EKIP– Expert Club for Economics and Politics A Different Opinion
Author: Frank Shostak, Mises.org
According to many mainstream economists, the lack of a strong correlation between money supply growth and the growth of various price indices casts doubt on the theory that increases in money supply are a primary source of inflation.
It is also argued that before 1990 there was a positive correlation between money supply growth and inflation. However, since 1990, in the US and other major economies, this correlation has ceased to exist.
Two definitions of "inflation"
Some analysts conclude that while increases in the money supply have had an impact on inflation in the past, this is not the case today.
In our opinion (Austrian economists), the lack of correlation between the growth of the money supply and the inflation rate does not prove that money has nothing to do with price dynamics.
The main issue here is not actually the strength of the statistical correlation between the two variables, but the definition of the term "inflation" itself.
Please note that according to common understanding, inflation is defined as an increase in the prices of goods and services, which is statistically expressed in the rise in various price indices such as the Consumer Price Index (CPI).
Some economists such as Ludwig von Mises and Murray Rothbard, following the tradition of classical economists, define the term "inflation" as an increase in the money supply. How do we determine which definition is correct? What is inflation? An increase in the money supply or an increase in the prices of goods and services?
The nature of inflation
The purpose of any definition is to present the essence, the most distinctive characteristic, of the phenomenon we are trying to identify. A definition should tell us what the fundamental characteristics of a given phenomenon are. And in order to define a phenomenon, we must be aware of its source.
For Mises and Rothbard, the subject of inflation involves not only an increase in the prices of goods and services, but also, in effect, an act of economic fraud and robbery.
Historically, inflation has occurred most often when the ruler of a country forced his subjects to give him all their money coins under the pretext that new coins would replace the old ones. In the process of this exchange, the king would adulterate the content of the gold coins by mixing them with another, less rare metal and return the devalued gold coins to the citizens. Regarding this practice, Rothbard writes:
"Specifically, the rulers minted all the coins of their domain anew, returning to their subjects the same nominal number of "pounds" or "marks", but with the trick that each coin weighed less than before. The gold or silver weight seized during the replacement was collected by the king and used to cover his expenses."
(See also, "Easy Money, Easy Morals" by Joseph Salerno)
Thanks to this devaluation of gold coins, the ruler is able to mint more coins for himself with the seized gold and use them for his own purposes. And what he issues back to his subjects as "pure" gold coins are actually diluted, i.e. devalued ones.
The increase in the overall number of coins resulting from this practice is the essence of inflation.
Note that what is happening here is an inflation of coins, i.e. an increase in their number. As a result of inflation, the ruler can effectively undertake an economic exchange of "nothing" for "something". He can redirect real resources (goods, services, land, etc.) from the citizens to himself.
Inflation in a fiat money system
Under the gold standard, the practice of misusing the medium of exchange (money) becomes much more sophisticated through the issuance of paper money that supposedly gives you rights to a certain amount of gold, but in reality has no such backing. Inflation in this case means an increase in the quantity of this type of paper money.
The holder of such money, not backed by real physical gold, can exchange nothing for anything just like the king in the example above. And so we have a situation where those who print such "money" are diverting real resources to themselves without actually contributing to the production of goods or services in any way.
In the modern world, money is no longer gold, but simply paper (fiat) money; therefore, inflation these days represents an increase in the quantity of paper money.
Note that we do not claim, as the monetarists (Friedman) do, that an increase in the money supply causes inflation. What we say is that inflation is an increase in the money supply.
If we assume that inflation represents an increase in the money supply, then we must conclude that it leads to the redirection of real wealth from those who generate wealth to those who hold the newly printed banknotes.
Furthermore, we will also conclude that pumping money into the economy (i.e. inflation) has negative effects on the process of generating economic wealth. This is logically obvious, we do not need empirical research to confirm or refute it.
Why don't prices always grow in sync with the money supply?
However, how can we explain the strong inflation of the money supply these days, accompanied by only a moderate increase in prices, which is defined as "low inflation".
The price of a good is the amount of money (currency) that is paid for it. If the growth rate of the quantity of money in circulation is 5% and the growth rate of the supply of goods is 1%, then prices will rise by 4% (the difference between the two quantities). However, if the availability of goods on the market also grows by 5%, then, other things being equal, we will not witness any increase in their prices.
If we assume that inflation is simply an increase in the magnitude of the CPI, then we must conclude that despite the increase in the money supply by 5%, inflation is 0%.
However, if we follow the definition of Austrian and Classical economists that inflation is an increase in the money supply, then we must conclude that its level is 5%.
The example above demonstrates that an increase in the money supply is not necessarily always accompanied by an overall increase in the prices of goods and services offered on the market.
Prices are determined by both real and monetary factors. It is therefore possible for real factors to push the price level in the opposite direction to that in which monetary factors push it. And in such cases, if the two forces are of approximate magnitude, then there will be no apparent change in the price level. Thus, while the growth of money in circulation, i.e. inflation, is very high, prices may rise only slightly or not at all.
