You might think that changes in the overall level of prices are just a matter of supply and demand. For example, higher gasoline prices reflect the higher price of crude oil, and higher crude oil prices reflect such factors as the exhaustion of major oil fields, growing demand from China and other emerging economies as more people grow rich enough to buy cars, and so on. Can’t we just add up what happens in each of these markets to find out what happens to the overall level of prices?

The answer is no, we can’t. Supply and demand can only explain why a particular good or service becomes more expensive relative to other goods and services. It can’t explain why, for example, the price of chicken has risen over time in spite of the facts that chicken production has become more efficient (you don’t want to know) and that chicken has become substantially cheaper compared to other goods.

What causes the overall level of prices to rise or fall? As we’ll learn in Chapter 8, in the short run, movements in inflation are closely related to the business cycle. When the economy is depressed and jobs are hard to find, inflation tends to fall; when the economy is booming, inflation tends to rise. For example, prices of most goods and services fell sharply during the terrible recession of 1929–1933.

In the long run, by contrast, the overall level of prices is mainly determined by changes in the money supply, the total quantity of assets that can be readily used to make purchases. As we’ll see in Chapter 16, hyperinflation, in which prices rise by thousands or hundreds of thousands of percent, invariably occurs when governments print money to pay a large part of their bills.