Inflation

Inflation is a general increase in the money supply. It is the opposite of deflation.

One of the effects, that may accompany inflation (and is sometimes confused for it) is a rise in prices called price inflation. Inflation is sometimes referred to as monetary inflation so as to distinguish it from price inflation.

Definitions
There are several ways to define inflation, with varying usefulness and ability to explain the phenomenon.

Increase in money supply
Prices do not stay constant, they are always rising and declining. An increase in the money supply - inflation, properly defined - has a tendency to raise them in general.

"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. Each individual dollar becomes less valuable because there are more dollars. Therefore more of them will be offered against, say, a pair of shoes or a hundred bushels of wheat than before. A 'price' is an exchange ratio between a dollar and a unit of goods. When people have more dollars, they value each dollar less. Goods then rise in price, not because goods are scarcer than before, but because dollars are more abundant."

An increased stock of commodity money will raise the standard of living by further satisfying nonmonetary demands for the commodity. New paper money does not demonstrably benefit some without injuring others.

Overly large increase in money supply
This has been a popular definition in the past. A large increase in the money supply would have the accompanying effects - like price increases. However, it is not clear how large exactly an increase has to be, making it a judgment call.

Unbacked money
According to Rothbard, inflation is the process of issuing money beyond any increase in the stock of specie. In other words, new money substitutes are issued without backing of their specie. The great gain comes from the issuer’s putting new money into circulation. The profit is practically cost­less, because, while all other people must either sell goods and services and buy or mine gold, the government or the commer­cial banks are literally creating money out of thin air. They do not have to buy it. Any profit from the use of this magical money is clear gain to the issuers.

Rising prices
In a popular definition, inflation is an ongoing rise in the general level of prices.

However, this fails to explain why inflation is dangerous or exactly how does it cause its effects. "Why should a general rise in prices weaken real economic growth? Or how does inflation lead to the misallocation of resources? Moreover, if inflation is just a rise in prices, surely it is possible to offset its effects by adjusting everybody's incomes in the economy in accordance with this general price increase."

It is sometimes claimed, that a specific price increase - e.g. of oil - can increase all prices on average. But if people must spend more on oil, will not prices drop for the goods that they can no longer afford to purchase? (It is also impossible to establish an average of prices of different goods and services. )

It is contended that the increase in commodity prices often occurs before the increase in the money supply. Immediately after the outbreak of war in Korea, strategic raw materials began to go up in price on the fear that they were going to be scarce. Speculators and manufacturers began to buy them to hold for profit or protective inventories. But to do this they had to borrow more money from the banks. The rise in prices was accompanied by an equally marked rise in bank loans and deposits. If these increased loans had not been made, and new money had not been issued against the loans, the rise in prices could not have been sustained. The price rise was made possible, in short, only by an increased supply of money.

Historical development of the definition
The term "inflation" as defined by the British Currency School was used strictly to denote an increase in the supply of money that consisted in the creation of currency and bank deposits unbacked by gold. It became accepted in the English-speaking world from the mid-nineteenth century.

However, because the writers of the British Currency School neglected to consider bank deposits as part of the money supply, their policies as adopted in Great Britain failed to prevent inflation and the business cycle. The School’s doctrines and policies fell into profound disrepute by the late nineteenth century, and its definition of inflation was replaced by that of the opposing Banking School, which saw inflation as a state in which the money supply exceeds the needs of trade. From there it was a short step to the currently prevailing definition of inflation as an increase in the price level.

Overview of dictionary definitions of the term "inflation":

The process of inflation
Historically, governments have often inflated by debasing coins, but they found it is cheaper and faster by creating paper money on a printing press.

In present times, the methods taken for inflation are usually more indirect. As an example from the US, the government will sell its bonds or other 'IOUs' to the banks. In payment, the banks create "deposits" on their books against which the government can draw. A bank in turn may sell its government IOUs to the Federal Reserve Bank, which pays for them either by creating a deposit credit or having more Federal Reserve notes printed and paying them out. This is how money is manufactured.

