Imagine a very closed-knit, isolated society living on an island. They have been so for centuries now. The society had well established, clearly defined, roles and responsibilities and had people just born into them. People were happy, or so I’d imagine, since life was simple. If I wanted to build a house, I will go to the timber merchant to buy woods; to blacksmith to buy nails, hammers and other necessary tools; to carpenter for the wood work… etc. etc.

Notice the term “buy” – obviously, if I am a conscientious human being, I will have to offer something in return for the goods and the services I need to build this house. So what do I “have” that is worth offering to these people? Since I am a farmer and have livestocks, I can offer them farm fresh vegetables, fruits, dairy products or meat. Now, I am sure the timber guy, the blacksmith, the carpenter will appreciate some fresh vegetables and meat.

Life continues uninterrupted for several years. The society is self-sufficient, with no trades with other societies that live on the mainland. Years go by, and we decided that direct exchange of goods and services is not efficient. There was a year, when I produced too much food than we all could consume. Everybody had enough for the year. And now I wanted to renovate my house, and could not do so since all I could offer was my farm produce. No one will accept them as a valid exchange, since their storage was full and adding more to the already existing store added no value.

So I postponed my plans for renovating my house that year.

Other islanders had faced similar situations over the years. Hence, it was obvious that we needed an independent medium of exchange. We decided to use a piece of sheep leather as the medium. The size of the piece decided what value that piece had. We already were conversant in decimal system of counting – we were not savages, you see – and hence had no problem establishing a 10-Base value for our new medium of exchange.

Everybody liked the idea. It was simple, independent of the seasonal and local conditions (imagine a year of drought, and I would have nothing worth left to exchange for other people’s goods and services!!), and handy being small in size.

Now, life went on merrily for some years.

I had renovated my old house, and built a new one.

One year, there were no woods left to fell. The timber merchant had sold all his logs. His inventory was empty. After some deliberation, he decided to go to the mainland to buy woods for his inventory. When I came to know about his plans, I pointed out that our sheep-skins may not work on mainland.

He decided to loan few sheep from my stock on his journey. On the mainland, he traded some sheep in exchange of woods. He traded the rest for his lodging and food – the mainland was still years behind us, and did direct trading (bartering). He comes back with woods worth 12 sheep – 10 sheep in exchange for the woods, 2 sheep in exchange for lodging, food and travel.

Back home, when he sat down to make his standard size logs, he realized that he needed to sell his logs for few more sheep-skins than he ever did. Why? Because he had to spend 12 sheep (worth 200 sheep-skins) for just buying the woods. This cost needed to be added to his labor cost of making the standard size logs from the woods – which, he decides to keep the same as before.

He finally determined his rate as one-and-a-half sheep-skin more than before. Now, we all had only as much sheep-skins in our possession – just 2000 sheep-skins, in my case. If I have to build a house, or need woods for any other purpose, I will have to pay more than I used to. This will force me to sell my farm produce at a rate higher than my previous price. Why? Because, I needed extra sheep-skins to pay for the higher log prices – I had to make and mend fences all year round for my livestock and farm land.

So, I started selling my farm produce, dairy products, and meat for little more sheep-skins than I used to. Suddenly, everyone on the island were slapped with higher food prices. They decided to pass on the increased prices to their consumers, since they, like me, had only limited number of sheep-skins to live and survive. So, we all had to take steps to ensure that our buying powers stay the same as before, or is more than ever.

Now the total number of sheep-skin in use on the island was limited as well. The new condition will force the island’s governor to generate more sheep-skins, but that’s another story. The new condition, where I can no longer buy a bundle of 10 logs for 1 sheep-skin is what is (in)famously known as Inflation.

The scenario used here is of course very simplistic and linear. Causes for inflation can happen anywhere, anytime and simultaneously, or in any random pattern.

The story only intends to illustrate how a stable isolated economy can be influenced by factors such as depleting natural resources, cost of importing goods, demand & supply, human behavior and other factors. Note that the timber merchant could have picked some other business in the event of depleting wilderness. In that case, the inflation could have been stalled till the time someone else stepped into that role of timber merchant. So human behavior also play a very dynamic role in onset of inflation.

The story also illustrate the fact that inflation is not necessarily evil. It indicates that the economy may change for better – people have better quality woods than before (may be the forest on the island never produced quality woods. But the islanders never realized it till they had a chance to buy the logs from the mainland.)

This planet has limited natural resources, and limited number of skilled people to make quality products. But the fact that we have our economies divided, segmented and there are defined boundaries between these economies, the medium of exchange – the money is bound to experience these balancing forces.

Money does not have any intrinsic value. Stripped off of all its psychological values, it is just a medium that is universally acceptable. As the economic context change, so does the assigned value of money.

Inflation is that adjusted value we assign to money.