Mises Daily

A
A
Home | Library | Defining Inflation

Defining Inflation

March 6, 2002

Frank ShostakOn August 16, the U.S. government will debut of a new type of Consumer Price Index (CPI), one which it says will better reflect true inflation. Unlike the existing CPI, the new index will be subject to revisions as more detailed data become available. The regular CPI has long been criticized for overstating the actual rate of inflation. The hope is that, once the Fed is able to use more accurate information concerning general prices, it will be in a better position to use its tools to counter inflation.

Is inflation about price rises?

The fundamental problem here is a failure to define the problem properly.  For example, the definition of human action is not that people are engaged in all sorts of activities, but that they are engaged in purposeful activities--purpose gives rise to an action. 

Similarly, the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services.

Consider the case of a fixed money supply. Whenever people increase their demand for some goods and services, money will be allocated toward other goods. Thus, the prices of some goods will increase--i.e., more money will be spent on them--while the prices of other goods will fall--i.e., less money will be spent on them.

If the demand for money increases against goods and services, there will be a general fall in prices. In order for an economy to experience a general rise in prices, there must be an increase in the money stock. With more money and no change in money demand, people can now allocate a greater amount of money for all goods and services.

From this we can conclude that inflation is a general increase in the money supply.

As Mises explained in his essay "Inflation: An Unworkable Fiscal Policy":

"Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. . . . As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation."

When inflation is seen as a general rise in prices, then anything that contributes to price increases is called inflationary. It is no longer the central bank and fractional-reserve banking that are the sources of inflation, but rather various other causes. In this framework, not only does the central bank have nothing to do with inflation, but, on the contrary, the bank is regarded, against all evidence, as an inflation fighter.

Thus, a fall in unemployment or a rise in economic activity is seen as a potential inflationary trigger which therefore must be restrained by central-bank policies. Some other triggers, such as rises in commodity prices or workers wages, are also regarded as potential threats and therefore must always be under the watchful eye of the central bank.

The popular definition cannot explain why inflation is bad

If inflation is just a general rise in prices, then why is it regarded as bad news? What kind of damage does it do? Mainstream economists maintain that inflation, which they label as general price increases, causes speculative buying, which generates waste. Inflation, it is maintained, also erodes the real incomes of pensioners and low-income earners and causes a misallocation of resources.

Despite all these assertions regarding the side effects of inflation, mainstream economics doesn't tell us how all these bad effects are caused. Why should a general rise in prices hurt some groups of people and not others? Why should a general rise in prices weaken real economic growth? Or how does inflation lead to the misallocation of resources? Moreover, if inflation is just a rise in prices, surely it is possible to offset its effects by adjusting everybody's incomes in the economy in accordance with this general price increase.

However, if we accept that inflation is an increase in the money supply, and not a rise in prices, all these assertions can be easily explained. It is not the symptoms of a disease but rather the disease itself that causes the physical damage. Likewise, it is not a general rise in prices but increases in the money supply that inflict the physical damage on wealth generators. 

Increases in the money supply set in motion an exchange of nothing for something. They divert real funding away from wealth generators toward the holders of the newly created money. This is what sets in motion the misallocation of resources, not price rises as such. Moreover, the beneficiaries of the newly created money--i.e., money "out of thin air"--are always the first recipients of money, for they can divert a greater portion of wealth to themselves. Obviously, those who either don't receive any of the newly created money or get it last will find that what is left for them is a diminished portion of the real pool of funding.

Furthermore, real incomes fall, not because of general rises in prices, but because of increases in money supply; in other words, inflation depletes the real pool of funding, thereby undermining the production of real wealth-- i.e., lowering real incomes. General increases in prices, which follow increases in money supply, only point to the erosion of money's purchasing power--although general rises in prices by themselves do not undermine the formation of real wealth as such.

As a result of an erroneous definition of inflation, some economists argue that low inflation is a precondition for healthy economic growth. For them, inflation is bad news only when it is reaches high figures (George Akerlof, William Dickens, George Perry, "Near Rational Wage and Price Setting and the Long Run Phillips Curve," Brooking Institution study, 2000). If a general rise in prices is the outcome of a rising money stock, how can it benefit the economy if it is stabilized at a low level? Surely the rising money stock that will dilute the real pool of funding cannot be good for economic growth.

