I constantly hear people refer to the CPI as the best measure for inflation. However, this does not make sense to me because the way I understand the CPI, it represents the price level of a market basket of consumer goods and services.
My question then, I believe, has two parts:
What should be the definition of inflation? Is it widely accepted that the definition of inflation is simply a rise in prices? Or is there belief that inflation is always and everywhere a monetary phenomenon as Milton Friedman said?
If we do define inflation is purely an issue of monetary policy, then how can we separate the change in a price due to supply and demand factors versus the change in price due to too much (or too little) money in circulation?
I recently brought up this example to one of my colleagues: What if there were a fire at an oil production facility that causes a drop in the supply of oil. And, keeping all other things equal, this causes a rise in the price of oil, which would increase the CPI. Surely people cannot believe that we should be categorizing this as inflation? The response I received was that the CPI would be adjusted for the fact that there was a fire at the oil facility. But how can we know exactly the amount by which it should be adjusted? Or how would we even be able to come up with a ballpark estimate of what the price change is due to supply and demand factors versus monetary factors?
Perhaps it would help me to know the details of how the CPI is calculated and/or adjusted, but I feel that the price changes of a basket of goods and services are a consequence of supply and demand as well as monetary policy. But how can they be separated?
Does anyone have thoughts on this? Are there any materials or books you would recommend for further reading on this topic?
What should be the definition of inflation? Is it widely accepted that the definition of inflation is simply a rise in prices? Or is there belief that inflation is always and everywhere a monetary phenomenon as Milton Friedman said?
The two are not mutually exclusive. Friedman defined inflation as a rise in the general price level, yet he believed that this rise in prices comes as a result of changes in the supply of money. Of course, if you define inflation as a rise in any price (that is, changes in price relative to each other) then Friedman’s causality no longer applies (changes in relative prices can come as a result in changes in preference).
If we do define inflation is purely an issue of monetary policy, then how can we separate the change in a price due to supply and demand factors versus the change in price due to too much (or too little) money in circulation?
The best approach is the orthodox Austrian approach, which is to define inflation as changes in the supply of money (which is the original definition). You can call “changes in prices” “changes in prices”, because we know that prices change relative to each other, not simultaneously and proportionally.
Personally I think the monetary base is the important money supply. I have a “theory” you should keep the supply of credit and money separate. Monetary inflation (money printing) causes permanent price increases. Credit inflation causes temporary bubbles that will end up deflating.
This explains why Japan didn’t have price increases despite having low interest rates. They didn’t print money. They tried to expand credit. It also explains why you can’t print money as a substitute for bad loans and other supposed deflationary forces. These deflationary forces are temporary. When the deflation wears off the permanent inflation kicks in.
I was vague in my phrasing and I agree that the two things I said in #1 are not mutually exclusive. But if I specify further and say: price changes due to supply and demand factors vs price changes due to changes in the money supply are mutually exclusive, that is correct, right?
It seems like a good answer to say that inflation should be defined as a rise in For examples sake, if we look at prices of the goods and services in the CPI over a certain period, then
It seems to me that if we look at the price of several goods/services from one period to another, there is no way to tell where the changes in price come from, whether it be from changes in supply/demand, or from changing money supply. I understand that prices will all change in the same direction when the money supply changes significantly, but all other things will not be held constant. So let’s say we are looking at 10 different goods/services in the CPI. It will not be the case that they all increase by the same amount. Maybe an increase in the money supply caused them to increase by ~2%, but there will be supply/demand factors that cause the price to change that will make this ~2% price change unclear and unmeasurable.
Money which affects prices is money in circulation, or money that is presently being bid towards existing economic goods.
Monetary inflation (money printing) causes permanent price increases. Credit inflation causes temporary bubbles that will end up deflating.
This isn’t necessarily true. Paper money is just as easy to destroy as electronic credit; they are both money substitute and/or fiduciary media. A commodity base money is more difficult to destroy, but you can melt coin and bullion.
This explains why Japan didn’t have price increases despite having low interest rates.
It’s because not all the new money created entered circulation. It’s a similar phenomenon to that which is currently occuring in the United States.
That is very interesting. I am a novice on this topic and don’t fully understand the dynamic between printing money vs expanding credit, and how this is actually implemented in practice. Any books/materials you’d recommend?
In regards to literally printing money, is it ever smart to knowingly increase the money supply by printing money? What if GDP is rapidly increasing, does that mean more money should be printed? Or what if the population of a country is increasing significantly, is that cause to increase the money supply by printing money?
I was vague in my phrasing and I agree that the two things I said in #1 are not mutually exclusive. But if I specify further and say: price changes due to supply and demand factors vs price changes due to changes in the money supply are mutually exclusive, that is correct, right?
