Tuesday, July 15, 2008
Inflation is in the news and blamed on the rise in oil and food prices. But, inflation is defined as a rise in the general price level, not the rise in the price of particular items. The only way that the rise in oil prices can cause inflation is if the banking system accommodates it by an increase in the money supply. If the money supply is constant, then a price rise for oil means a price drop for other things depending on their relative demand elasticities. The popular misconception of inflation causes us to look at the wrong policy options.