Should Inflation Be Defined Only as Price Increases?
Frank Shostak

If inflation is a general increase in prices, as most experts hold, then why is it regarded as bad news? What kind of damage does it do? Most experts are of the view that inflation causes speculative buying, which generates waste. Inflation, it is maintained, also erodes the real incomes of low-income earners and causes a misallocation of resources. Inflation weakens real economic growth.

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? The popular definition of inflation as a general increase in prices is questionable. In order to ascertain what inflation is all about, we must go back in time when this phenomenon emerged.

Historically, inflation occurred when a country’s ruler, such as a king, would force his citizens to give him all their gold coins under the pretext that a new gold coin was going to replace the old one. In the process of minting new coins, the king would reduce the amount of gold contained in each coin and return lighter gold coins to citizens. Because of the reduced weight of gold coins that were returned to citizens, the ruler was able to generate extra coins that were employed to pay for his expenses. What was passing as a gold coin of a fixed weight was a lighter gold coin. Rothbard wrote,

More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks,” but of a lighter weight. The leftover ounces of gold or silver were pocketed by the king and used to pay his expenses.

The extra gold coins that the ruler was able to generate enabled him to channel wealth from the citizens to himself. All other things being equal, we now have more coins relative to goods, causing higher prices. Hence, the dilution of gold coins resulted in higher goods prices. The inflation of gold coins sets in motion the diversion of goods from citizens to the king and others close to power (i.e. from wealth-producers to non-wealth-producers).

In the modern world, money proper is no longer gold coins, but metallic coins, paper notes in circulation known as cash, and often digital transactions between accounts (e.g., debit cards). Hence, inflation, in this case, is an increase in the supply of fiat currency. Also, observe that increases in cash sets an exchange of nothing for something—a similar effect that was produced by the king’s dilution of gold coins. 

It follows then that the subject matter of inflation is not a general rise in prices, but artificial increases in the money supply (and higher prices are usually the consequence). Increases in money supply set in motion the misallocation of resources and undermine the wealth-generation process. According to 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.

Furthermore, once money is injected, there are always early receivers of money and the late receivers. Because of the time lag between money supply changes and changes in prices of goods, the early receivers of money are the greatest beneficiaries since the prices of goods they purchase have not increased yet. The late receivers of money are likely to face increases in prices and economic impoverishment. The early receivers of the newly-printed money benefit at the expense of the late receivers. Or the early receivers divert goods to themselves from the late receivers. As a rule, low-income individuals are usually part of the late receivers, hence, they suffer the most as a result of monetary inflation.

It is extraordinary that, in attempting to explain movements in prices, various commentators have nothing to say about the role of money and monetary policy in forming the prices of goods. After all, a monetary price of a good expresses the amount of money exchanged for it (i.e., dollars paid per unit of something).

Friedman’s Expected versus Unexpected 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, pp. 47-48). The problem, according to Friedman, is with unexpected inflation, which causes a misallocation of resources and weakens the economy. For Friedman, inflation is a general increase in prices.

According to Friedman, if a general rise in prices can be stabilized by means of a fixed rate of monetary injections, individuals will adjust their conduct accordingly. Consequently, expected general price increases—which Friedman labels as expected “inflation”—will be harmless, with no real effect. For Friedman, bad side effects are not caused by inflationary increases in the money supply, but by the outcome of that policy: increases in prices. Friedman regards money supply as a policy tool that can stabilize general increases 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.

What is overlooked, however, is that fixing the money supply’s rate of growth so that it is predictable does not alter the fact that money supply continues to artificially 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.

Is it possible to establish the “average price” of goods?

Despite its popularity, the whole idea of a consumer price index (CPI) is questionable. It is based on a view that it is possible to establish an average of the prices of goods and services. While it is certainly possible to look at the prices of a good within a range of time and come up with a mathematical price average, there is really no such thing as an “average price.” The absurdity of this can be seen in comparing prices of heterogeneous goods.

Suppose two transactions are conducted. In the first transaction, one loaf of bread is exchanged for $2. In the second transaction, one gallon of milk is exchanged for $1. The price—or the rate of exchange—in the first transaction is $2 per one loaf of bread. The price in the second transaction is $1 per one gallon 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. 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.

Reconciling Strong Monetary Inflation with Moderate Price Increases

If there is an artificial increase of the money supply—alongside real economic production and growth—then prices may not necessarily increase following inflation. If one were to hold the definition that inflation is a general increase in prices, one would conclude that—despite an artificial increase in money supply—“inflation” could be 0 percent. However, if we were to follow the definition that inflation is about artificial increases in the money supply, then we would come to a completely different conclusion.

For example, we can see how a faulty definition of inflation in the lead-up to the Great Depression contributed to this problem. If we were to pay attention to the so-called “price level,” as many economists did during that era, and if we disregard inflationary increases in the money supply, we would reach misleading conclusions regarding the state of the economy. 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.

Conclusion

Regardless of how the symptoms of inflation are displayed (e.g., price increases, boom-bust cycles), what matters are the artificial increases in money supply, which is what inflation is. These increases set in motion the exchange of nothing for something and distort the structure of production. Therefore, policies aimed at fixing the symptoms of inflation are making things much worse.

Courtesy of Mises.org

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies.

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