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Mix-Ansicht- Defining Inflation / Artikel, engl. - JÜKÜ, 08.03.2002, 16:15
Defining Inflation / Artikel, engl.
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<font face="Verdana" size="1" color="#002864">http://www.mises.org/fullstory.asp?control=908</font>
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<font size="2"><font face="Verdana" color="#002864" size="5"><strong>Defining
Inflation</strong></font>
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<font size="4">by Frank Shostak</font>
[Posted March 8, 2002]
<img alt="Frank Shostak" src="http://www.mises.org/images/Shostak.jpg" align="right" border="0" width="156" height="203"></font><font size="3">On
August 16, the U.S. government will debut of a new type of Consumer Price
Index (CPI), one which it says will better reflect true inflation. Unlike the
existing CPI, the new index will be subject to revisions as more detailed data
become available. The regular CPI has long been criticized for overstating the
actual rate of inflation. The hope is that, once the Fed is able to use more
accurate information concerning general prices, it will be in a better
position to use its tools to counter inflation.</font>
<font size="2">
<h1>Is inflation about price rises?</h1>
</font>
<font size="3">The fundamental problem here is a failure to define the
problem properly. For example, the definition of human action is not that people
are engaged in all sorts of activities, but that they are engaged in purposeful
activities--purpose gives rise to an action.</font>
<font size="3">Similarly, the essence of inflation is not a general rise in
prices but an increase in the supply of money, which in turns sets in motion a
general increase in the prices of goods and services.</font>
<font size="3">Consider the case of a fixed money supply. Whenever people
increase their demand for some goods and services, money will be allocated
toward other goods. Thus, the prices of some goods will increase--i.e., more
money will be spent on them--while the prices of other goods will fall--i.e.,
less money will be spent on them.</font>
<p align="center"><font size="3">[img][/img] </font>
<font size="3">If the demand for money increases against goods and services,
there will be a general fall in prices. In order for an economy to experience a
general rise in prices, there must be an increase in the money stock. With more
money and no change in money demand, people can now allocate a greater amount of
money for all goods and services.</font>
<font size="3">From this we can conclude that inflation is a general
increase in the money supply.</font>
<font size="3">As Mises explained in his essay"Inflation:
An Unworkable Fiscal Policy":</font>
<font size="3">"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."</font>
<font size="3">When inflation is seen as a general rise in prices, then
anything that contributes to price increases is called inflationary. It is no
longer the central bank and fractional-reserve banking that are the sources of
inflation, but rather various other causes. In this framework, not only does the
central bank have nothing to do with inflation, but, on the contrary, the bank
is regarded, against all evidence, as an inflation fighter.</font>
<font size="3">Thus, a fall in unemployment or a rise in economic activity is
seen as a potential inflationary trigger which therefore must be restrained by
central-bank policies. Some other triggers, such as rises in commodity prices or
workers wages, are also regarded as potential threats and therefore must always
be under the watchful eye of the central bank.</font>
<font size="2">
<h1>The popular definition cannot explain why inflation is bad</h1>
</font>
<font size="3">If inflation is just a general rise in prices, then why is it
regarded as bad news? What kind of damage does it do? Mainstream economists
maintain that inflation, which they label as general price increases, causes
speculative buying, which generates waste. Inflation, it is maintained, also
erodes the real incomes of pensioners and low-income earners and causes a
misallocation of resources.</font>
<font size="3">Despite all these assertions regarding the side effects of
inflation, mainstream economics doesn?t tell us how all these bad effects are
caused. Why should a general rise in prices hurt some groups of people and not
others? 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.</font>
<font size="3">However, if we accept that inflation is an increase in the
money supply, and not a rise in prices, all these assertions can be easily
explained. It is not the symptoms of a disease but rather the disease itself
that causes the physical damage. Likewise, it is not a general rise in prices
but increases in the money supply that inflict the physical damage on wealth
generators.</font>
<font size="3">Increases in the money supply set in motion an exchange of
nothing for something. They divert real funding away from wealth generators
toward the holders of the newly created money. This is what sets in motion the
misallocation of resources, not price rises as such. Moreover, the beneficiaries
of the newly created money--i.e., money"out of thin air"--are always
the first recipients of money, for they can divert a greater portion of wealth
to themselves. Obviously, those who either don?t receive any of the newly
created money or get it last will find that what is left for them is a
diminished portion of the real pool of funding.</font>
<font size="3">Furthermore, real incomes fall, not because of general rises
in prices, but because of increases in money supply; in other words, inflation
depletes the real pool of funding, thereby undermining the production of real
wealth-- i.e., lowering real incomes. General increases in prices, which follow
increases in money supply, only point to the erosion of money's purchasing
power--although general rises in prices by themselves do not undermine the
formation of real wealth as such.</font>
<font size="3">As a result of an erroneous definition of inflation, some
economists argue that low inflation is a precondition for healthy economic
growth. For them, inflation is bad news only when it is reaches high figures
(George Akerlof, William Dickens, George Perry,"Near
Rational Wage and Price Setting and the Long Run Phillips Curve,"
Brooking Institution study, 2000). If a general rise in prices is the outcome of
a rising money stock, how can it benefit the economy if it is stabilized at a
low level? Surely the rising money stock that will dilute the real pool of
funding cannot be good for economic growth.</font>
<font size="2">
<h1>Friedman's misleading view of inflation</h1>
Some economists, such as Milton Friedman, maintain that if inflation is
"expected" by producers and consumers, then it produces very little
damage (see Friedman's Dollars and Deficits, Prentice Hall, 1968, pp.