The value of money varies for basically the same reasons as the value of any commodity. Just as the value of a bushel of wheat depends not only on the total present supply of wheat but on the expected future supply and on the quality of the wheat, so the value of a dollar depends on a similar variety of considerations. 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.

The value of a unit of money does not depend only on the present supply of money 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.

Limits
If the government of a country is running a printing press, it may seem like a source of infinite wealth. But there are pragmatic limits on how much new money can be printed up each year. The more monetary inflation they sow, the greater the price inflation they will reap.

At some point, a government would actually make itself poorer in the long run by running the printing press too heavily in the present. For example, if the stock of money would be doubled in one year, the resulting price inflation could destabilize the economy and cause much needless capital consumption. The citizens would be less willing to invest in their businesses and retirement portfolios, knowing that their savings might be effectively confiscated again through massive creation of new money. Foreign investors would be also wary of exposing themselves to this country if its fiat currency is too volatile.

Because of these considerations, the government would no doubt print new money every year, but wouldn't overdo it. He would aim for a moderate level of constant price inflation, with the purchasing power of his fiat currency slowly falling over time in a predictable manner. Each year, the new influx of money into the economy would represent a transfer of wealth from all other currency holders into the government's possession. If the government wants to spend more money than it receives via its taxes and new money from the printing press (inflation), it can still resort to old-fashioned borrowing.

Countries which sustained high inflation also often experience dollarization (the use of foreign currency). A government that has grossly abused its monopoly over the currency and payments system will often find this monopoly more difficult to enforce in the aftermath, and dollarization to be hard to get rid of.

Values
The median inflation rates before World War I were well below those of the more recent period: 0.5 percent per annum for 1500-1799 and 0.71 percent for 1800-1913, in contrast with 5.0 percent for 1914-2006. In periods with much lower inflation rates and little expectation of high inflation, much lower inflation rates could be quite shocking and traumatic to an economy - and therefore considered crises.

Profit of money creators
Increases in the money supply initiate an exchange of something for nothing. They divert real funding away from those, that generate wealth towards the holders of the newly created money. The general increases in prices, which follow, are a symptom of the erosion of money's purchasing power.

Ways to increase prices
The increase in the money supply will create a new level of prices, but it will not be the old level of prices, multiplied in all relations and quantities.

New money will change the spending habits of people. Also, some of them will make gains and losses and will alter their spending habits accordingly. Therefore, all prices will not increase uniformly. Some prices will rise more than others, therefore, some people will be per­manent gainers, and some permanent losers, from the inflation.

Instead of raising prices, some companies prefer to reduce the quantity of the good sold. Another possibility is to create blends of coffee out of cheaper ingredients or watering beer down.

Velocity of money
It is frequently said that the value of money depends not merely on its quantity but on the "velocity of circulation." Increased "velocity of circulation," however, is not a cause of a further fall in the value of the dollar; it is itself one of the consequences of the fear that the value of the dollar is going to fall (or, to put it the other way round, of the belief that the price of goods is going to rise). It is this belief that makes people more eager to exchange dollars for goods. The emphasis by some writers on "velocity of circulation" is just another example of the error of substituting dubious mechanical for real psychological reasons.

See also Is Velocity Like Magic? by Frank Shostak.

Shortage of goods
A rise in prices can be caused either by an increase in the quantity of money (inflation) or by a shortage of goods — or partly by both. Wheat, for example, may rise in price either because there is an increase in the supply of money or a failure of the wheat crop. But we seldom find, even in conditions of total war, a general rise of prices caused by a general shortage of goods. Even in the Germany of 1923, after prices had soared hundreds of billions of times, high officials and millions of Germans were blaming the whole thing on a general "shortage of goods" — at the very moment when foreigners were coming in and buying German goods with gold or their own currencies at prices lower than those of equivalent goods at home. Similarly, the rise of prices in the United States since 1939 was attributed to a "shortage of goods", while official statistics have shown a rising industrial production.

