I think I’ve looked up and had explained to me what the term “inflation” is.  The concept has remained a bit of a mystery.  Mark Blyth the Scottish-American (Austerity – The History of a Dangerous Idea) economist parsed down the meaning of inflation to this – “too much money chasing not enough goods in an economy”.  I like that definition as it sticks easily in the mind.  However, without the necessary context, understanding what inflation is remains elusive.

Enter Yanis Varoufakis and his book “Talking to My Daughter About the Economy or, How Capitalism Works – and How it Fails”.  This short quote describes how inflation and deflationary pressures work in an economy – he tells a story based on a famous paper by R.A. Radford titled The Economic Organization of a P.O.W. camp (original linked here).

“The Exchange Value of Money

When I was your age I recall hearing a grown-up saying something I could not get my head around. I just did not get it, however hard I tried. Even when I thought I had understood it, I tried to explain it to a friend and realized that I hadn’t. What was it that this grown-up had said? That a one-thousand-drachma note (the currency we had then) cost only twenty drachmas to produce. How can it be worth a thousand dratchmas, I kept wondering, when it only cost twenty.

Maybe you are smarter than I was, but humour me nevertheless as I attempt to explain this puzzle in the context of Radford’s POW camp. Periodically, the Red Cross Would place a few more cigarettes in the prisoners’ packages but keep the quantity of chocolate, tea, and coffee the same. When extra cigarettes arrived, each cigarette now bought less coffee, less chocolate, and less tea.

Why?

Since overall a larger number of cigarettes now corresponded to the same amount coffee and tea, each individual cigarette corresponded to less coffee and less tea. The opposite also held true: the fewer cigarettes there were in comparison to the other goods that the Red Cross placed in the packages, the great the exchange value, or purchasing power, of each cigarette. In short, the purchasing power of a unit of currency has nothing to do with how much it costs to produce but, rather, its relative abundance or scarcity.

Imagine that a prisoner has been hoarding his cigarettes in order to make a large purchase when suddenly the Red Cross sends tons of cigarettes to the captives. Suddenly, the exchange value or his cigarettes drops, and his parsimony and abstinence have been to no avail.

In this way we see how having access to a currency lubricates transactions to no end, helping the economy move more commodities more quickly. On the other hand, for a currency to function it requires trust and faith: the trust that everyone will continue to accept it in return for any commodity, which is in turn based on faith that the currency’s exchange value will be maintained. It is no coincidence that in your second language, Greek, the word for “coin: (nomisma) straddles the verb “to think” (nomizo) and the noun for “law” (nomos). Indeed, what gives value to coins and paper money is the legal obligation to accept them across the realm and the belief that they are and will remain valuable.

One night Allied Bombers hammered the area where the camp was located. The bombs landed closer and closer, some falling in the camp itself. All night long the prisoners wondered whether they would live to see daybreak. The next day the exchange value of cigarettes had gone through the roof! Why? Because over the course of that endless night, surrounded by exploding bombs and consumed by anxiety, the prisoners had smoked cigarette after cigarette. In the morning the total number of cigarettes had shrunk dramatically in relation to the other goods. If previously five cigarettes had been needed to buy one chocolate bar, now only one cigarette was needed to buy that same bar.

In short, the bombardment had caused what is known as price deflation – a decrease in all prices as a result of a reduction of the quantity of money in relation to all other goods. The opposite, a genderal increase in prices as a larger quantity of money in the overall system, is known as price inflation.”

Talking to My Daughter About the Economy or, How Capitalism Works – and How It Fails. Yanis Varoufakis, pp 142 -144.

 

So, this is how I increased my knowledge of basic economic theory and what I think is a great heuristic tool if you happen to be trying to explain what inflation is and how it works in an economy.  I will need to reread both Blyth’s ( his writing is for the layperson but remains quite dense and meaty, a slow but rewarding go) and Varoufakis’s books again as both were invaluable to understand how our economy works.