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2014-03-06 10.33.49Recently, a friend asked me for an explanation of inflation. Her children were asking about the minimum wage, and they wanted to know why prices had to go up, and she was stumped. Here’s an explanation; you can decide if it is simple enough.

First, economists talk about “real” prices and “real” wages, which would be prices without any inflation. If the effect of inflation is included, then the term is “nominal” prices or “nominal” wages. The Bureau of Labor Statistics has a little calculator you can use to compare prices for different years. It shows how inflation changed the value of goods and services over time.

Prices increase over time for lots of reasons, and a large part of the field of economics research on why this happens. At a simple level, banks create money when they lend it out. If you depost $100, the bank will keep a percentage on deposit to meet withdrawals and then lend the rest out. So you deposit $100 and then the bank loans someone else $90. You have $100, the borrower has $90, et viola! The amount of money flowing through the economy has grown from $100 to $190.

Now, the quantity theory of money says that the total amount of money in the economy divided by the total amount of stuff in the economy equals the average price. This is a gross simplification, but that’s okay. If the amount of money in the economy increases but the amount of stuff produced does not, then prices go up. If the person who borrows the $90 uses it in productive ways, then the amount of stuff will go up along with the amount of money, and everyone is happy. And if the amount of money goes up before the new stuff is produced, then prices go up a little bit while we wait – which means a little bit of inflation. That’s not necessarily a bad thing.

If you have a huge increase in money and no increase in stuff, or even a decrease in stuff, you end up with hyperinflation. Hyperinflation is bad, and it is almost always the result of a government failure. In Germany after WWI, the government printed money in order to meet the reparations demanded by the victorious nations. In Zimbabwe in 2008, the government started printing money to meet all its various international debts, pay its bills despite economic sanctions, and spend money like crazy. The result was hyperinflation that would be comical if real people were not affected.

Hyperinflation is not good. No way, no how.

The other end of the spectrum is deflation, which is a decline in prices – including a negative price of money. With interest rates so low that banks are talking about adding service charges on deposit accounts, you have deflation in at least some sectors of the economy. Deflation seems like a good idea – falling prices! – but it’s not. The benefits of lower-priced consumer goods are offset by other falling prices, such as wage rates and residential real estate. Consumers wait to buy things in the hope that either prices will fall further or that they will eventually receive a raise; businesses are afraid to invest because they don’t know when consumers will be buying. John Maynard Keynes described the sluggishness as “pushing on a string.”

Deflation is not as destructive as hyperinflation, but it is not good.

Deflation can take place if an economy doesn’t have enough money. For example, if a currency is on a gold standard, then the amount of money that can be issued is limited by the amount of gold that a country has. The amount of money is fixed, so prices fall as the amount of goods produced goes up. A country can go out and find more gold (a big driver for European exploration back in the 16th century), or it can suffer. The U.S. kept its currency tied to silver or to gold until after the Civil War. It went off the gold standard and printed money to pay for debts incurred in the war, then went back on it to curb high inflation. When the government went back on the gold standard, farmers watched prices for their crops fall – because, of course, the amount of money was fixed even as the amount of stuff produced increased. This led to a campaign for a bi-metal standard, using both gold and silver, a movement championed by presidential candidate William Jennings Bryan, known for his “Cross of Gold” speech given at the 1896 Democratic National Convention.

Bryan failed, and the U.S. stayed on a pure gold standard until 1933. It gradually eased off and by 1972, all of our currency became fiat money. That’s a term for money that essentially has value because we say it does; given the military capabilities of the U.S. government, we can force value.

One of the attractions of bitcoin is that only a limited amount of the currency can be produced, which means that it won’t create inflation but could lead to deflation. It is backed by the faith and credit of its users, which is not the same as the faith and credit of the U.S. government – or any government, for that matter.

Now, getting back to the original question – what does this mean for the minimum wage? It means that every time prices go up, the pay the worker receives buys less stuff.

Inflation isn’t going away. Low, stable inflation is not a bad thing, although many people find that hard to believe. A little inflation is the result of a growing economy, and that’s good – but only if wages keep pace.