What is inflation?

The Wall Street Journal had an interesting article on the definition of inflation.

Is inflation best defined as “rising prices” or “printing money?” The answer depends on which dictionary you use.

Inflation hawks say the Federal Reserve’s easy-money policies will lead inevitably to an upward spiral in the prices of everything from bread to haircuts. Inflation doves say that if policy makers are careful, that doesn’t have to happen.

Who’s right?

I’m inclined to the ‘printing money’ view. I’m reproducing some material I wrote up in 2008 below.

Arthur Seldon defines inflation as ‘a fall in the value of money due to a persistent expansion in its quantity’. Ludwig von Mises wrote that ‘everyone knows’ that inflation is an increase in the quantity of money. Furthermore he wrote that ‘everyone knows’ that a general increase in prices is a consequence of inflation. Yet, inflation is often defined as a sustained increase in the general level of prices. This latter definition, however, is unsatisfactory. As von Mises has written, ‘What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency towards a rise or a fall in commodity prices and wage rates. This innovation is by no means harmless’. A sustained increase in prices is a symptom of inflation and not inflation itself.

This semantic difference is widespread. Milton Friedman, for example, has said, ‘By inflation, I shall mean a steady and sustained rise in prices’. Friedman goes on to claim that increases in the stock of money cause inflation. To be clear, Friedman argues, ‘more rapid increase in the quantity of money than in the quantity of goods and services available for purchase will produce inflation, raising prices in terms of that money’. Seldon, von Mises and Friedman agree that a general sustained increase in the average price level is caused by an increase in the quantity of money. Friedman, however, chooses to define inflation by the symptom, while Seldon and von Mises define inflation by its cause. As an aside, it worth indicating that Milton Friedman argues that government spending ‘may or may not’ be inflationary. The important source of inflation is deficit financing that is subsequently validated through the creation of money.

This semantic difference is important. Not all price increases are due to inflation. For example, the world price of oil has increased dramatically over the past few years. As a consequence petrol prices have increased, leading to increased transport costs and higher consumer prices. This is not inflation. It is true, however, that the Consumer Price Index (CPI) would have increased. Similarly, food prices have increased due to the drought – this too is not inflation. When the drought breaks, food prices will fall. Recall the banana crop failure of 2006. A tropical storm destroyed the Australian banana crop and the price of bananas rose to over $12.00 per kilogram. The price of substitute fruits also rose – yet in 2007 the price of bananas fell. Furthermore when economists advocate that water prices be increased to greater reflect scarcity and opportunity cost they are not advocating a policy of inflation.

Those price increases are what economists call changes in relative prices. They provide a signal to the market that certain goods and services are more valuable, and the supply of those good should be expanded. Conversely, they may signal that particular goods and services are now scarcer and should be conserved. An increase in the oil price, for example, signals that oil is now more valuable than it was before. Consumers should then use less of it, and producers should act to acquire more of it through exploration. Innovators should develop substitutes, and so on. The fact that inflation obscures price signals leads to economic inefficiency. In an inflationary environment, individuals cannot be sure that a price increase constitutes a market signal or inflation.
(HT: Ron)

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27 Responses to What is inflation?

  1. Andrew Reynolds

    Sinclair,
    For you to be right on this you would need an exact definition of what constitutes “money” and “the money supply”. As I have argued many times here I doubt that there is a satisfactory definition – and by satisfactory I mean one that can actually be used for policy purposes.
    In this I would tend to agree with Friedman as the “symptom” (to use your word) is at least reasonably (if incompletely) knowable. The “cause” is, IMHO (yes, “H”), is an interesting debating point, but not a practical policy instrument.

  2. JC

    Andrew

    M2 or MZM. Both seem to trend in lockstep

  3. Andrew Reynolds

    JC,
    I would agree that they could well be a useful measure – but like many other things, once you try to actually use them as a policy instrument they (and the M3 that used to be used) naturally get worse and worse as measures.
    To me the point is that government action to try to target real indicators like this simply does not work.
    the Germans made (IIRC) the best fist of monetary targeting during the 1960s and 1970s, but even they gave up in the end.

  4. Sinclair Davidson

    Andrew – I’m not talking about policy choices here, just the actual definition. It may be preferable (but I’m not convinced) to target prices and not money supply when undertaking monetary policy – but that should detract from what the actual problem is.

  5. .

    The only way is to do it privately – and let the loan book constraint and issuance arbitrage balance each other out.

  6. JC

    You know Andrew, it’s best to ignore the aggregates and do what professor Sumner has been suggesting for the past few years (loudly). Target nominal GDP, which I think would mean allowing interest rates to be market determined for the most part and let the Fed swing the bat that way by adjusting quantity to fit the pre-determined parameter.

    The system of targeting core inflation I think is not only pretty useless but also quite dangerous as there’s next to no way of determining if a change in relative prices has materially affected core inflation signals and therefore sends the wrong signal to adjust policy. Incidentally I think that’s what we’re experiencing here at the moment and the RBA actions to tighten could send us to the wall.

    Sumner has an interesting theory and to be honest it was my hunch too at the time.

    He thinks the Fed was way too tight in 08, sent the US economy over the edge and then fatally was far too slow in reacting to a really serious, sudden drop in nominal GDP.

    He also thinks the collapse of the two i-banks (not including Merrill but perhaps should be) was principally caused by the Fed. Of course there was a sub-prime issue that couldn’t be avoided, but the real losses were sustained in a material drop in real asset prices.

    I think he’s onto to something… and I don’t think he’s a quack by the way and has pretty solid credentials.

