It is not increasing prices, that is the effect of the cause.
The cause is an increase in the amount of money in the system.
If you think of prices as ratios eg. a kilo bag of potatoes cost a certain number of dollars.
Prices are signals, signals of demand and supply.
Recently Australian bananas have been really expensive due to a couple of reasons
- Cyclone destroyed a large growing region in North Queensland.
- Imports are restricted due to quarantine requirements.
OK, so what is inflation, and what does banana prices have to do with the increase in prices of a whole swag of goods and services. Prices are still ratios so something has happened to either the supply of goods and services, or the supply of money on the other hand.
There is a increase in the money in the system (monetary inflation) which is causes the same or fewer goods to increase in price.
Where is this money coming from? it is happening because there is a demand for money which the Reserve Bank of Australia (RBA) is supplying to maintain its monetary policy (the interest rate).
Australia doesn't live in a closed world, we are affected by other countries demand for our goods as well. Hence when China, Japan, South Korea, Europe and the US want our commodities they will bid the price up, sending the signal that supply is restricted. This leads to a long chain of price signaling all the way through the supply chain.
Why is there such as demand for money at the moment. The RBA has had to increase the interest rate again to try and dampen the demand. See this statement.
This is rational behaviour from investors and everyone, if you believe that prices are going to be higher in the future then the goods and services are cheaper now then in the future...
The money you have now is going to be worth less in the future, so you exchange for something else.
If the price signal mechanism is constrained due to regulation, monopolies, or the supply is inelastic, eg. it takes 5-10 years to get a mine going, it takes 10 years to be a good doctor.
Then the rational thing to do is to demand as much money now to buy any goods and services which are available now or borrow to build to satisfy that demand. This is arbitration at its best.
I have said this in the past, the RBA is acting like an overbearing nanny! It believes it can calm down the arbitration process by making money more expensive. They are looking into the future and predicting some of the current demand is transient (caused by other arbitrators) and there will be a massive over-investment in supply.
Why is it rational to take as much money as you can get and buy goods or services?
Why is it rational to get rid of any money you get as quickly as possible?
Steps for being rational:
- I download this spreadsheet from the RBA
- I add some percentage changes over the last year for M1 (Currency and Currency in the bank) raw money.
- If I start at Jan 2006, I see that last year M1 increased by 6.95%!!
- Interest rates are 5.50%!!
- That is a negative interest rate! You leave the money in the bank and you will get nothing, worse you will have something which is potentially worth less at the end of the year.
If you check in May 2006 year over year M1 increased by 8.98%!!
Have Fun
Paul
