How inflation works

Gary Rabbior is the president of the Canadian Foundation for Economic Education. This is the second of a six-part series on understanding how the economy works and why it matters to investors.

To explore the relationship between money, monetary conditions, and the economy, let's use an analogy. Specifically, let's use a game we'll invent and call "Auction Block."

The Auction Block Game

The purpose of the game is for each player to try to accumulate as much wealth as possible. Each player is given $10,000 at the start of the game.

Players roll dice and move around a game board. The game board is made up of a series of pictures of items for sale. When a player lands on an item, a card with a picture of that item is placed on the "Auction Block." Players then bid for the item, and the item (and the card) go to the highest bidder.

There are also squares on the board titled "News and Information." The player landing on one of these squares is made aware of some piece of news or information that may ultimately affect the market price of a particular item on the game board. Other players will not have access to that information. As each player accumulates more knowledge, the bidding activity of the players will be affected. At the end of the game, the actual current market price of each item (reflecting news that was shared with players throughout the game) will be revealed. Players will then calculate the dollar value of the wealth they have accumulated and the player with the most wealth is the winner.

Therefore, it may work out that a player pays more for an item than it is ultimately worth since they may not have received information in the game that affected its value. Or a player may have paid less. Everything will depend on the bidding activity, players' access to and interpretations of information, and the effects of market events.

For our purpose, we are going to assume that there are five games of Auction Block taking place simultaneously involving five different groups of players in five different rooms. This will enable us to learn about how the amount of money affects the game - and the "Auction Block" economy. In this article, we will examine the games going on in Rooms #1 and #2. We will look at the games in the other three rooms in the next article.

In Room #1, the game is being played in the manner just described.

In Room #2, however, we'll make one change to our Auction Block game: we'll double the amount of money that each player receives at the outset of the game from $10,000 to $20,000.

If we were to observe the game in Room #1 and compare it with the game in Room #2, what would we likely see as the impact of doubling the quantity of money? To answer this question we need to ask ourselves the following: Can more items be purchased from the Auction Block with the higher quantity of money available for spending? The answer is no. Why? Because there has been no increase in the number of items available in the game for purchase. We doubled the amount of money, but we did not increase the number of items available for purchase.

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As a result, players are likely spending more in Room #2, but only because prices are being bid up because they have more money to buy the same "stuff." With twice as much money to spend - but without any additional things to buy - prices in the game in Room #2 will probably double.

But are the players in Room #2 - with twice as much money - any better off, as a group, than those in Room #1? Again the answer is no. Why - because the same items are acquired by the players in both rooms in both games. The only difference is that the players in Room #2 acquire their items by paying higher prices. The players in Room #2 may have been better off in money terms (having $20,000 versus $10,000) but they are no better off in real terms since they are not able to acquire anything more than those in Room #1.

What difference does the additional money make in the game in Room #2? It raises the average price level.

Prices

There are many prices for the many goods and services produced in our economy. And, over time, some prices rise while others decline or stay the same. What economists and policymakers are concerned with are changes in the general or average level of prices. That is, are prices, on average, rising or falling? If the extent of price increases is greater than the decreases, then the average level of prices in the economy will rise. This is "inflation." That is, inflation occurs when there is an increase in the average price level in the economy over a sustained period of time.

From here on, in these articles, we will refer to changes in the average price level, or simply price level, in the economy. If we state that the price level is higher, we mean that the average level of prices at which goods and services are being exchanged in the economy is higher than in the previous period. If the rise continues over a period of time, then inflation is occurring in the economy.

In our Auction Block game, doubling the quantity of money in Room #2 only served to double the prices being bid over those being bid in Room #1. The average price level increased and caused inflation. At the same time, the players are no better off in real terms since it was impossible for players in Room #2 to acquire more items even with their additional money. There simply isn't anything else to buy, and the additional money only serves to push up prices.

Money is a medium of exchange in our economy and is used to acquire the goods and services that are produced. If we don't produce more, but increase the amount of money, we simply get inflation. However, if we can produce more, and create more wealth, then the amount of money can be increased. In fact, the economy will need more money to enable the additional goods and services to be purchased. But that is the focus of the next article in this series -- where we will look in on what's going on in the games in Rooms #3, 4, and 5.