Inflation, how does it work? Why is it there? Let’s use an an example. Imagine you are on an island and there is a supply of mats and guitars.
The amount of mats and guitars are fairly similar to each other. So you would say, if you want to swap a guitar for a mat, the value would be around one guitar to one mat. Now over time, let’s imagine that making guitars became easier, and the supply of guitars started to increase, much faster than the supply of mats. To the point where there was roughly about three times as many guitars as mats. At this point you could say that the value of guitars compares to mats was three guitars to one mat.
So, the value of guitars have kind of gone downward as the supply of guitars has increased much faster than the supply of mats. Now, money actually, kinda works exactly the same way because money is just swapping a thing for another thing. That thing just happens to be money. If you increase the supply of money, what you will tend to find is that, the value of that money goes down. So inflation is the loss of purchasing power.
How does money supply increase?
How do you increase the supply of money? In most countries you can create money if you are the central bank. Imagine if you’re playing a game of monopoly and you take the money and you photocopy some more and put it back on the board. It does make the headlines if it happens and it has become more common lately.
Confidence and Fear
The other way money increases in supply is through the lending process. So, in terms of banking if you, if you create loans and those loans become new deposits, and that creates further loans. There are other factors though, such as fear and confidence. If you have a whole bunch of people hoarding money, it actually decreases the supply of money. In the same sense, if you have a lot of confidence in the market and everyone’s out there spending, then there’s a lot more money sloshing around. So increasing the supply of money, increases inflation. Effectively, the central bank is really there to make sure that that, increases don’t get catastrophic. Likewise, the decrease in supply also doesn’t become a problem.