Yes, but just remember to differentiate between general price inflation (an increase in nominal spending) and relative price inflation, which can occur due to changes in the supply of money or supply/demand factors.
It seems to me that if we look at the price of several goods/services from one period to another, there is no way to tell where the changes in price come from, whether it be from changes in supply/demand, or from changing money supply.
If the price level has risen then there has been an increase in nominal spending. This can only come about as a result of an increase in money. Changes in nominal expenditure have everything to do with the quantity of money in circulation.
The money supply is the amount of money in process at a specific period…
again, inflation is simply the increase of a money supply… or in Lesson For The Young Economist, inflation is defined as the creation of more money, which drives up prices… you can be more specific and say Monetary inflation is the increase of the money supply and Price Inlfation is the increase in prices…
But that just begs the question… When/how should the money supply be adjusted by a central bank (if ever)?
In a free-market believer’s view, I would say that no government/central bank function should try to control or react to changs in what you called “price inflation.”
But how should the money supply be grown or shrunk by a central bank?
Nominal expenditure is the total amount of monetary expenditure in an economy. We can call it “aggregate demand” (well, technically, “aggregate nominal demand”)—in fact, this is the “aggregate demand” most Keynesians refer to when they use the word. Therefore, if there is a general increase in the price level it means that the level of nominal spending has increased, because had the money supply in circulation remained the same then the general (average) price level would have remained the same. Without an increase in money in circulation an increase in price for good A necessarily means that the price of some other goods have fallen (together, by the same amount).
you are wanting to know about Federal Reserve policy on adjusting the money supply… well, the best source to that would be to read Milton Fiedman’s writings… you are getting into the theory of monetarism
A Theoretical Framwork For Monetary Analysis By Friedman
and you can also read A Monetary History, co authored by Friedman
According to my college Econ Textbook,under monetarism, the money supply should be expanded each year at the same annual rate as the potential rate of growth of the real GDP. The money supply should be increased steadily between 3 and 5 percent per year.
Austrians reject this because we call for an abolishment of the central banks… monetarism is a neoclassical, Chicago economics theory, not Austrian Economics theory…
Inflation is defined by an increase in the supply of money beyond the demand for money (this doesn’t necessary yield general price inflation but it will always yield relative price distortions). This is the definition used by Hayek, Mises, Wicksell, and others.
i do not what source you have for Mises but in his paper on inflation, Inflation:An Unworkable Fiscal Policy, he doesn’t define it that way,
“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.”- Mises
I prefer to avoid talking about “inflation”, per se, because I think it means different things to different people. We can easily speak, however, of increases or decreases in the money supply and increases or decreases in the demand for money (demand for cash balances). These two variables (money supply and money demand) act like supply and demand of any other good or service. The problem of defining “purchasing power” still remains, however.
In discussing economics on the internet I find this is a frequent point of contention, especially coming from an Austrian perspective. As far as most people are concerned the mainstream definition is the correct one: inflation is a rise in the general price level, particularly as measured by the CPI. Insisting that inflation is actually an expansion of the money supply and pointing out that that was the original definition of inflation goes nowhere. I sometimes resort to hyphenating the term into monetary-inflation and price-inflation in order to differentiate the two.
One tactic I’ve used to show the problems with this view of inflation is that if the price would otherwise be lower due to a higher supply but remains the same due to monetary expansion that, to my thinking, would be a symptom of inflation. As an analogy you could think of vector addition; two vectors of equal magnitude but opposite direction result in a vector of zero magnitude. Increasing supply exerts downward pressure on prices as weight exerts a “downward” force on position, while inflation exerts an upward pressure on prices as lift exerts an “upward” force on position. If the two forces are equal you end up with zero velocity.
The person I was debating with denied this interpretation as the definition of inflation is rising prices and the forces resulting in those prices were irrelevant. So it seems the mainstream definition of inflation, as applied to my vector analogy, would be that inflation is like change in position, or velocity, rather than a force. I suppose if we destroyed large portions of the items included in the CPI that would measure as inflation.
“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.”- Mises
Bolding is mine. Increases in the quantity of money in circulation. I rather not start a debate (although, others can partake in one if they’d like), but an increase in demand for money will withdraw money from circulation.
Inflation is defined by an increase in the supply of money beyond the demand for money (this doesn’t necessary yield general price inflation but it will always yield relative price distortions). This is the definition used by Hayek, Mises, Wicksell, and others.
I was about to write something like: “When the money supply increases at a faster rate than the size of the economy generally (as measured by either GDP or your favorite metric).” I think Esuric says it better, though. It gets to the heart of the matter.