# What is Inflation?



## Chris

The term inflation has been mentioned numerous times on various threads of this forum, especially since the financial crisis. Politicians and central bankers also constantly reference inflation in one way or another. What I want to do in this post is to clarify what inflation actually is. I also want to show that the common, modern definition of inflation, i.e. the general rise in prices, is wrong and why it was and is popularised by bankers and politicians.

Let us first imagine an economy where the money supply is fixed at a certain level. If in this economy demand for one product went up, while supply stayed the same, then the price for that product would go up. This would result in more money being spent on that product. As we have a fixed supply of money, the increased amount of money being spent on this specific product, must have the result of less money being spent on other products. Less money being allocated to other products equals lower demand, which results in lower prices (assuming supply remains the same). The conclusion here is that with a fixed money supply the price of one product can only go up if the price of other products goes down. It is not possible for the price of all products to go up in unison.

The only way that the price of all products can go up (or down), is if the supply of money is manipulated. Therefore, it is the very actions of central banks, i.e. setting interest rates and increasing amount of money stock, that cause the increase in prices in the first place, which they are apparently trying so hard to keep at bay. Central banks, stating that their main purpose is to keep inflation low, is like a vodka distiller saying their main purpose is to reduce alcoholism, or a fire fighter setting fires in order to put them out.

So this begs the question of why is the term inflation used in this way, and why are governments and central banks so insistent on creating new money? The answer to this lies in the fact, that when money is created by a central bank (through the purchase of government or corporate debt), this does not have an immediate effect on prices. It takes time for this new money to trickle down through the monetary system. However, with each step through the monetary system, the increased supply of money causes increased prices. This means that, whoever gets the money first benefits of having more money while prices are still the same. Once the money has found its way down to the consumer, prices have gone up and therefore the purchasing power of each unit of money has gone down. Ask yourself this: Why is it ok for the central bank to create money out of thin air, but you and I would go to prison for doing so? Whoever gets the new money first benefits.

What this means is that a government can borrow newly created money, by issuing bonds to the central bank, spend it at current price levels, and then repay the debt some time in the future with devalued money. A currency which is devalued through inflation benefits debtors at the expense of savers, and since governments throughout the world are the most indebted organisations, it is clear why they are so in favour of causing inflation.

Price deflation, which we are being so ruefully warned about, is only bad in the world of government and high levels of debts. Why would anybody be upset to walk into a shop and pay less for a product than was paid last week? The argument is made that this causes "uncertainty" and results in consumers not spending because they think they'll get a better deal next week or month. But this cannot, in any way, be backed up by what actually happens on the open market. Take flat screen TVs for example; 10 years ago a 32" plasma would have put you back about €8000 or more. Since then prices have plummeted, and are still going down, and the number of people buying plasma or LCD TVs increased exponentially. The same thing has happened with computers. The other argument is that lower prices cause profits of businesses to go down. This also is nonsense. To a business the importance lies in the margin between cost of production and price. Yes, if price goes down and cost of production stays the same or increases, then profits go down. But in a deflationary period, prices of production goods also go down, so a lower price of end product is not an issue to be concerned about.

Bottom line is that the general increase in prices is the consequence of inflation, and not in itself inflation. Higher prices in general are only possible when the total supply of money is increased, which is exactly what central banks do. Saying that inflation is the rise in prices is dishonest at best, and in my opinion more aptly referred to as treachery.


Here are some links and books on the topic:
Hazlitt – Economics in One Lesson, Chapter 12: http://www.hacer.org/pdf/Hazlitt00.pdf
Shostak – Defining Inflation: [broken link removed]
http://mises.org/daily/2914
Rothbard - What has Government Done To Our Money?


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## Protocol

Chris said:


> Let us first imagine an economy where the money supply is fixed at a certain level. If in this economy demand for one product went up, while supply stayed the same, then the price for that product would go up. This would result in more money being spent on that product. As we have a fixed supply of money, the increased amount of money being spent on this specific product, must have the result of less money being spent on other products. Less money being allocated to other products equals lower demand, which results in lower prices (assuming supply remains the same). The conclusion here is that with a fixed money supply the price of one product can only go up if the price of other products goes down. It is not possible for the price of all products to go up in unison.


 
With a fixed nominal money supply (M), it is possible for all consumer prices (P) to rise. All you need is a rise in the velocity of money (V).

Quantity equation: M * V = P * Y


Most of the rest I agree with.


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## Chris

Protocol said:


> With a fixed nominal money supply (M), it is possible for all consumer prices (P) to rise. All you need is a rise in the velocity of money (V).
> 
> Quantity equation: M * V = P * Y
> 
> 
> Most of the rest I agree with.



Hi Protocol,
I do not believe that the "velocity of money" has any impact on prices or is in any way relevent in price theory. The topic of "velocity" is rather complicated, but for an Austrian School view I recommend this article: http://mises.org/daily/918


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## Duke of Marmalade

A simple example to prove that velocity *does* matter.  Billionaires have very low velocity - so much money they don't know what to do with it - those on the dole have very high velocity - they spend money as quick as they get it.  Now engage in a massive redistribution of money were all billionaires were cut back to their last 100K and the amount confiscated distributed evenly to the population at large.  This would be massively inflationary even though it need involve on increase in the overall supply of money.

