The Connection Between Money-Supply Growth, Inflation

In the article “Rapid money supply growth does not cause inflation” written by Richard Vague at the Institute for New Economic Thinking, December 2, 2016, the author argues that empirical evidence shows that increases in money supply has nothing to do with inflation. According to Vague,

Monetarist theory, which came to dominate economic thinking in the 1980s and the decades that followed, holds that rapid money supply growth is the cause of inflation. The theory, however, fails an actual test of the available evidence. In our review of 47 countries, generally from 1960 forward, we found that more often than not high inflation does not follow rapid money supply growth, and in contrast to this, high inflation has occurred frequently when it has not been preceded by rapid money supply growth.

Now Vague defines inflation as, three or five consecutive years of increases in the consumer price index (CPI) of 5% or more. Based on this he has concluded that an increase in the money supply does not cause inflation.

The main problem here is that inflation is not changes in prices but rather changes in money supply. The fact that Vague could not find strong correlation between increases in money supply M2 and changes in the CPI does not prove much.

To begin with the price of a good is the amount of dollars paid for the good. If the growth rate of money is 5% and the growth rate of goods is also 5% then there will not be any increase in the prices of goods. If one were to follow that inflation is the increase in the CPI then one will conclude that despite the increase in money supply by 5% inflation is 0%.

However, if we were to follow the definition that inflation is about increases in the money supply then we will conclude that inflation is 5%.

So how are we to decide about the correct definition of inflation? Is it about increases in the money supply or increases in prices?

The Essence of Inflation

The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. A definition is to tell us what the fundamentals of a particular entity are. To define a thing we need to go to the origin of how it has emerged.

Historically inflation originated when a country’s ruler such as the 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 the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens. On this 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.

On account of the dilution of the gold coins, the ruler could now mint a greater amount of coins and pocket for his own use the extra coins minted. What was now passing as a pure gold coin was in fact a diluted gold coin.

The increase in the number of coins brought about by the dilution of gold coins is what inflation is all about.

Note that what we have here is an inflation of coins, i.e., an expansion of coins. As a result of inflation, the ruler can engage in an exchange of nothing for something (he can engage in an act of diverting resources from citizens to himself).

Under the gold standard, the technique of abusing the medium of exchange became much more advanced through the issuance of paper money un-backed by gold. Inflation therefore means an increase in the amount of receipts for gold on account of receipts that are not backed by gold yet masquerade as the true representatives of money proper, gold.

The holder of un-backed receipts can now engage in an exchange of nothing for something. What we have is a situation where the issuers of the un-backed paper receipts divert real goods to themselves without making any contribution to the production of goods.

In the modern world money proper is no longer gold but rather paper money; hence inflation in this case is an increase in the stock of paper money.

Observe that we don’t say as monetarists are saying that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.

If we were to accept that inflation is increases in the money supply then we will reach the conclusion that inflation results in the diversion of real wealth from wealth generators toward the holders of newly printed money. We will also reach the conclusion that monetary pumping, i.e., inflation is bad news for the wealth generating process. No empirical study is required to confirm or to refute this.

As we have shown in the example at the beginning increases in the money supply need not always to be followed by general increases in prices. Prices are determined by both 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, prices might display low increases.

This was originally published on Mises.org.