In any case, the answer to the title at least is yes, inflation is caused by an increase in the money supply. That’s the only kind of inflation that exists. In a natural, limited money state, you’d have a natural minor deflation, and that would be fine. We have continual inflation only for political reasons, because politicians find it advantageous to inflate. We, for instance, had deflation throughout the 19th century, where workers continually took pay cuts to keep wages down to the continually decreasing cost of living And yet their purchasing power increased over time.
The deflation that took place between ~1879 and 1894 was a price deflation; the supply of money grew. I didn’t know about the wage cuts (never come across that before).
In order for this to be possible the increase supply of money would need to be stored under people’s mattresses (or something similar). Why was this the case?
That’s probably a very good idea. And since most non-Austrians are asking (or referring) to price inflation, we could still assert that monetary inflation is the cause for price inflation. I’ll keep that in mind and try to use that from now on.
I like Mises’s inflation definition. Should you also add the additional qualifier that a general rise in prices is caused by inflation when there is not a commensurate increase in the supply of goods? I think it’s also important to note that a general rise in prices is not only caused by inflation, of course. However, with an increased money supply, there will be a lag between that and the increased production.
Jonathan is this possible because while the supply of money grew the demand for money also grew (in line with or more so than the money supply) therefore nullifying price inflation?
So is it more accurate to state that price inflation occurs when the growth in the supply of money is greater than the demand for cash balances?
I think it would be helpful if Austrians abandoned the money supply increase definition for inflation, and replace it witht he commonly held price increase definition of inflation. The fact is, both are “inflations”, but with two definitions it is hard to get on the same page.
This topic reminded me of a topic on another forum, with axiomatic economist Victor Alguliar battling John T. Harvey, in the form of his quotes and a proponent of his views.
Be sure to check that link. Also, there’s of course this:
In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur.[1]
There is nowadays a very reprehensible, even dangerous, semantic confusion that makes it extremely difficult for the non-expert to grasp the true state of affairs. 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. It follows that nobody cares about inflation in the traditional sense of the term.
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 technological confusion is not entirely wiped out, there cannot be any question of stopping inflation.[2]
Increasing the money supply causes inflation? How can that be? Even though the FED may lower interest rates or engage in quantitative easing, thus encouraging banks to loan out money. When the bank loans this money, there still has to be an asset backing the newly created wealth (new wealth = new money). When the principal is fully paid back (plus interest) the banks retire the newly created money out of circulation. People are under the mistaken idea that the FED just creates new money without any associated wealth backing it, thus they see increased money supply without an increase in goods and services as “creating inflation”.
In a fiat based fractional reserve system with a central bank, banks don’t need new assets to create new money. All they need are two conditions, solvency and qualified borrowers. Assets and liabilities are merely bookeeping entries between the fed and member banks.
First of all, the Fed does create new money, namely when it uses open market operations to purchase assets. Bernanke doesn’t have a bunch of cash he previously saved up in order to finance these OMOs; that money is created at that moment. That’s the whole point of the open market operation in the first place: to introduce liquidity into the market.
Secondly, whether banks create most of the money or the fed does (it’s the banks) is immaterial, since all US banks are part of the federal reserve system. Because banks in this system operate on only a fractional reserve, every deposit of cash into the system results in a ten fold increase in the money supply, very loosely speaking.
Thirdly, and this addresses the subject of your post, inflation is a meaningless term if it doesn’t refer to the increase of the money supply/money substitutes. There have been numerous examples through history in which an increase in the money supply did not lead to an absolute, measurable rise in prices. However, it would be a mistake to conclude that inflation didn’t occur, or that increases in the money supply must not always result in inflation. The fact is that an increase in the money supply (an inflation of the money supply) places an upward pressure on prices that, all else equal, will result in higher prices. This is irrefutable and clear when logically deduced from first principles. However, the world of human beings is constantly in flux and there are countervailing factors that may make the effects of monetary inflation hard to track. Therefore, what we can say about increases in/inflations of the money supply is that they must result in prices that are higher than they otherwise would have been. It is important to see, though, that these new prices could be higher, lower, or exactly the same as the prices from before the episode of monetary creation, without changing the essential nature of inflation and its relationship to changes in prices.
Could you elaborate on the open market operations? Just trying to understand the process and make sense out of this.
Here’s the way I’m seeing it at the moment.
I believe what we’re experiencing in our economy today is perpetual deflation caused by banks charging interest on money, effectively taking the interest out of circulation (as well as the principal being retired) and deflating the amount of money available to be earned. Money then has to then be re-introduced into circulation by creating more loans (also subject to interest). Eventually we can no longer afford to service the astronomically huge sums of debt subject to interest and the economy goes into a recession. IMHO, our present economic system is a fraud and a deception and real reform is needed to introduce a truly just system.
And yet their purchasing power increased over time.