On Monetary Inflation Leading to Price Inflation
After reading what Dan linked, I realized that at the root of the Austrian definition of inflation is their belief that an increase in M necessarily leads to increases in prices.
Again, if I print up a bunch of currency and sit on it, there has been an increase in the money supply but there would be no increase in the general level of prices.
So if an increase in the money supply (inflation) doesn’t lead to a general increase in prices (price inflation) then inflation doesn’t actually seem bad because price inflation is what erodes real savings, wages, and creates other intertemporal distortions.
Austrians do not claim that an increase in M necessarily leads to price inflation under any and all conditions. Instead, we assert that it tends to. But if - like you explain - the new money is not actually introduced into the economy (which includes even non-circulated money since there would be a reasonable expectation that it eventually will be. After all, what purpose is served by money that earns no interest, is not counted as a store of value, and is never exchanged?) or if demand for the money increases enough to offset the new supply, then that may not necessarily lead to price inflation.
Mises, in his Theory of Money and Credit, built that demand caveat right into his definition of inflation:
In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur.
Hazlitt, in What You Should Know About Inflation, offered this caveat by framing it in terms of the supply of goods that money would be used to exchange for:
When the supply of money is increased, people have more money to offer for goods. If the supply of goods does not increase — or does not increase as much as the supply of money — then the prices of goods will go up.
Indeed, Hazlitt later stated as true that “to attribute [price] inflation solely to an increase in the volume of money is ‘oversimplification.’” And went on to provide other means with which money can be made to change in value.
The value of money, like the value of goods, is not determined by merely mechanical or physical relationships, but primarily by psychological factors which may often be complicated.
Also, Hazlitt noted that an expectation in a change in the supply of money can also lead to changes in prices:
It is also an oversimplification to say that the value of an individual dollar depends simply on the present supply of dollars outstanding. It depends also on the expected future supply of dollars. If most people fear, for example, that the supply of dollars is going to be even greater a year from now than at present, then the present value of the dollar (as measured by its purchasing power) will be lower than the present quantity of dollars would otherwise warrant.
Rothbard, in What Has Government Done to Our Money?, explained that the process of new money entering and circulating through the economy is what drives price inflation:
[After the first creators] take the newly-created money and use it to buy goods and services… The new money works its way, step by step, throughout the economic system. As the new money spreads, it bids prices up—as we have seen, new money can only dilute the effectiveness of each dollar.
So it is only under certain conditions (which, ultimately, are nearly all real-world conditions) in which monetary inflation “necessarily” leads to price inflation. When Austrians use the terms inevitable and necessarily, as Mises does here, it is by implicitly assuming - as all economists tend to - ceteris paribus conditions:
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… . As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.
Again, the new money must be introduced into the economy (or recognized to exist and therefore expected to be used) and demand for this new money must not increase commensurate to the new supply. Only under these conditions can the “Austrian definition of inflation” be said to state that an increase in the money supply necessarily leads to an increase in price inflation.
What we do explain is that price inflation is a primary consequence of monetary inflation and, conversely, that monetary inflation is the true cause of price inflation (Austrians are usually careful to distinguish between such inflation and mere changes in prices). Not many years ago, this was mostly an uncontroversial and pretty universally accepted truth. Indeed, many Keynesians and Monetarists today will claim a “target” for price inflation (usually 2% or 4% or some ostensibly innocuous - and ultimately dubious - figure) and flatly recognize that the central bank’s mechanism for monetary expansion is precisely the primary means to that end. Austrians, like other economists, understand that price inflation is the goal of monetary policy.
Assuming that the demand for money is always constant for the remainder of this post and doesn’t play a factor in keeping prices static.
I think that the problem here is that there are a few schools of thought within the Austrian camp. One that believes in the hard-line Quantitative Theory of Money, where any new money instantly leads to inflation. Another, which applies a more flexible approach to money supply increases and views increased supply as “eventually” leading to inflation. Within that second group, there can be smaller niches of thought, where some believe in sticky prices and some don’t. Correct me if I’m wrong here, but most Austrians don’t believe in sticky prices, correct?
Certainly, the introduction of additional liquidity which has no demand and is introduced into circulation can lead to inflation. But even this is no guarantee. It is possible that you can increase money supply, not just to those who hoard it, but into the system, beyond the system’s demand for additional funds and then at a later time decrease the money supply before any inflation takes place and you’ll have no inflationary impact. It’s no guarantee but it is possible.
In other words, it’s all about the stickiness or unstickiness of prices.
If you believe that prices are sticky, then you also believe that introduction of additional capital can have a delayed impact and that one can counter that impact and decrease the money supply before prices react.
As Hazlitt said, it’s all psychological. Prices can change irrespective of money supply because the prices are set by the preferences of people.
I personally believe in price stickiness, for many reasons; contracts, wages with yearly raise agreements, convenience, laziness, etc, etc. Lot’s of reasons why prices might stay static longer than they should.
For this reason I think that it is possible to introduce additional money into a system and not have a (eventual) inflation. There are some Austrians who would disagree and there are some Austrians who would say I’m not an Austrian.
Side Note: I like this discussion and I think that almost all of economics should focus on inflation because it is the key, one way or another. It’s probably safe to say that the three main schools (Austrian, Keynesian and Monetarist/Chicagoan) differ on inflation as the main factor. Both on the causes and the impact of inflation and it’s toxicity to the system. Fun topic.
P.S. I’m just wrapping up 20 hours of work, 80 hours this week, so if this is a bit incoherent, I’m sorry.
EDIT: i forgot to comment on the last paragraph that LAL posted. I agree that price inflation is the goal of monetary policy. Because there’s a belief that current spending/debts are made more affordable in the future via inflation. You can secure spending today and finance it overtime so that once the debt is paid off, looking back in retrospect, the cost seems relatively lower because the money is worth less and supply is greater and more available.
freemarketliberal asked: Prices are sticky. Wages are sticky. Moms are sticky. Everything's sticky.
I agree and that’s why Quantity Theory of Money fails, at least in the short term. Prices react to money supply but that reaction time varies and isn’t (always) instantaneous, this is why monetary inflation and price inflation can exist individually and aren’t economic singularity like rknjl says they are.