47-48). The problem, according to Friedman, is with unexpected inflation, which
causes a misallocation of resources and weakens the economy. According to
Friedman, if a general rise in prices can be stabilized by means of a fixed rate
of monetary injections, people will then adjust their conduct accordingly.
Consequently, Friedman says, expected general price increases, which he calls
expected inflation, will be harmless, with no real effect.
Observe that, for Friedman, bad side effects are not caused by increases in
the money supply but by the outcome of that: increases in prices. Friedman
regards money supply as a tool that can stabilize general rises in prices and
thereby promote real economic growth. According to this way of thinking, all
that is required is fixing the rate of money growth, and the rest will follow
suit.
However, it is overlooked by the distinguished professor that fixing the
money supply's rate of growth does not alter the fact that money supply
continues to expand. This, in turn, means that it will continue the diversion of
resources from wealth producers to non-wealth producers even if prices of goods
will stay stable. In short, the policy of stabilizing prices is likely to
generate more instability.
While increases in money supply ( i.e., inflation) are likely to be revealed
in general price increases, this need not always be the case. Prices are
determined by real and monetary factors. Consequently, it can occur that if the
real factors are pulling things in an opposite direction to monetary factors, no
visible change in prices might take place. In other words, while money growth is
buoyant--i.e., inflation is high--prices might display low increases. Clearly,
if we were to regard inflation as a general rise in prices, we would reach
misleading conclusions regarding the state of the economy.
On this, Rothbard wrote,"The fact that general prices were more or less
stable during the 1920s told most economists that there was no inflationary
threat, and therefore the events of the great depression caught them completely
unaware" (America?s Great Depression, Mises Institute, 2001
[1963], p. 153).
<h1>Why price indices cannot establish the status of inflation</h1>
</font>
<font size="3">Because inflation is not a general increase in prices but
rather increases in the money supply, it is an exercise in futility to devise a
more accurate Consumer Price Index. Moreover, despite its popularity, the whole
idea of a CPI is flawed. It is based on a view that it is possible to establish
an average of prices of goods and services.</font>
<font size="3">Suppose two transactions are conducted. In the first
transaction, one loaf of bread is exchanged for $2. In the second transaction,
one liter of milk is exchanged for $1. The price, or the rate of exchange, in
the first transaction is $2/one loaf of bread. The price in the second
transaction is $1/one liter of milk. In order to calculate the average price, we
must add these two ratios and divide them by two; however, it is conceptually
meaningless to add $2/one loaf of bread to $1/one liter of milk.</font>
<font size="3">It is interesting to note that in the commodity markets,
prices are quoted as dollars/barrel of oil, dollars/ounce of gold, dollars/tonne
of copper, etc. Obviously it wouldn't make much sense to establish an average of
these prices. Likewise, it doesn't make much sense to establish an average of
the exchange rates dollar/sterling, dollar/yen, etc.</font>
<font size="3">On this Rothbard wrote,"Thus, any concept of average
price level involves adding or multiplying quantities of completely different
units of goods, such as butter, hats, sugar, etc., and is therefore meaningless
and illegitimate. Even pounds of sugar and pounds of butter cannot be added
together, because they are two different goods and their valuation is completely
different" (Man, Economy, and State, p. 734).</font>
<font size="3">If changes in price indices cannot provide us with the status
of inflation, what can? All that is required in establishing the status of
inflation is to pay attention to the money supply's rate of growth. The higher
the rate of growth, the higher the rate of inflation.</font>
<font size="3">Using the money supply definition of the Austrian School of
economics, we can suggest that the rate of inflation in the U.S. is accelerating.
The yearly rate of inflation jumped to 9.5 percent in February, >from 0.1
percent in January last year. Moreover, between 1980 and 2001, the average rate
of inflation stood at around 14 percent. Clearly, this shows that, rather than
fighting inflation, the Fed has been the biggest promoter of inflation.</font>
<font size="2">
<h1>Conclusions</h1>
</font>
<font size="3">The U.S. government?s plan to introduce an improved Consumer
Price Index in order to more accurately measure inflation is an exercise in
futility. Inflation is not about a general increase in prices; it is about
increases in the money supply. Hence, whatever the improved index would measure
has nothing to do with true inflation, which is always increases in the money
supply. Consequently, to find out the status of inflation, there is no need for
various sophisticated price indices; all that is required is to pay attention to
the money supply's rate of growth.</font>
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Frank Shostak, Ph.D., is an adjunct scholar of the Mises Institute and a frequent
contributor to Mises.org. Send him <font color="#000080" size="2">MAIL</font>
and see his outstanding Mises.org <font color="#3571ca" size="2">Articles
Archive</font>.
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