Inflation and deflation

One of my side interests is in economics. I am not formally trained in this field, but due to my engineering mathematical background, understanding the concepts are simple. There are many schools of thought on economics including the Chicago, Keynesian, and Neoclassical. I tend to lean towards the Austrian school of thought. This post provides background to a key topic among those interested in this field, specifically what is inflation and deflation. This post will later be followed up with a hotly debated topic, will the US face inflation or deflation over the next few years.

First, we are going to define what is the basis of economics, currency (money) and credit. Currency is a barter exchange medium within a state. It allows individuals to purchase items without the requirement of a specific barter item a retailer may desire. It is much easier to fill a cash register than to have stores of bulky commodities like grain for each transaction. Modern fiat money has not intrinsic value except what is backed by the government of issue. Fiat money in circulation is measured in many ways as M0, M1, and M2. Since M0 is the representation of physical, printed currency and is a small percentage of money available, the majority of existing money is nothing more than 1s and 0s on a bank's computer.

Credit is a loan from a banking entity (creditor) to a debtor. It is an IOU that is paid back to the creditor plus interest over a specified period of time. Credit behaves in a similar manner within the economy as actual money.

The amount of effective money (EM) flowing within an economy depends on the monetary base (MC) in circulation and credit (CR):
EM = MC + CR.

Second, in modern economies central banks (CB) control the EM through many means. The central bank for the USA is known as the Federal Reserve. They can create money out of thin air or withdraw money from the system. It is fiat money so they do not have to back it with solid assets, just the promise of the backing government. The most common means for CBs to manipulate the EM is through monetary creation (printing money) and interest rates. Interest rate increases discourages credit and decreasing interest rates increases credit availability. One other factor to note is it has been demonstrated that often commercial banks lend to customers before CBs create money. The CBs will increase the amount of currency accordingly later.

Third, I am going to define inflation and deflation. Most people have experience with inflation. We all hear stories of our parents buying nickel cokes and gas a quarter per gallon. Inflation has increased the value of these items. You dollar buys less, thus, inflation means the currency is losing relative value. The exact opposite is deflation with the currency gaining relative value. There are many causes of inflation and deflation. The issue I am going to tackle here has to do with effective money moving through the economy. If the supply of EM increases significantly, it has less value and inflation is the result. If EM contracts significantly, deflation occurs.

This has been an introduction to inflation/deflation. As early stated, the next post will cover the predicament the US will face over the next few years.