Relationship Between Inflation and Government

The relationship between inflation and the government’s stance on the issue is filled with obscurity and confusion. There have been many conjectures which state that the government is the people’s ally against inflation and wants to prevent it at any cost. At the same time, there have been numerous economic conjectures stating the exact opposite i.e. that the government is not the people’s ally. Rather the government benefits off the inflation that the common man suffers from.

These opposing viewpoints may confuse a new person who is trying to study the subject. Hence, it is important that the debate be addressed and the points for and against the issue be considered before arriving at a conclusion. This article will make an attempt to do the same.

The Myth: Government as Trying to Control Inflation

If newspapers, prescribed economic textbooks and the popular media are to be believed then the government is indeed trying extremely hard to control inflation. It appears as if this is the government’s number one priority and an enormous amount of resources are being spent on taming the inflation problem. Theory has us believe that the government, in co-ordination with the central bank, makes monetary policy decisions i.e. increasing and lowering the interest rates with the intent of providing maximum benefit to the masses.

However, one also needs to consider the result of all these efforts. Countries all over the world have experienced unprecedented inflation in the past century. The United States dollar has lost 94% of its purchasing power in the past century. The other major currencies like Pound Sterling, Euro, Japanese Yen etc. are all reeling under the effect of massive inflation.

Whereas earlier it was possible for one working adult to make enough income to sustain an entire family, nowadays working couples are also finding it extremely difficult to make ends meet!

If the government is indeed spending all these resources on controlling inflation, it is doing a very poor job since the results have been dismal. Inflation has been increasing year on year and the common man finds himself becoming increasingly poor through the ages despite working increasingly harder.

The Reality: Government as the Cause of Inflation

The opposing theory states that the government is actually the cause of inflation. The study is not accepted by the mainstream economists however it provides accurate empirical evidence to prove its point. Studies have shown that inflation was nonexistent or very less in ancient societies wherein the government did not have the exclusive right to coin money and regulate its value. As and when government interference in the monetary system increased, so did the inflation. To have a better understanding of this point, let’s consider the following case:

Inflation: Impossibility Without Government Involvement

Let’s say that there were only $100 present in the economy and this $100 was spent equally on purchasing four types of goods viz. A, B, C and D. That would make $25 available for the consumption of each good.

Now, if there was inflation in the price of good A, let’s say the economy has to spend $30 on good A but the total amount of money in the system remains at $100, people would be forced to cut back the consumption of B, C or D goods to compensate for the rise in A.

This means that good A will experience inflation. However, the other goods will experience deflation of the same magnitude and the economy as a whole would remain unaffected.

The point being made here is that the prices of all the goods in the economy can rise simultaneously only and only under one circumstance i.e. the creation of more money. If the money available in the system increases from $100 to $120, the prices of all the goods will increase simultaneously. This is the situation today and this is what we commonly refer to as inflation.

The Real Cause: Increase in Quantity of Money

Now, since we have ascertained that increase in the quantity of money is the root cause of inflation, the next question obviously arises, who controls this quantity of money creation? The answer to this question is that the government does!

Hence, while in the newspapers and magazines, you may read that the government is trying to control inflation the reality is that they are the only ones who have the power to create it in the first place! Hence it would be apt to say that the government itself is creating the inflation and later creating the illusion that it is trying to fight it.

Obviously, this is an oversimplification. There are other factors at play too, like the concept of velocity of money as propounded by eminent economist Dr Milton Friedman which is not exactly in government control. But for the most part, the government does have a massive role to play in creating inflation.

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Managerial Economics