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Why Understanding Inflation Is So Important

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Tags Money and BanksMoney and Banking

03/19/2018

According to Ludwig von Mises,

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.1

What is today called inflation is the general rise in prices, which is in fact only the outcome of inflation. Consequently, anything that contributes to price rises is now called inflationary and therefore must be guarded against. Thus, a fall in unemployment or a rise in economic activity are all seen as potential inflationary triggers and therefore must be restrained by central bank policies.

Some other triggers such as rises in commodity prices or workers’ wages also regarded as potential threats and therefore must be always under the watchful eye of the central bank policymakers.

If inflation is indeed 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 general price increases cause 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 what they define as inflation, mainstream economics does not tell us how all these bad side 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?

Furthermore, if inflation is just a rise in prices, surely it is possible to offset its bad side effects by adjusting everybody’s incomes in the economy in accordance with this general price increase.

If, however, inflation is about increases in money supply then all the above questions are easily answered.

We know that 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, which is only the manifestation of this misallocation.

Moreover, the beneficiaries of the newly created money, i.e., money out of “thin air” — are always the first recipients of money, and so they can divert a greater portion of wealth to themselves.

Obviously, those who either do not 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 pool of real wealth.

Additionally, real incomes fall not because of general rises in prices but because increases in the money supply deplete the pool of real wealth and that in turn undermines the production of real wealth, i.e., a lowering of real incomes. 

General increases in prices, which follow increases in money supply, is an indication, as it were that the erosion of peoples’ purchasing power has taken place.

Can Inflationary Expectations Trigger a General Price Rise?

According to popular thinking workers expectations for higher inflation makes them demand higher wages. Increases in wages in turn lift the cost of producing goods and services and forces businesses to pass these increases on to consumers by raising prices. In this way of thinking inflationary expectations is an important factor in setting inflation.

It is true that businesses set prices and it is also true that businessmen while setting prices take into account the various costs of production. However, businesses are ultimately at the mercy of the consumer who is the final arbiter.

The consumer determines whether the price set is “right,” so to speak. Now, if the money stock has not risen then consumers will not have more money to support the general increase in prices of goods and services. (Remember, that a price is the amount of money per unit of a good.)

Consequently, a strengthening in inflationary expectations cannot by itself set in motion a general increase in prices, all other things being equal.

Hence, irrespective of what people’s expectations are if the money supply has not increased then people’s monetary expenditure on goods cannot increase either. This means then that no general strengthening in price increases can take place without an increase in the pace of monetary pumping.

One could however argue that a rise in inflationary expectations will cause the lowering of the demand for money, which within all other things being equal will result in the decline in money’s purchasing power, i.e., a general rise in prices.

We suggest that a fall in the demand for money is likely to emerge once people sense that the quantity of money is out of control. To defend the purchasing power of their earnings it will be logical for them to reduce the demand for money, which loses its purchasing power. So the fall in the demand for money here is on account of massive monetary pumping.

We suggest that the popular view, which holds that by means of transparency the Fed can prevent rises in inflation, does not hold water. Irrespective of how transparent the Fed is what matters here is the rate of increase in the money supply. It is rises in the money supply that cause the physical damage to the process of real wealth formation irrespective of the Fed’s transparency.

Imagine that somehow the Fed did manage to convince people that central bank policies are aimed at stopping inflation and maintaining price stability, yet at the same time the central bank also raises the growth rate of money supply.

Therefore, even if inflationary expectations were stable the destructive process will be set regardless of these expectations because of the increase in the growth rate of money. Note that people’s expectations and perceptions cannot offset this destructive process.

It is not possible to alter the facts of reality by means of expectations. The damage that was done cannot be undone by means of expectations and perceptions.

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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