.
Exchange Rate Changes
When the US dollar’s value falls in relation to other currencies, it loses purchasing power. In other words, imported goods which account for the vast bulk of consumer goods purchased in the United States become more expensive to purchase. Their price rises. The resulting inflation is known as cost-push inflation.