#010: What is Inflation and What Causes It?

A top post on Reddit captures how confused most people are about inflation. The opinion of this reddit user, is the same opinion as most mainstream economists and the corporate media today – that inflation is a requirement for the modern economy to function. The reddit user writes:

“[The opposite of inflation] is deflation, which we have learned is actually really bad for the economy, because if your money is worth more tomorrow or next year, you are much less likely to spend it today.”

– Reddit user (r/explainlikeimfive)

This mainstream view suggests that by gradually increasing the # of dollars in circulation, we keep prices stable, which is fundamental for our economy to thrive.

But is this true? Let’s begin by understanding what inflation is.

What is Inflation?

Imagine a small, deserted island economy of 2 people. Let’s call it Inflation Island.

The two people on the island have $10 each, so there is a total of $20 in the economy. Now, imagine that Person A has a coconut that Person B wants, and that this coconut is scarce (not common) on this island.

Let’s say Person B is willing to pay $1 for that coconut. There are likely other coconuts on the island, but because the coconuts are scarce, Person B is willing to pay 10% of all their money for the fruit.

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Now, let’s imagine instead that each person has $100. There is now a total of $200 circulating in the economy. However, the coconut is still just as scarce.

If nothing else changes, Person B is still willing to pay 10% of their money for the coconut. That means, the price of the coconut is now $10, and Person A would no longer accept only $1.

The price of the coconut has increased due to inflation – because there is more money chasing the same amount of goods.

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An alternative scenario is if we imagine that this is the last coconut on the island. In this scenario, Person B might be willing to part with all of his/her money for the coconut.

The price of the coconut has increased due to inflation – this time because there is the same amount of money chasing fewer goods.

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Inflation is easy to understand we are studying 2 people on an island. In our next post, we’re going to build on our understanding to better understand how inflation works in the global economy.

Because inflation ultimately means that your money is worth less and less over time. And that should scare you.

To your prosperity,
Wealth Potion