Friedman's misleading view of inflation

Some economists, such as Milton Friedman, maintain that if inflation is "expected" by producers and consumers, then it produces very little damage (see Friedman's Dollars and Deficits, Prentice Hall, 1968, pp. 47-48). The problem, according to Friedman, is with unexpected inflation, which causes a misallocation of resources and weakens the economy. According to Friedman, if a general rise in prices can be stabilized by means of a fixed rate of monetary injections, people will then adjust their conduct accordingly. Consequently, Friedman says, expected general price increases, which he calls expected inflation, will be harmless, with no real effect.

Observe that, for Friedman, bad side effects are not caused by increases in the money supply but by the outcome of that: increases in prices. Friedman regards money supply as a tool that can stabilize general rises in prices and thereby promote real economic growth. According to this way of thinking, all that is required is fixing the rate of money growth, and the rest will follow suit.

However, it is overlooked by the distinguished professor that fixing the money supply's rate of growth does not alter the fact that money supply continues to expand. This, in turn, means that it will continue the diversion of resources from wealth producers to non-wealth producers even if prices of goods will stay stable. In short, the policy of stabilizing prices is likely to generate more instability.

While increases in money supply ( i.e., inflation) are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant--i.e., inflation is high--prices might display low increases. Clearly, if we were to regard inflation as a general rise in prices, we would reach misleading conclusions regarding the state of the economy.

On this, Rothbard wrote, "The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware" (America's Great Depression, Mises Institute, 2001 [1963], p. 153).

Why price indices cannot establish the status of inflation

Because inflation is not a general increase in prices but rather increases in the money supply, it is an exercise in futility to devise a more accurate Consumer Price Index. Moreover, despite its popularity, the whole idea of a CPI is flawed. It is based on a view that it is possible to establish an average of prices of goods and services.

Suppose two transactions are conducted. In the first transaction, one loaf of bread is exchanged for $2. In the second transaction, one liter of milk is exchanged for $1. The price, or the rate of exchange, in the first transaction is $2/one loaf of bread. The price in the second transaction is $1/one liter of milk. In order to calculate the average price, we must add these two ratios and divide them by two; however, it is conceptually meaningless to add $2/one loaf of bread to $1/one liter of milk.

It is interesting to note that in the commodity markets, prices are quoted as dollars/barrel of oil, dollars/ounce of gold, dollars/tonne of copper, etc. Obviously it wouldn't make much sense to establish an average of these prices. Likewise, it doesn't make much sense to establish an average of the exchange rates dollar/sterling, dollar/yen, etc.

On this Rothbard wrote, "Thus, any concept of average price level involves adding or multiplying quantities of completely different units of goods, such as butter, hats, sugar, etc., and is therefore meaningless and illegitimate. Even pounds of sugar and pounds of butter cannot be added together, because they are two different goods and their valuation is completely different" (Man, Economy, and State, p. 734).

If changes in price indices cannot provide us with the status of inflation, what can? All that is required in establishing the status of inflation is to pay attention to the money supply's rate of growth. The higher the rate of growth, the higher the rate of inflation.

Using the money supply definition of the Austrian School of economics, we can suggest that the rate of inflation in the U.S. is accelerating. The yearly rate of inflation jumped to 9.5 percent in February, from 0.1 percent in January last year. Moreover, between 1980 and 2001, the average rate of inflation stood at around 14 percent. Clearly, this shows that, rather than fighting inflation, the Fed has been the biggest promoter of inflation.

Conclusions

The U.S. government's plan to introduce an improved Consumer Price Index in order to more accurately measure inflation is an exercise in futility. Inflation is not about a general increase in prices; it is about increases in the money supply. Hence, whatever the improved index would measure has nothing to do with true inflation, which is always increases in the money supply. Consequently, to find out the status of inflation, there is no need for various sophisticated price indices; all that is required is to pay attention to the money supply's rate of growth.


Frank Shostak, Ph.D., is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org.  Send him MAIL and see his outstanding Mises.org Articles Archive.


Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

Follow Mises Institute