What You Should Know About Inflation

Among the popular ideas which make the inflation of our era so hard to combat is the belief that the supply of money ought to be constantly increased “in order to keep pace with the increase in the supply of goods.”

This idea, on analysis, turns out to be extremely hazy. How does one equate the supply of money with the supply of goods? How can we measure, for instance, the increase in the total supply of goods and services? By tonnages? Do we add a ton of gold watches to a ton of sand?

We can measure the total supply of goods and services, it is commonly assumed, by values. But all values are expressed in terms of money. If we assume that in any period the supply of goods and services remains unchanged, while the supply of money doubles, then the money value of these goods and services may approximately double. But if we find that the total monetary value of goods and services has doubled during a given period, how can we tell (except by a priori assumption) how much of this is due to an increase of production, and how much to an increase in the money supply? And as the money price (i.e., the “value”) of each good is constantly changing in relation to all the rest, how can we measure with exactness the increase of “physical production” in the aggregate?

Yet there are economists who not only think that they can answer such questions, but that they can answer them with great precision. The late Dr. Sumner H. Slichter of Harvard recommended a 2½ per cent annual increase in the money supply in order to counterbalance the price-depressing effect of an assumed annual 2½ per cent increase in “productivity.” Dean Arthur Upgren of the Tuck School of Business Administration at Dartmouth wrote in 1955: “Businessmen, bankers, and economists estimate that the nation requires a money supply growth of 4 or 5 per cent a year.” He arrived at this remarkable figure by adding “a 1½ per cent a year population growth, a 2½ per cent yearly gain in productivity, and a gain of 1 per cent in the money supply needed to service the more specialized industries.” This looked like counting the same thing two or three times over. In any case, it is questionable whether such estimates and calculations, which vary so widely, have any scientific validity.

Yet a lot of people have come to believe sincerely that unless the supply of money can be increased “proportionately” to the supply of goods and services there will not only be a decline in prices, but that this will bring on “deflation” and depression. This idea will not stand analysis.

If the quantity and quality of money remained fixed, and per capita industrial and agricultural productivity showed a constant tendency to rise, there would, it is true, be a tendency for money prices to fall. But it does not at all follow that this would bring about more net unemployment or a depression, for money prices would be falling because real (and money) costs of production were falling. Profit margins would not necessarily be threatened. Total demand would still be sufficient to buy total output at lower prices.

The incentive and guide to production is relative profit margins. Relative profit margins depend, not on the absolute level of prices, but on the relationship of different prices to each other and of costs of production (factor prices) to prices of finished goods. An outstanding example of prosperity with falling prices occurred between 1925 and 1929, when full industrial activity was maintained with an average drop in wholesale prices of more than 2 per cent a year.

The idea that the supply of money must be constantly increased to keep pace with an increased supply of goods and services has led to absence of concern in the face of a constant increase in the money supply in the last twelve years. From the end of 1947 to the end of 1959 the supply of bank deposits and currency increased $79 billion, or 46 per cent. And since the end of 1947 average wholesale prices have increased nearly 24 per cent, in spite of an increase in the industrial production index of 60 per cent.