Skyrocketing oil prices are not causing inflation

What?? How is that possible? I hear you ask.

Honestly, I struggled with this for several months now. I knew that according to Friedman, “Inflation is a monentary phenomenon” (which means it’s caused by the government’s management of the money supply). But this didn’t square with the obvious fact in front of me: Oil prices are up, which means that food prices are up, flying costs more, etc. Prices are going up, not because of the government, but because of oil.

And it is true – certain prices are going up. But lets take a trip to the gas station as an example. Last year, you went to the gas station every week with $60. It cost you $30 to fill up, and you went inside and bought a big gulp and a bag of chips, which totaled $5. So you leave the gas station with a full tank and $25 to spend on other things – say, for example, dinner out some weeks, or a new DVD on the others.

This year, you again go to the gas station with $60, but it costs you $50 to fill up because the price is higher. Now you go inside and…. maybe you buy nothing. Maybe you don’t bother with the chips, and just buy the soda, spending only $2, instead of $5. So now you leave the gas station with $8 to spend on other things.

You won’t be buying dinner out for $8 and you won’t be buying a DVD for $8 either. You’re going to have to substitute something else – something cheaper. Like a movie on On-Demand cable, or a frozen dinner at home.

…So what?
Well, last year, your decision to eat out increased the demand for restaurants. Your decision to buy a DVD increased the demand for DVDs.

But now, you aren’t eating out, and you’re not buying DVDs. The demand for those goods is falling. The poor restaurant owner is obliged to find ways to cut costs or reduce profits in order to reduce the cost of his service. At the same time, he has higher food prices to contend with, and this will be a real struggle for him. On the other hand, the movie studios pay almost nothing for each DVD they make – they can easily drop the price of their DVDs to get you to spend your money on them.

You may not have quite the same experience watching a movie on-demand at home over a frozen dinner than you would going out and having a nice dinner at a fancy restaurant.

But you are affecting prices with your decisions. Some prices will go up, others will come down. Some restaurants will go out of business, because they can’t handle the reduction in income at the same time they are experiencing an increase in costs. Others, which may have better cost management techniques or more profits, can weather the storm.

Inflation, in its truest form, is increases in prices where you have no alternative – no way to choose to spend on X instead of Y to save money. According to Friedman, that only happens because of government’s interaction with the money supply.

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