Buddy Wells contends that my article “Inflation is unequivocally bad for the poor – why is the Reserve Bank targeting 6%” doesn’t hold water because I haven’t accounted for cost push inflation. For the sake of space I kept the cost-push-inflation discussion out of my previous article but I’ll happily explain in this article why cost-push inflation doesn’t need to impact overall economic inflation if the central bank doesn’t meddle with money supply and prices are allowed to adjust.
Let’s return to the simple CarLand example with CLD as the currency and assume that 150 CLD’s are in circulation as total money supply. We’ll expand the products to include both cars and barrels of oil as the two and only representative products that are produced and consumed. Let’s assume 5 cars are produced in CarLand and 5 barrels of oil are imported from the Middle East. A car costs CLD20 and a barrel of oil costs CLD10, which equates to the CLD150 total money supply ([20*5]+[10*5]=150).
Suddenly oil prices spike due to a war in the Middle East that has constrained the global supply of oil. The price of oil rises from CLD10 to CLD15. In this example the total money supply spent on oil becomes CLD75 (15*5=75). This implies that there is CLD75 left over to buy the cars and thus the price of cars becomes CLD15 each (75/5=15).
At the end of the day people in CarLand are still consuming 5 cars and 5 barrels of oil with the same amount of money supply. The people in CarLand cannot control the price of oil but the price of the domestic goods (cars) can adjust. Yes, there was oil price inflation from CLD10 to CLD15 but there was car price deflation from CLD20 to CLD15. So net-net there is no overall inflation in the economy.
The outcome of no overall inflation in an economy is always the case if the central bank does not tamper with the total quantity of money supply, irrespective of outside price shocks. Inflation is always and everywhere a monetary phenomenon, the prices of goods and services will adjust as long as we allow them to do so.