Inflation and Spare Capacity

Readers Question: I thought of an analogy and wondered if I am correct. Suppose there is a concert venue that seats 10,000 people. On one day, the Rolling Stones are scheduled to perform there. Tickets are nominally $50, but since the venue is likely to sell out, scalpers buy them up. Lets assume that Rolling Stones fans have lots of disposable income. So prices quickly rise. This represents the economy at full employment with too much money chasing too few goods.

Now suppose The Fluorescent Leech and Eddie are playing the same venue the following week. I’d love to see them in concert and have no problem paying $50 for the ticket. But the venue will never sell out. Flo and Eddie are just not that popular. If a scalper bought up tickets and tried to raise the price, it doesn’t matter how rich I am, I have no reason to pay more for the ticket. This is analogous to the economy far below capacity. More money in circulation does not increase the price, but instead stimulates more production. (Schedule another group to play with Flo and Eddie to draw in additional fans, for instance.)

If I am right, then printing money to put people to work when unemployment is very high will put people to work without raising prices very much at all.

I’ve never particularly thought of it like that. But, roughly it does make sense. To summarise.

If you increased the money supply in Manchester, the price of tickets for Manchester United would increase. This is because the ground is already sold out, so if people have more money they will be willing to push up prices even further. Therefore increasing money supply does cause inflation

If you increase the money supply in Telford, then the price of tickets for Telford United won’t increase, because there are already unsold tickets. Increasing money supply doesn’t lead to higher prices because there is much spare capacity at Telford United already.

I’m not sure how helpful this analogy is. But, in economics it is an interesting question when and whether increasing money supply leads to inflation.

If the economy is at full capacity, low unemployment and banks willing to lend, then increasing money supply does tend to cause inflation.

However, in a liquidity trap, an increase in the money supply tends to be saved. People don’t want to spend and so we don’t tend to see inflation.

Who Gets the Money.

It also depends how you increase the money supply. Quantitative easing caused an increase in the money supply, but it mainly occured to banks. The Bank of England bought back bonds and gilts from banks leading to an increase in the money balances of big banks.

However, the banks don’t want to really lend this money out. They are trying to recover their previous losses. Therefore, the impact of quantitative easing has been relatively subdued. (and why you often heard politicians say ‘banks really ought to be lending more’

If we had pursued a policy of giving money to say unemployed, this increase in the money supply would probably have been all spent. Therefore, the impact of increasing money supply would have been greater, and inflation a stronger possibility. Though if there was still spare capacity it wouldn’t occur.

(p.s. I chose Telford United purely out of randomness, I just checked their site out (Telford United) and noticed they didn’t even have one friend on facebook. Maybe you could be first to be a friend of Telford United 🙂

 

 

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