Money and Inflation
From: William F Hummel (wfhummel_at_comcast.net)
Date: 07/02/04
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Date: Fri, 02 Jul 2004 16:01:26 GMT
Money and Inflation
Price inflation is commonly thought to be caused by "too much money
chasing too few goods." The general price level is indeed correlated
with the money supply, but _correlation_ should not be confused with
_causation_. The causes of inflation are many and varied. In a modern
economy, prices are seldom driven by an excess of money. More often,
an increase in the money supply is caused by an increase in prices.
Credit Money versus Commodity Money
It's easy to understand how the money supply drives prices when a
commodity like gold is used as money. In the gold 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 the California increased. Indeed it increased much faster
than the available supply of goods and services, so prices in terms of
gold naturally rose.
In a modern fiat money system, the _net_ monetary wealth of the
private sector is due to government spending. Currency issued by the
government has replaced gold as the monetary base. Base money derives
its value from the fact that it is required in the payment of taxes.
However currency is a minor part of the money supply. Most of the
money we use is credit money borrowed from the banking system, and
exists only as bank deposits. Bank deposits retain value because the
government requires them to be converted into currency on demand.
A bank loan creates both an asset and a liability, and therefore does
not result in net monetary wealth. The borrower receives a deposit he
can use as money, but he owes the bank the principal as well as
interest payments. Thus credit money behaves differently from base
money, whether currency or gold. The growth of credit money depends
on the demand for bank credit and the willingness of banks to lend.
There is no practical limit to the supply of credit, but all credit
comes at a price. To understand the relation between money and
inflation today, we must therefore determine what creates demand for
credit.
Effects Related to the Price of Credit
The amount of money created is a function of many economic variables,
including the price of credit which the central bank controls. The
central bank can easily increase the price of credit enough to make
borrowing unprofitable, stifle growth of the money supply, and even
reduce total economic output. That would result in increased
unemployment and possibly price deflation.
Conversely the central bank can easily reduce the price of credit, but
the results are not symmetric. When the economy is operating well
below capacity, cheaper credit will normally increase output and
employment. The resulting growth must be supported by an increasing
amount of credit over which the central bank has no direct control.
Other factors may discourage borrowing in spite of the availability of
cheap credit. However when economic growth is achieved, it normally
occurs without significant price inflation up to the point of nearly
full employment. Thereafter the effects of cheap credit will
generally lead to higher prices, due largely to the increasing cost of
labor near full employment.
Demand for Credit and its Effects
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 affects the money supply and
prices.
(1) A new enterprise, or an existing enterprise planning to expand
production, requires funds well ahead of the expected return from
sales. It is often financed with credit money, and the whole process
has little or no effect on current prices. As the economy grows,
however, the amount of credit must grow in support. Indeed if credit
were curtailed, the economy would stagnate for lack of adequate
liquidity.
(2) Money borrowed for consumer purchases implies the availability of
existing products whose prices have already been set by the sellers.
Such borrowing increases the money supply without affecting prices.
However where supply falls short of demand, prices on those consumer
goods will generally rise, at least temporarily. But the shortages
tend to occur in isolated cases and are usually short-lived. They
seldom have a lasting effect on the general price level.
(3) Money borrowed for speculative purposes mainly affects asset
prices, particularly stocks and real estate. If the borrowing cost is
set too low for an extended period, asset prices could become
inflated. This creates a money illusion that can lead to a relaxed
attitude by consumers toward prices, and result in a general increase
in the price level.
Effects of Government Spending
Government deficit spending means borrowing from the private sector.
Such borrowing and spending has no direct effect on the amount of base
money, though it does increase 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 inflation.
If a government is unable to recapture its spending through taxes and
bond sales, the base money supply will increase. In severe cases,
which usually occur only as a result of insurrection, corruption, or
war, governments have resorted to printing money to spend. If
continued long enough, that can become a hyperinflation. Such
pathological cases are quite different in origin and character from
the low level inflation that exists in most fiat money systems today.
A Case History - Inflation in the 1970s
During the 1970s, the U.S. experienced a significant inflation in
which the consumer price index rose at an annualized rate of 7.5%.
However M1 rose at an annualized rate of only 6.5%. Clearly something
besides an excess of transaction 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 that had to
be passed on as higher consumer prices. However that was not the only
important cause of the inflation during the period.
Key industries were dominated by powerful corporations, some of which
had the clout to set prices. This in turn enabled strong unions to
gain generous wage contracts, sometimes well above the growth in labor
productivity. COLAs in the contracts added a positive feedback effect
on wage growth. The benefits achieved by unions were mainly in the
manufacturing sector, but gradually spread to the service sector.
With labor the main cost in most consumer items, the result was a
cost-push inflation that became a serious wage-price spiral.
Increasing wages enabled consumers to absorb the rising prices imposed
by producers. These factors, together with the demands for expanding
production, required a larger money supply to support it. As
profit-seeking enterprises, banks were more than happy to lend to
creditworthy borrowers, and so the money supply grew.
In summary, there are numerous forces that apply upward pressure to
prices which are not driven by money supply growth. Global
competition now limits the power of many domestic producers to set
prices. But less competitive sectors remain and contribute to a long
term upward bias in prices. As prices rise, the money supply growth
must necessarily keep pace.
William F Hummel
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