Explanation of inflation and model of inflation hyperinflation

An introduction to the model of inflation and hyperinflation

The inflation rate affects us all and I had discussed how it affects us in my previous articles (see "what is inflation and how to manage inflation" and "causes of economic crisis recession and high inflation or hyperinflation" ). In this article I will explain inflation by way of a model of inflation that I invented many years ago. This model explains many probabilistic phenomena is not the simplistic “too much money chasing too many goods”, which is the accepted norm for the model of inflation.  

Recap about hyperinflation, bull runs and bubbles

In my last article (see "causes of economic crisis recession and high inflation or hyperinflation" ) I had explained that hyperinflation, bull runs and property bubbles are the same phenomena occurring in different markets or segments of the economy. It occurs when there is a limited amount of goods, services or other items for sale but there is a greater supply of customers.  

Using oranges to explain a simple model of inflation and hyperinflation

I shall use the sale of oranges to explain a simple model of inflation and hyperinflation. Let us say that there are 1000 oranges for sale in New York. That is there is no other source of oranges and no one can import oranges into New York. This situation is almost similar to a monopoly. Let us say that there are 100,000 potential customers for oranges in New York. As word gets around that there is a supplier of oranges in New York, early customers beat a path to the seller.

In reality there will be a lot of marketing hype and rumours circulating about the rare fruit called orange and its miraculous properties. And eventually it becomes a must buy item … to die for, an opportunity that cannot be missed, after all you could turn around and sell it to your neighbour for a huge profit. As more calls or inquires come in, the seller increases the price and offers to hold prices to ‘special’ or ‘favoured’ customers who will drop everything rush to the shop, pay hard cash and take delivery this very moment. Remember this is a once in a life time opportunity that cannot be missed. As the price of oranges increases in the secondary market the seller has to increase the price of oranges at his shop. Orange prices spiral out of control as no one can introduce substitute products to meet the new found demand for oranges.

Doesn’t this sound familiar, especially if you were a stock market speculator during a bull run or caught in the property bubble? The prices of oranges begin to oscillate and most people see the climb phase of the oscillation but this is not inflation, it is hyperinflation or a bull run or a bubble.

The moment you allow a second, third or fourth party to bring in oranges into New York the additional supply of oranges meets the extra demand and prices stabilise or readjust to a new level of equilibrium. If you had spent much time examining stock and commodity charts you will notice the ‘states of equilibrium’, that is periods where the prices are in range bound zones or periods where prices cannot fall below a certain level – strong support zones or a level shift upward in the price lows when compared to historical data.  

A graphical presentation of a simple model of inflation and hyperinflation

Here you you will see that inflation appears like a straight line upwards and hyperinflation is the oscillation in prices. The combined effect is shown in brown but I have changed the frequency of oscillation so that the two curves do not overlap and become difficult to view, in this simple model of inflation.  

The simple model of inflation

This rate of replacement of oranges introduces a more stabilising influence on the prices of oranges. That is prices exhibit inflationary behaviour. The rise in prices is greatly moderated and predictable and commonly known as the rate of inflation. The rate of replacement of oranges suppresses hyperinflation and changes the price behaviour to an inflationary behaviour - the simple model of inflation is an introduction of a rate of replacement to the probability of transaction.

If there was an excess rate of replacement, in the simple model of inflation, for oranges in the shops – supply exceeding demand, we will have a deflationary situation. Deflation can come about from either supply exceeds demand or when demand evaporates as in high unemployment – more and more customers have lost their purchasing power, or negative news – customers have lost interest, lost confidence, or worried about their future hence their pockets and wallets tighten, they try to manage with less. This is the simple model of inflation.    

The equation for the model of inflation

  The equation for the model of inflation is

r - q = I … Equation for Inflation

Where r is the rate of replacement and q is the probability of transaction and I the rate of inflation. Please refer to my book for further explanation of the derivation of this model of inflation and hyperinflation  

In my next article on inflation and Supply and Demand I will show some probability equations for the simple model of inflation and how they can be related to Supply and Demand.

Please refer to terms page for terms of use of this blog

All Rights Reserved. Copyright © Dr. Peter Achutha, 2011 for this article on “Explanation of inflation and model of inflation hyperinflation”