by Dr. Roy Cordato
Senior Economist, Emeritas
If the supply of oil goes up, the price of oil and gasoline falls.
If the supply of oranges goes up, the price of oranges and orange juice goes down.
If the supply of computers, televisions, and smart phones increases, the prices of all these products decline.
These are all examples of how the basic laws of supply and demand play out in the marketplace. Extrapolating from this, if you believe that prices generally would decline when the quantity of all goods and services across the economy increases over time, you would be right.
Yet, if one regularly listens to commentators on business networks like Fox or CNBC, you are led to believe that the opposite is true. That is, when expansions occur across the economy at some particularly high rate and there is strong economic growth, they turn this basic relationship on its head and say it will cause prices to rise. We are told that there can be “too much” economic growth and that the economy can “overheat” and this will actually cause inflation. That kind of thinking is a relic of Keynesian economics that is, in fact, nonsense.
The fact is that economic growth, defined as an increase in goods and services throughout the economy, cannot cause inflation, regardless of the strength of that growth. In fact, as suggested above, it is likely to lead to a general decline in prices, thereby making each dollar worth more. The problem is that the Keynesian model, which still permeates the thinking of most business commentators on television, does not define economic growth in this common sense manner, that is, as producing more stuff. Instead, it is defined as a general increase in the demand for goods and services, what’s called “aggregate demand,” and not necessarily an increase in the supply. When economic growth is defined as an increase in the aggregate demand, it is easy to see why talking heads say that “too much” economic growth can cause inflation or a general increase in prices.
But this begs the question. How can people increase their demand for goods and services without producing more? In other words, where does the money come from?
In economics, there is an important principle called Say’s Law, named for the early 19th-century economist, Jean-Baptiste Say. Say’s Law points out that in a market economy the only way people can gain the wherewithal to be a consumer, i.e., to purchase goods and services, is to first be a producer, that is, to provide something that others are willing to pay them for in the marketplace. And to increase their demand for goods and services, their productivity must increase.
So how can aggregate demand outstrip aggregate supply and therefore cause a general rise in prices? This is where the Federal Reserve steps in. The answer is money creation. For well over a decade, the Fed has been pursuing a policy of “easy money.” That’s what the talk of interest rates approaching zero and so-called “quantitative easing” has been all about. As has been said many times, inflation is about too much money chasing too few goods and services. The fears of inflation that is all the chatter among the business commentator class are in fact real. What isn’t real is the explanation that the economy is experiencing (or is expected to experience) too much growth.
Real economic growth featuring across-the board-increases in the quantity of goods and services will restrain any inflation that is anticipated to come our way. This is why the tax cuts that were recently passed are, contrary to the aforementioned commentators schooled in Keynesian economics, actually an antidote to inflation and not a cause of it. These tax cuts were not designed to stimulate aggregate demand but to increase output. That is, they provide incentives to work harder, invest more, and to promote entrepreneurial activity. They are designed to stimulate the production of more stuff that we, as consumers, want. If inflation is a problem of too much money chasing too few goods and services, the kinds of tax cuts that were just passed, along with a less expansionary monetary policy, are exactly what is called for.