If inflation hits 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.

Posted on June 20

Bertrand Larroque and Marc St-Pierre
Economists, the authors are respectively a financial planner and portfolio manager*

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

A spark to start a fire needs fuel. However, the reasons cited are actually only sparks. Rather, the abundance of money in the economy is the fuel. The more money circulating in the economy, the higher the risk of inflation. Since the 2008 financial crisis, governments have pumped huge amounts of money into the economy and financial markets. The emergence of the COVID-19 pandemic has increased the injection of money, resulting in 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 seems much simpler to us than it is today.

Our little story about inflation will start this way. Once upon a time, there was a very quiet small village, in which people lived a peaceful and harmonious life. Everyone had a job and contributed to society through their talent and work.

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

Keen to improve his flour production, Armand recently pledged to invest in technology to build a windmill. An innovation that comes from the countries of the South, which will allow him to save his bulls, while producing more flour.

great idea

Concerned about the slowing economy and the poverty that engulfs more and more families, the village mayor proposes a brilliant idea to all the people of his village: “We will double the amount of money in our village, which will reduce poverty. Happy with the solution, all the villagers inherit the silver equivalent of the currency that everyone already owns.”

In the weeks that followed, all the businessmen and villagers at work, delighted with the newfound prosperity.

But in a short time, everything ran out. The artisans and businessmen of the village could no longer meet the demands. Gertrude’s hens don’t lie any longer. Emile did not manage to make all the shoes he required of him, just like Joseph the carpenter and Florence, the seamstress. This is how everyone starts to raise the price of the goods and services demanded of them. Everything is getting more expensive in the village. Finally, since everyone has twice the money, prices are multiplied by two, since the quantity of goods produced remains the same. Only Armand, who invested in a new windmill, is able to produce more flour. He can sell his minute 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 result in more wealth. For there to be wealth creation, there must be more production, as in the example of the innovation of the windmill.

In conclusion, the disproportionate increase in the money supply since the pandemic is the real cause of inflation. Interest rates have been near zero for too long, and mortgage rates have also been ridiculously low. Some countries have even seen negative interest rates on their bonds. This reality, coupled with the generosity of government assistance programs, cannot continue. All that was left were sparks that lit the whole thing up, 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 over the past 40 years has been reversed upwards. It remains only to know for how long and to what level.

*Authors of the book From wallet to wallet – 45 tips for using your money at work, Editorial, 2021

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