Primer On Inflation

This post draws substantially on John Hussman

Marginal Utility: Price of a good in dollars is the ratio of the marginal utility of that good and the marginal utility of the dollar.

How Inflation: Increase the numerator, the marginal utility of that good. We increase the marginal utility of a good by supply becomes more scare or if demand becomes stronger.

Or...

Reduce the denominator, the marginal utility of the dollar. This happens if supply of dollars increases or if demand to hold dollars declines.

So - inflation occurs when you have an increase in the marginal utility of goods relative to the marginal utility of money. During the later stages of an economic expansion, the capacity for the economy to grow diminishes. The inability for the economy to grow fast enough to satisfy demand means the marginal utility of goods goes up. This is why monetary authorities increase interest rates - to contain the demand side of the economy. The recession realigns demand sufficient to bring down the marginal utility of goods in the economy.

Deflation occurs when you have a decline in the marginal utility of goods relative to the marginal utility of money. Think about the Great Depression. Demand collapsed even though production constraints made goods scarce. The utility of money, or course, soured as people frantically converted deposits into cash.

Curve Ball: Long Term Inflation is NOT caused by the growth of money. It is caused by the growth of government spending.

When government spending appropriates goods and services in an economy in exchange for an increasing supply of government liabilities, the ratio above sharply tilts higher and you get inflation. It does not matter if the government finances its spending with cash or debt, because both pieces of paper fiercely compete as stores of value and means of payment. The values of currency and government securities are set in tight competition.

So, the expansion of government spending, regardless of form, will tend to raise the marginal utility of goods while lowering the marginal utility of money: inflation. The mechanisms are: supply constraints, unsatisfied demands, excessive growth of government liabilities, or a reduction of willingness to hold those liabilities.