If inflation hit a medieval village…

You must be at least 45 years old to have already experienced inflation rates of more than 3% per year. For three decades, inflation has hovered between 0% and 3%, driving interest rates down to levels never seen before.

Are the causes of inflation invoked by economists really the source of the problem?

For a spark to start a fire, a fuel is needed. However, the causes invoked are in reality only sparks. Rather, it is the abundance of money in the economy that is the fuel. The more money there is in circulation in the economy, the greater the risk of inflation. Since the financial crisis of 2008, governments have injected colossal sums of money into the economy and the financial markets. The advent of the COVID-19 pandemic has given rise to further injections of money, leading to an excessive increase in the money supply.

To better imagine the situation, let’s imagine that we live in a small medieval village, where life would seem much simpler to us than today.

Our little story of the appearance of inflation would begin like this. Once upon a time there was a very quiet little village, where people lived a peaceful and harmonious life. Everyone had a job and contributed to the community through their talent and their work.

Gertrude has many children, but she finds the time to raise chickens. She sells her eggs every morning at the village market. Once a week, she also sells chickens. This is the case with all the inhabitants who contribute to the economy of the medieval village through their work, such as Bastien the blacksmith, Émile the shoemaker, Armand the miller and Julien the baker.

Anxious to improve his flour production, Armand recently undertook to invest in technology to build a windmill. An innovation which comes from the countries of the South and which will allow him to save his oxen, while producing more flour.

A great idea

Worried about the slowing economy and the poverty that is overwhelming more and more families, the village mayor suggests a brilliant idea to all his villagers: “We are going to double the amount of money in our village, which will reduce the poverty. Happy with the solution, all the villagers inherit the silver equivalent of the currency everyone already has.

In the weeks that followed, all the entrepreneurs and the villagers were at work, happy with the newfound prosperity.

But in a short time, we run out of everything. The craftsmen and entrepreneurs of the village can no longer meet the orders. Gertrude’s hens don’t lay any more. Émile does not manage to make all the shoes that are asked of him, just like Joseph the carpenter and Florence the seamstress. This is how everyone begins to raise the price for the goods and services ordered from them. Everything is getting more and more expensive in the village. Finally, as everyone has twice as much money, prices are multiplied by two, since the quantity of goods produced remains the same. Only Armand, who has invested in a new windmill, is able to produce more flour. He can sell his flour at a lower price while increasing his profit. Unfortunately, this is not enough to prevent prices from rising in the village.

The moral of our story teaches us that more money in the economy does not necessarily create more wealth. For there to be wealth creation, there must be more production, as in the example of the windmill innovation.

In conclusion, it is the disproportionate increase in the money supply since the pandemic that is the real cause of inflation. Interest rates have stayed close to zero for too long and mortgage interest rates ridiculously low. Some countries have even experienced negative interest rates on their bonds. This reality, coupled with the largesse of government aid programs, could not last. All that remained were sparks that ignite the whole thing, which economists have identified as bottlenecks linked to the pandemic, low unemployment and the consequences of the war in Ukraine.

Central banks must now reduce the money supply by raising interest rates and reducing the money circulating in the economy. The downward trend in interest rates of the past 40 years has now been reversed upwards. It only remains to know for how long and up to what level.

* Authors of the book From purse to wallet – 45 tips to put your money to work, Editorial, 2021

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