Saturday, February 5, 2011

Reasons Budget Deficits and Inflation Don’t Always Align

In a recent post, I pointed out that government spending is limited by inflation, not revenue.  You might ask, "so what?  don't federal budget deficits and inflation rise together?"  Well, not necessarily.  There are times when other conditions can affect inflation other than the federal budget.

Currency Destruction: If physical currency is destroyed or lost, that means it can no longer be used.  That results in less money in circulation.  Since there is less of it, it means the value of it rises.  If money is more valuable, then prices drop which means deflation.  Therefore, if someone just burned a whole pile of cash it would cause deflation.  Since only 6 to 7 percent of our money is physical  currency, I doubt this would ever happen in a large enough amount to have a measurable effect.  However, some of the following items will.

Personal Savings: People hoarding cash has the same deflating effect as destroying cash.  The only difference is that eventually the cash will eventually be brought back into circulation.  However, until it is brought back into circulation the effect is deflation.  Whether or not the cash is hoarded by putting it in a cookie jar at home, or by putting it in the bank, it can cause deflation.

Confident consumers can have an effect on inflation.  If a lot of loans are taken out it creates a lot of bank money.  This can have an inflating effect completely independent of any federal budget deficits.

A financial bubble or a bubble in any other sector of the economy becoming overly inflated can have an effect on the over all inflation rate.  While the bubble is forming a lot of extra bank money is pumped into the economy, inflating the supply of money.  Then, when the bubble bursts a lot of people default on their loans and that bank money disappears which causes deflation.  Both of these things can happen independently of any budget deficit or surplus.

Notice that all of these are things are results of decisions by consumers and decisions and cannot be directly controlled by federal spending decisions.  In other words, to keep inflation low and steady requires government policies to react to the private market.  Right now that mostly happens with the fed controlling the interest rates, but that doesn't mean there aren't other inflation regulating options out there.
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