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. So, extrapolating, if the quantity of all goods and services in the economy increased, i.e. there was economic growth, even at a particularly rapid rate, what would you expect to happen to prices in general? If you said fall, 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. We are told that economic growth can be too strong and the economy can “overheat.” This, we are told, can cause an overall increase in prices, i.e., inflation. Indeed, some have gone so far as to argue that the Trump tax cuts, because they will successfully spur economic growth, will actually be fueling that inflation.
This kind of thinking is a relic of what is called Keynesian macroeconomics, i.e., the economics derived from the writings of early 20th Century economist John Maynard Keynes. And it has consistently proven to be a failure in both helping us understand the economy and as a tool for guiding economic policy.
The fact is that economic growth, defined as an overall increase in goods and services, 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, making each dollar worth more.
The problem is that the Keynesian model, which despite its shortcomings still permeates the thinking of most business commentators on television, does not define economic growth in this common-sense way. Instead, economic growth 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, who accept this definition, say that “too much” economic growth can cause inflation.
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 at least a decade and a half, 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 are 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, defined as 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.