6. Inflation is not a cost-push phenomenon.

Many economic commentators used to believe (and some still do) that inflation could result from rises in the input costs of production. An increase in the price of raw materials or in the wages paid to workers would have to be passed on, it was supposed, leading to a rise in the price of the finished product. If enough goods were thus affected, this would bring about the general rise in price levels which is popularly called inflation.

If the money supply is unchanged, then price rises for some products will be matched by lower prices elsewhere. If people have to pay more for their essentials, for example, following increased prices brought about by higher input costs, then they will have less money to spend on non-essentials, the demand for which will go down.

The reverse is true, in that if people pay less for essentials because falling input costs allow lower prices, they will have money left to spend elsewhere, with the increased demand leading to higher prices in other sectors. The significance of this is that for over a decade cheap imports from China meant lower prices in developed countries for many household goods. The result was downward pressure on the consumer price index, leading central banks to keep interest rates low, with easy credit and cheap money.

The fall in prices was mostly in goods which show in the various price indices. It left people with money to spare elsewhere, some of which found its way into asset bubbles, including housing. Some of the goods which saw increased demand and higher prices did not feature in price indices, and therefore did not undermine the visible fall in prices. The choice of some items and not others to feature in price indices means that some price rises are effectively hidden from consideration.

With a stable money supply, price increases in some economic sectors will be matched by reductions elsewhere, and vice versa. If the money supply is increased when prices are stable or falling, the result might well be asset bubbles as people seek places to gain good returns on it, given falling prices and narrower profits elsewhere. Inflation is not caused by the push of higher input costs, but by extra money in the economy, or by its faster circulation.

This is part of Dr Pirie's ongoing series: Philosophical Observations on Economics.