|Money and Inflation
Price inflation is
commonly thought to be caused by "too much money chasing too few
The general price level is indeed correlated with the money supply, but
should not be confused with causation.
In a modern economy,
prices are seldom driven by the money supply. More commonly, the
supply reacts to changes in the general price level.
Credit Money versus Commodity
It's easy to
understand how the money supply
can drive prices when a commodity like gold is used as money. In
rush days, California
was basically on a barter system in which gold traded for goods and
services. Gold was an asset for the holder and a liability for no
one. As more gold was mined by private enterprise, monetary
wealth in California
increased. Indeed it increased much faster than the available
goods and services, so prices in terms of gold naturally rose.
comprised the monetary base,
it is just another commodity. In a modern fiat money system, the
base is created by the central bank. However base
money is a minor part of the money supply. Most of the
money we use is credit issued by private banks in the form of
Bank deposits are accepted as money because of the promise that they
converted into base money on demand.
A bank loan
increases the money supply but
does not increase net wealth. The borrower receives a deposit
that he can
use as money, but he owes the bank that amount. Thus bank money
differently from base money. A bank can issue credit up to a
multiple of its own capital. Within that constraint, the growth
money depends only on the demand from the public and the willingness of
to lend. To understand what causes inflation today, we must
determine what creates the demand for credit.
Effects Related to the Price
The amount of
bank money created is a
function of many economic variables, including the price of credit
central bank controls. The central bank can easily increase the
credit enough to make borrowing unprofitable, stifle growth of the
supply, and even reduce total economic output. That would result
increased unemployment and possibly price deflation.
central bank can easily
reduce the price of credit, but the results are not symmetric.
economy is operating well below capacity, cheaper credit will usually
output without a significant increase in prices up to the point of
employment. Thereafter the effects of cheap credit will generally
Demand for Credit and its
The demand for
credit arises mainly out of
the desire to finance (1) new enterprise, (2) consumer spending, or (3)
speculative investment. Let's briefly examine how each of these
the money supply and prices.
(1) A new
enterprise or an existing
enterprise planning to expand production requires funds well ahead of
expected return from sales. New production is often financed with
money, and the whole process has little effect on current prices.
economy grows however, the amount of credit must grow in support.
credit were curtailed, the economy would stagnate for lack of adequate
borrowed for consumer purchases
implies the availability of existing products whose prices have already
set by the sellers. Such borrowing increases the money supply
affecting those prices. However where
supply falls short of demand, prices on consumer goods may rise, at
temporarily. But supply shortages tend to occur in isolated cases
usually short-lived. They seldom have a lasting effect on the
borrowed for speculative purposes
mainly affects asset prices, particularly stocks and real estate.
borrowing cost is set too low for an extended period, asset prices can
inflated. This creates a money illusion that can lead to a
attitude by consumers toward higher prices, and result in an
the general price level.
Effects of Government Deficit
deficit spending is normally
financed by borrowing from the private sector. On balance, such
and spending has no effect on the amount of base money, though it does
the net financial wealth of the private sector in the form of Treasury
securities. However contrary to conventional wisdom, there is no
significant correlation between government deficit spending and price
government were unable to obtain
funds through taxes or bond sales, it may resort to printing money to
spend. If continued long enough, such
spending would end in hyperinflation. This occurs infrequently
as a result of serious corruption, revolution, or war.
quite different in origin and character from the low level inflation
exists in most fiat money systems today.
A Case History - Inflation in
1970s, the US
a significant inflation in which the consumer price index rose at an
rate of 7.5%. However M1 rose relative to the real GDP at an
rate of about 3%. Clearly something besides an excess of
money drove that inflation.
A major factor
was the roughly ten-fold
increase in the price of oil resulting from two oil embargoes by OPEC. That led to a sharp increase in material
costs in several important industries which had to be passed on as
consumer prices. However that was not the only important cause of
inflation during the period.
were dominated by powerful
corporations, some of which had the clout to set prices. This in
enabled strong unions to gain generous wage contracts, sometimes well
growth in labor productivity. COLAs in the contracts added a
feedback effect on wage growth. The benefits achieved by unions
mainly in the manufacturing sector, but gradually spread to the service
With labor the
main cost in most consumer
items, the result was a cost-push inflation that became a serious
spiral. Increasing wages helped enable consumers to absorb the
prices imposed by producers. However these factors, together with
demands for expanding production, required a larger money supply to
it. As profit-seeking enterprises, banks were more than happy to
creditworthy borrowers, and so the money supply grew.
numerous forces that apply upward
pressure to prices which are not driven by money supply growth.
competition now limits the power of many domestic producers to set
prices. But less competitive sectors still exist and contribute
to a long
term upward bias in prices. As prices rise, the money supply
necessarily keep pace.
See Money &
Inflation, 1960 - 1994
for a revealing picture of this relationship.