Last month, President Bush nominated Dr. Ben S. Bernanke, currently chairman of the President's Council of Economic Advisors, as chairman of Federal Reserve Board to replace the retiring Alan Greenspan. Alan Greenspan's replacement comes at a time of heightened fears of inflation resulting from the recent spike in oil prices.
First, let's decide what is and what is not inflation. One price or several prices rising is not inflation. When there's a general increase in prices, or alternatively, a reduction in the purchasing power of money, there's inflation. But just as in the case of diseases, describing a symptom doesn't necessarily give us a clue to a cause. Nobel Laureate and professor Milton Friedman says, "[I]nflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output." Increases in money supply are what constitute inflation, and a general rise in prices is the symptom.
Let's look at that with a simple example. Pretend several of us gather to play a standard Monopoly game that contains $15,140 worth of money. The player who owns Boardwalk or any other property is free to sell it for any price he wishes. Given the money supply in the game, a general price level will emerge for all trades. If some property prices rise, others will fall, thereby maintaining that level.
Suppose unbeknownst to other players, I counterfeit $5,000 and introduce it into the game. Initially, that gives me tremendous purchasing power, whereby I can bid up property prices. After my $5,000 has circulated through the game, there will be a general rise in the prices -- something that would have been impossible before I slipped money into the game. My example is a highly simplistic example of a real economy, but it permits us to make some basic assessments of inflation.
First, let's not let politicians deceive us, and escape culpability, by defining inflation as rising prices, which would allow them to make the pretense that inflation is caused by greedy businessmen, rapacious unions or Arab sheiks. Increases in money supply are what constitute inflation, and the general rise in the price level is the result. Who's in charge of the money supply? It's the government operating through the Federal Reserve.