Monday, October 21, 2013

Bathtub analogy

A good way to understand inflation is through the bathtub analogy. Think of a bathtub as the economy. The size of the bathtub is the size of the economy. The water is money. The current water level is the price level. This analogy is fairly precise, as long as you imagine that the bathtub can grow or shrink. If the bathtub gets bigger, i.e. the economy enlarges, the water level (prices) obviously will decrease. If you add more water (money), the water level will increase. If you add more water at the same rate as the bathtub gets bigger, the water level won’t change. And it doesn’t matter where you add the water; the overall water level will rise. However, it won’t necessarily rise all at once. If you turn on the shower and distribute the new water more-or-less evenly, the water level will rise all at once. But if you turn on the tap and put all the new water into one end of the tub, that end of the tub will rise first, and the other end of the tub will rise last. In that time, where one end of the tub has more water than the other, those at that end have an advantage: They have the new money, and can buy goods at the old prices. Near the end of the process, when everywhere but the far end of the tub has evened out, those at the far end are facing the new prices, but don’t have the new money yet, so they are at a disadvantage.

It’s important to note that inflation will occur regardless of where or how money (water) is added. Regardless of whether the Fed prints money and hands it to the banks, or whether Congress prints money and spends it, or whether everyone owns their own printing press and prints money for themselves, the water level will rise based on how much water is added to the tub, not how it got there.

Under our current system, the Fed is the faucet, and the wealthy, in particular the banks, are at the front of the tub. They receive the new money first, before the economy is able to adjust, and can buy things at artificially low prices. The poor and those living on fixed incomes or solely on interest (such as retirees) are at the back of the tub. They get the new money last, so they are facing artificially high prices.

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