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Less Money and Inflation Equals Recession

According to mainstream measurements today, the money supply (M3) is going down, GDP is going up, though modestly, and we have inflation. This is impossible. Which I will now explain.

When we hear inflation we think rising prices. Does inflation signify an expanding economy? Can a contracting economy have inflation? What is Inflation?

It seems some people think of inflation only in terms of a rising money supply. These folks would be confused where the money supply goes down yet prices go up. If we correctly diagnose what inflation is, the confusion vanishes.

Why do prices rise? Before answering that we must answer, what determines prices. The short answer, supply and demand. The purest example is an auction. The more people bidding (demand) on an item (supply) the higher the price will go. On the other hand, where there is low demand and high supply prices are bid lower.

Demand is money, supply is goods. Prices can be derived by dividing demand in money terms by supply, or goods. The ratio of money per goods gives the price. This can be indicated as a fraction, M/G. Goods are products and services, in other words production. Put another way, prices are the ratio of money per production, M/P.

Base case: $1000/1000units = $1/unit

The price will change when the ratio changes, when the amounts on either side of the fraction change at a different rates. There are five cases which increase the price of units.

1. Money increases, units remain the same.
$1500/1000units = $1.50/unit
2. Money increases more than units.
$2000/1600units = $1.25/unit
3. Money increases, units decrease.
$1200/800units = $1.50/unit
4. Money remains the same, units decrease.
$1000/800units = $1.25/unit
5. Money decreases less than units.
$900/600units = $1.50/unit

Change the ratio and the price changes. Which leads us to the classic definition of inflation, "more money chasing fewer goods". Or, more demand for less supply. Notice there are two amounts involved, money and goods. Inflation happens when the ratio changes, more money, fewer goods, or both.

Inflation: $1000/1000units = $1/unit ... $1200/800units = $1.50/unit

Inflation is an increase in the ratio of money per production, M+/P-. Just as there are five ways to change the ratio of money to units that increase the price, there are five ways to change the ratio of money to production to get inflation.

1. Money increases, production remains the same.
(M+/P)
2. Money increases more than production increases.
(M++/P+)
3. Money increases, production decreases.
(M+/P-)
4. Money remains the same, production decreases.
(M/P-)
5. Money decreases less than production decreases.
(M-/P--)

Notice on our little thumbnail graphs for each case money and production start together and money ends up higher. Just as the price of units rose as the ratio changed, the prices of goods in general rise from the same type of ratio change. Rising prices are the sign of inflation, the increase in the ratio of money to production.

Though some may suppose inflation and growth go together, there are four ways to have inflation when production either remains static or decreases. Some might also suppose to have inflation the money supply must increase, but there can be inflation where the money supply is static, case four, or decreases, case five. There can be inflation in a deleveraging environment where the money supply is shrinking.

Just as there are five ways to get inflation, there are five ways to get deflation.

1. Money decreases, production remains the same.
(M-/P)
2. Money decreases more than production decreases.
(M--/P-)
3. Money decreases, production increases.
(M-/P+)
4. Money remains the same, production increases.
(M/P+)
5. Money increases less than production increases.
(M+/P++)

Notice on our little thumbnail graphs for each case money and production start together and money ends up lower. That's deflation.

Now we can answer the opening questions. Inflation does NOT always signify an expanding economy. A contracting economy CAN have inflation. Inflation is an increase in the ratio of money to production.

Inflation Today

According to mainstream measurements today, the money supply (M3) is going down, GDP is going up, and we have inflation. Yet if the money supply is shrinking and production is growing there should be deflation as in deflation case 3. What is wrong? Simply this, at least one of the three measurements, money supply, GDP or inflation, is being calculated wrongly. Or two, or all three.

I suggest both inflation and GDP are currently miscalculated.

Inflation is higher than the official figures claim. As GDP is figured in money amounts and not units of production, the value of money effects the value of the GDP figure. Meaning GDP must be discounted for inflation. If inflation is higher than stated the discount of GDP will be too low, the GDP figure will be too high.

More than that, I suggest the basic calculation of GDP is flawed. Nonproductive spending on used goods is counted as productive. Nonproductive government transfer payments are counted as productive. (To be explained at a later date.)

Overstated GDP together with understated inflation means production is shrinking though calculated as growing. I suggest this is the situation today. We are in inflation case five, money decreases less than production decreases (M-/P--).

If the money supply is shrinking and there is inflation, production MUST be shrinking. There is no other possible way to have inflation when the money supply decreases. Therefor, GDP is currently shrinking. Thus it is proved.