On another point, deflation is bad not _per se _but because what caused it is bad viz. a fall in demand and economic activity.


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## Duke of Marmalade

Chris said:


> Ask yourself this: Why is it ok for the central bank to create money out of thin air, but you and I would go to prison for doing so.


When Joan Soap borrows 300K from a bank and buys a house she, with the connivance of her bank, has created a massive amount of money (the bank balance of the seller) out of thin air. 

Money is created by the banking system with the connivance of the populace. This is a good thing. It is the job of Central Banks to ensure that we don't get too much of a good thing and also to use their open market operations to keep the money supply synchronised with the needs of the economy.


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## Chris

Duke of Marmalade said:


> A simple example to prove that velocity *does* matter.  Billionaires have very low velocity - so much money they don't know what to do with it - those on the dole have very high velocity - they spend money as quick as they get it.  Now engage in a massive redistribution of money were all billionaires were cut back to their last 100K and the amount confiscated distributed evenly to the population at large.  This would be massively inflationary even though it need involve on increase in the overall supply of money.
> 
> On another point, deflation is bad not _per se _but because what caused it is bad viz. a fall in demand and economic activity.


You are making a fundamental mistake. Billionaires' money is not sitting somewhere in a vault doing nothing. It is in someway invested. Let's say it is all in cash savings. Contrary to common belief, savings are not idle money. Savings in a bank are lent out for someone else to spend on credit, so when someone saves money they are letting someone else spend it for them. It has no impact on overall price levels. 
Liquidating those funds over 100k would result in a drop in prices, and spending it again would result in an increase. Overall the price level would stay the same.
What would cause an increase is if the 1 billion were to be added to the money supply out of thin air, which is exactly what central banks do.
Here is an article by Henry Hazlitt on velocity that makes some more points why velocity has no impact on prices: http://mises.org/daily/2916




Duke of Marmalade said:


> When Joan Soap borrows 300K from a bank and buys a house she, with the connivance of her bank, has created a massive amount of money (the bank balance of the seller) out of thin air.
> 
> Money is created by the banking system with the connivance of the populace. This is a good thing. It is the job of Central Banks to ensure that we don't get too much of a good thing and also to use their open market operations to keep the money supply synchronised with the needs of the economy.



No, fractional reserve banking is NOT a good thing as it causes inflation, and inflation is hidden taxation, where the wealth of creditors is transferred to debtors. As we can see with the current, and past, crisis, that no matter how intelligent and well-meaning central bankers are (and I am not saying that they are), it is impossible to adjust the money supply accurate enough, even if this were their intention. The intention of central bankers however is to constantly inflate the money supply, i.e. create inflation. The free market is perfectly able to keep things stable.


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## Duke of Marmalade

Chris said:


> You are making a fundamental mistake. Billionaires' money is not sitting somewhere in a vault doing nothing.


I'll make my example more stark. Country A has 1m citizens all with 1 gold doubloon each except for one person who has 1 bn doubloons. Although not necessary to the argument let's make this billionaire one of frugal tastes whose personal demands are no different from the other citizens. Country B has 1m citizens with 1,000 doubloons each. Both countries produce the same level of goods and services. Clearly the price level in B will be higher than in A despite the same money supply. The difference is the velocity.

I agree with everything in the _Mises_ note but in the present context it is largely semantic. It argues that Velocity is not a primary cause - it is a result of some other cause. That could be changing consumer confidence, changing perceptions of the (future) value of money or indeed changes in distribution like the one in my example. Fair enough, but the bottom line is that _Protocol_ is right, the same money supply backing the same economic activity can have different price levels due to different velocities.  _Mises_ would have preferred if _Protocol_ had said "due to changing attitudes to money which cause a change in velocity" but I will forgive _Protocol_ her shorthand.


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## Chris

Duke of Marmalade said:


> I'll make my example more stark. Country A has 1m citizens all with 1 gold doubloon each except for one person who has 1 bn doubloons. Although not necessary to the argument let's make this billionaire one of frugal tastes whose personal demands are no different from the other citizens. Country B has 1m citizens with 1,000 doubloons each. Both countries produce the same level of goods and services. Clearly the price level in B will be higher than in A despite the same money supply. The difference is the velocity.


Very good example, but it would also have to assume that the billionaire's wealth was not being put to any use within the country, through loans or investments. Then I agree that the price level would be different, not because of velocity, but because hoarding the billion would be like reducing the money supply.



Duke of Marmalade said:


> I agree with everything in the _Mises_ note but in the present context it is largely semantic. It argues that Velocity is not a primary cause - it is a result of some other cause. That could be changing consumer confidence, changing perceptions of the (future) value of money or indeed changes in distribution like the one in my example. Fair enough, but the bottom line is that _Protocol_ is right, the same money supply backing the same economic activity can have different price levels due to different velocities.  _Mises_ would have preferred if _Protocol_ had said "due to changing attitudes to money which cause a change in velocity" but I will forgive _Protocol_ her shorthand.


