According to many, the key cause of a general increase in prices is inflationary expectations. For instance, if there is a large increase in the prices of oil, individuals, it is held, will start forming expectations for higher inflation ahead. Consequently, individuals will speed up their purchases of goods and services at present thereby raising the demand for goods and services. This, it is held, will set-in motion general increases in prices. According to the former Fed Chairman Ben Bernanke,
Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.
It is held that if inflationary expectations could be made less responsive to various shocks, then, over time, this would mitigate the effects of these shocks on the prices of goods and services.
Many commentators are of the view that, through central bank monetary policies, it is possible to bring inflationary expectations to a state of equilibrium. At this state, it is believed, expectations can be anchored. Once inflationary expectations are anchored, various shocks, such as a large increase in the price of oil, are likely to have a short-lived effect on general increases in prices.
According to Bernanke, anchoring inflation expectations is of utmost importance to eradicate inflation,
. . .the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations. The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.
It is also believed that to make inflation expectations well-anchored, individuals must be clear about the monetary policy of central bank policymakers. For many commentators, through inflation targeting and clear communication by policymakers, the central bank can make inflationary expectations well-anchored.
General Price Increases and the Money Supply
It is held that the emergence of inflation in response to the increase in the price of oil or other commodities requires increases in expected inflation. On this, the former Fed Chairman Bernanke is of the view that,
. . .a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent “wage-price spiral.”
The main problem with this way of thinking is that inflation is defined as an increase in the prices of goods and services rather than increases in the money supply. However, without the preceding inflationary increases in the money supply there cannot be a general increase in prices, which is often called inflation.
A monetary price is the amount of money exchanged per unit of a good. Hence, for a given quantity of goods, if the stock of money remains unchanged the amount of money employed per unit of a good will also remain unchanged.
Let us say that, because of an increase in the price of oil, individuals have raised their inflationary expectations. If the money stock remains unchanged, then no general increase in the prices of goods and services will take place, notwithstanding the increase in inflationary expectations. If more money is spent on oil and energy-related products, less money will be left for other goods and services. The prices of oil and energy-related goods will go up while the prices of other goods and services will go down.
It is increases in the money supply and credit expansion that underpin a general price increase, and not inflationary expectations. Without monetary inflation, no general increase in prices will take place, notwithstanding inflationary expectations.
Furthermore, what matters, as far as inflation is concerned, is not its manifestation in terms of the prices of goods and services, but the damage it inflicts to the entire wealth-generation process. This is inferred from the fact that inflationary increases in money supply sets in motion an exchange of nothing for something. According to Murray Rothbard,
Inflation. . .redistributes the wealth in favor of the first-comers and at the expense of the laggards in the race. And inflation is, in effect, a race—to see who can get the new money earliest.
Some economists, such as Milton Friedman, maintain that if inflation is “expected” by producers and consumers, then it causes very little damage. 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 could be stabilized by means of a fixed rate of money growth, individuals would then adjust their conduct accordingly. Consequently, Friedman held, expected general price increases, which he called expected inflation, will be harmless, with no real effect.
The fixing of the money supply’s growth rate does not alter the fact that money supply continues to expand although at a fixed percentage. This means that it will lead to the diversion of resources from wealth-producers to non-wealth-producers. Hence, the policy of stabilizing prices will generate more instability through the misallocation of resources.
Employing the definition that inflation is an increase in the money supply, it follows that to counter inflation the focus should be on curbing the increases in money supply and not anchoring inflationary expectations. By curbing increases in the money supply, the impoverishment of wealth-generators will be arrested too. This, in turn, will revitalize the economy.
Conclusion
Inflation is not about general increases in prices and inflationary expectations but about increases in the money supply. Also, contrary to various commentators, inflationary expectations—in the absence of monetary inflation—will not cause a general increase in the prices of goods and services.