Nor is a better explanation to say that the rise in prices in wartime is caused by a shortage in civilian goods. Even to the extent that civilian goods were really short in time of war, the shortage would not cause any substantial rise in prices if taxes took away as large a percentage of civilian income as rearmament took away of civilian goods.

Rising commodity prices
According to some economists, increases in commodity prices such as oil can be behind strong increases in the prices of goods and services.

If the price of oil goes up, and if people continue to use the same amount of oil as before, people will be forced to allocate more money to oil. If people's money stock remains unchanged, less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come down. (The term "average" is used here in conceptual form. We are well aware that such an average cannot be computed.)

Note that the overall money spent on goods doesn't change; only the composition of spending has altered, with more on oil and less on other goods. Hence the average price of goods or money per unit of good remains unchanged.

Likewise, the rate of increase in the prices of goods and services in general is going to be constrained by the rate of growth of money supply, all other things being equal, and not by the rate of growth of the price of oil.

It is not possible for increases in the price of oil to set in motion a general increase in the prices of goods and services without corresponding support from the money supply.

Budget deficits
A budget deficit is inflationary only to the extent that it causes an increase in the money supply. If it is fully financed by the sale of government bonds paid for out of real savings, it does not need to cause any inflation.

Inflation can occur even with a budget surplus if there is an increase in the money supply notwithstanding.

Wage price spiral
Sometimes it is spoken of so-called "inflationary pressures" — particularly the so-called "wage price spiral."

If it were not preceded, accompanied, or quickly followed by an increase in the supply of money, an increase in wages above the "equilibrium level" would not cause inflation; it would merely cause unemployment. And an increase in prices without an increase of cash in people's pockets would merely cause a falling off in sales. Wage and price rises, in brief, are usually a consequence of inflation. They can cause it only to the extent that they force an increase in the money supply.

Inflation compared to counterfeiting
Why is counterfeiting so bad if the government itself prints money? Suppose that Joe Doakes and his merry men have invented a perfect counterfeit. What would happen? In the first place, the aggregate money supply of the country would increase by the amount counterfeited; equally important, the new money will appear first in the hands of the counterfeiters themselves. Counterfeiting, in short, involves a twofold process: (1) increasing the total supply of money, thereby driving up the prices of goods and services and driving down the purchasing power of the money-unit; and (2) changing the distribution of income and wealth, by putting disproportionately more money into the hands of the counterfeiters.

David Hume, in order to demonstrate the inflationary and non-productive effect of paper money, in effect postulated what Rothbard called the "Angel Gabriel" model, in which the Angel, after hearing pleas for more money, magically doubled each person's stock of money overnight. (In this case, the Angel Gabriel would be the "counterfeiter," albeit for benevolent motives.) While everyone would be happy from their seeming doubling of monetary wealth, society would in no way be better off: there would be no increase in capital or productivity or supply of goods. As people rushed out and spent the new money, the only impact would be an approximate doubling of all prices, and the purchasing power of the money would be cut in half, with no social benefit being conferred. An increase of money can only dilute the effectiveness of each unit of money.

In real life, the very point of counterfeiting is to constitute a process of transmitting new money from one pocket to another. Whether counterfeiting is in the form of making brass or plastic coins that simulate gold, or of printing paper money to look like that of the government, counterfeiting is always a process in which the counterfeiter gets the new money first.

In short, the early receivers of the new money in this market chain of events gain at the expense of those who receive the money toward the end of the chain, and still worse losers are the people (e.g., those on fixed incomes such as annuities, interest, or pensions) who never receive the new money at all. Monetary inflation, then, acts as a hidden "tax" by which the early receivers expropriate (gain at the expense of) the late receivers. As the earliest receiver of the new money is the counterfeiter's gain is the greatest. This tax is particularly insidious because it is hidden, few people understand the processes of money and banking, and because it is all too easy to blame the rising prices, or "price inflation/' caused by the monetary inflation on greedy capitalists, speculators, wild-spending consumers, or whatever social group is the easiest to denigrate. Obviously, too, it is to the interest of the counterfeiters to distract attention from their own role by denouncing any and all other groups and institutions as responsible for the price inflation.