Yes indeed, that would probably be a more accurate statement. If velocity is defined as the speed at which money changes hand, then the more people spend the quicker the effect of fractional reserve banking, i.e. higher prices, are manifest. But this means that velocity is not the cause of higher/lower prices, but merely the speed at which higher prices are reflected on the market after an increase of the money supply. So, on a fixed money supply, like a gold standard, velocity could not change prices levels.


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## Duke of Marmalade

Chris said:


> Then I agree that the price level would be different, not because of velocity, but because hoarding the billion would be like reducing the money supply.


Ah, I was hoping you wouldn't spot that answer I think our differences on Velocity are largely semantic and I intend to leave it at that.

Some interesting links on a Sunday afternoon. Much of it common sense and with which I would not disagree. Where I do disagree is this tendency to see it all as a plot by Central Bankers against the rest of us. This leads to an advocacy of the Gold Standard as the only way to put manners on CBs and Governments.

To be sure the Gold Standard (absent finding that the Moon is made of gold) will certainly keep down prices. But the production of real goods and services is a huge multiple today of what it was say 50 years ago. How could it possibly be that a relatively rigid supply of money would be appropriate for a world economy which has changed so vastly in real terms? The Gold Standard would have been hugely deflationary i.e. the money supply would be decreasing rapidly in relation to the real economy.

In a perfect world we would have a system which attempts to keep the money supply exactly in line with the demands of the real economy. To my mind this can only be achieved by a system of debt backed money supply. Of course, the temptation to abuse this are very great and have led to notable disasters. However, the Germans seem to have got it about right and luckily we are in with them.


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## Chris

Duke of Marmalade said:


> Ah, I was hoping you wouldn't spot that answer I think our differences on Velocity are largely semantic and I intend to leave it at that.


Yeah, I agree, I think we are pretty much on the same page, and we can leave semantics to scholars.


Duke of Marmalade said:


> Some interesting links on a Sunday afternoon. Much of it common sense and with which I would not disagree. Where I do disagree is this tendency to see it all as a plot by Central Bankers against the rest of us. This leads to an advocacy of the Gold Standard as the only way to put manners on CBs and Governments.


Absent some constitutional laws that restrict central banks' actions, I think that a gold standard is the only solution. And in fairness, politicians and bankers are not exactly prone to adhering to rules and laws, and tend to change them as it suits them.



Duke of Marmalade said:


> To be sure the Gold Standard (absent finding that the Moon is made of gold) will certainly keep down prices. But the production of real goods and services is a huge multiple today of what it was say 50 years ago. How could it possibly be that a relatively rigid supply of money would be appropriate for a world economy which has changed so vastly in real terms? The Gold Standard would have been hugely deflationary i.e. the money supply would be decreasing rapidly in relation to the real economy.


Yes indeed, under a gold standard prices would come down as the economy became more productive. But I think this is precisely why during the industrial revolution and times of the gold standard many products became affordable to the masses. Increasing productivity and decreasing prices was the way to prosperity in the past. In today's world, where politicians despise deflation because it makes their debt levels less manageable, the general public has bought into the PR of deflation being an evil resulting in reduced economic activity.



Duke of Marmalade said:


> In a perfect world we would have a system which attempts to keep the money supply exactly in line with the demands of the real economy. To my mind this can only be achieved by a system of debt backed money supply. Of course, the temptation to abuse this are very great and have led to notable disasters. However, the Germans seem to have got it about right and luckily we are in with them.



Money is only a device to make economic transactions and exchange easy. It should not and cannot be used as a means of "creating" wealth. Production is the only way to economic prosperity.
You are right the temptation to abuse the monopoly of money supply is too large, especially when politicians make ever larger promises that would not be popular if they had to be paid for through direct taxation. Easy solution is to print the money, as the majority of the general public do not understand what inflation is and does.


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## Duke of Marmalade

Chris said:


> Absent some constitutional laws that restrict central banks' actions, I think that a gold standard is the only solution.


Ahhh! That's like being a flat earther these days. Maybe you solve one problem but you create many others. For a start since nominal interest rates cannot be less than zero, we would have persistent real interest rates because of productivity gains. More importantly one would be giving up a very useful policy instrument (money supply management) if used responsibly. To use one of your own metaphors it would be like banning alcohol just because it can and often is abused. (Maybe you are a prohibitionist)


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## Chris

Duke of Marmalade said:


> Ahhh! That's like being a flat earther these days. Maybe you solve one problem but you create many others. For a start since nominal interest rates cannot be less than zero, we would have persistent real interest rates because of productivity gains. More importantly one would be giving up a very useful policy instrument (money supply management) if used responsibly. To use one of your own metaphors it would be like banning alcohol just because it can and often is abused. (Maybe you are a prohibitionist)



Hahahaha, let me think about that as I take a sip of wine ;-) I prefer to see all the monetarists and inflationists as the flat earthers.

I certainly would prefer a central bank like the Bundesbank *was* (anything but what we have), but I firmly believe that eventually the temptation of creating even a small amount of extra money out of thin air becomes too big. Free markets are perfectly capable of achieving the perfect balance.


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