  7. Andrew Reynolds

    JC,
    Two problems with that:
    1. Logic – nominal GDP is itself an aggregate
    2. You would then need to define the quantity of money – so that you could increase or reduce that quantity. As I said before I doubt this is sensible.

  8. JC

    1. Logic – nominal GDP is itself an aggregate

    Yea, it’s also a reasonable indicator of the economy.

    2. You would then need to define the quantity of money – so that you could increase or reduce that quantity. As I said before I doubt this is sensible.

    The deflator is also pretty good.

    Why would you need to define quantity? What the Fed has to do is simply buy or or sell securities to target nominal GDP bullseye. The Ms would simply be observable data and not the target.

  9. GDP is not a reasonable indicator of the economy. As the great Viv Forbes says:

    Attempts to measure “GDP” or “the economy” represent the ultimate error of aggregation. It cannot be done in any meaningful or accurate way. At best, GDP forecasts are useless trivia — at worst, dangerous delusions.

    The media has a duty to expose such delusions. I look forward to the TV presenter who says, “The quarterly GDP statistics were released today. Luckily no one noticed, and no harm was done.”

  10. .

    “The quarterly GDP statistics were released today. Luckily no one noticed, and no harm was done.”

    I wish.

    However, GDP is higher now than when I was born and I am very happy about that.

  11. JC

    GDP correlates reasonably well with economic ebbs and flows and also with living standards.

    Here’s a suggestion BM. If you can think of a better alternative, write it up, have it peer reviewed by people like Sinclair or other academic economists and publish.

    If your finding is ground breaking you ought to be in contention for a Nobel Prize in economics.

    I’m not kidding either.

  12. .

    I like the social accounting matrix but it is very esoteric. Can’t imagine it being reported on the news.

  13. JC: It’s already been done by the Austrian school economists. Here’s Nobel laureate F.A. Hayek who said in a 1978 letter to The Wall Street Journal:

    Please print in front of every issue in headline letters the simple truth that INFLATION IS MADE BY GOVERNMENT AND ITS AGENTS: NOBODY ELSE CAN DO ANYTHING ABOUT IT.

    “.”: Does the GDP increases you refer to include increased government spending?

  14. JC

    Ben

    I’m well aware of the Austrian School discussions on this subject.

    The problem with the Austrian School these days is that a bunch of cranks have misfits seem to have take a liking to it (see Birdiie as a an example of what I mean) hijacking and abuse the shit out of it.

    You seem all over the palce. You said that GDP is not only bad indicator but it’s also a dangerously bad one. You’re now heading off track about inflation as though it has something to do with the fact that I suggested you come up with something better. Go ahead.

  15. JC: The point is, nothing “better” is required. There is no reason for the RBA or government to be involved in regulating the economy at all.

  16. JC

    Ben

    You are going off base again. That is another discussion. You made the point that GDP is a bad indicator and dangerously so.

    Please follow my advice. Write a paper have Sinc or someone review it. I don’t exactly know how peer review works. Talk to him/them and publish it.

    If you really have groundbreaking work, you will undoubtedly receive a Nobel and change the world for the better most likely.

    So there’s no point talking about other shit like banning the RBA etc. That’s for another time.

    Go!

    Are you one of Sukrit’s buddies by the way?

  17. JC

    On a smaller scale, in Australia, if a bachelor spends $150 per week in a live-in housekeeper, this expenditure inflates the GDP. But if he decides to marry the girl, and gives her $150 per week housekeeping, the GDP contracts by this amount.

    Marginal bullshit. Some effect but really marginal. She doesn’t eat, need clothes, wash herself with soap etc?

    It would be counted in final sales.

  18. JC

    JC: The Austrian school have done all this and Hayek has won the Nobel prize.

    No Ben. That’s wrong. Hayek did not win a prize for disavowing GDP. Stop the bullshit.

    As I said. GDP is a marker. I reasonable one that correlates well with other indicators.

    Go and create a better one.

    Seriously, are you Sukrit’s buddy? Honest question as it’s not leading anywhere. I’m just curious.

  19. sdfc

    Ben

    At least get the basics right.

    GDP=expenditure=production=income. It measures flows not stock.

    Before consigning it to the rubbish bin you might want to ponder why GDP growth and employment growth tend to move together.

  20. Louis Hissink

    Inflation is simply an expansion of money quantity divorced from physical activity; Fiat money, in other words.

  21. Louis Hissink

    Ben Marks,

    Please continue posting here, but don’t take too much notice of some of the fossils here.

  22. Labor Outsider

    Andrew up thread is spot on. As most people on this site should know, there are various definitions of money – M1, M2, M3, broad – and they usually don’t change at the same pace (or have stable relationships with inflation in general prices, wages, or commodities). In the US, for example, in recent years, while the narrow money supply jumped, broad measures of the money supply fell, because the money multiplier fell off a cliff (just look at what happened to excess reserves at the Fed). The key question in the US will be whether the Fed can successfully drain excess reserves at a pace that prevents excess inflation when the money multiplier starts to pick up again…

  23. Andrew Reynolds

    Louis,
    It’s a pity your comment was, at least in part, divorced from logic. Even under your definition of inflation it is possible to have inflation under non-fiat money systems (Spain from about 1500 for example) and it is possible to have zero, or negative, inflation under fiat systems (Japan recently).

  24. Peter

    If money supply has no bearing on the rate of price increase why would we care about it anyway? Look at base expansions in Japan and recently in US, no acceleration in prices, so why care? Only prices impact the economy, not the monetary base. You are very confused.

    Start here: http://libertarianpapers.org/articles/2010/lp-2-43.pdf

  25. .

    Inflation is simply an expansion of money quantity divorced from physical activity; Fiat money, in other words.

    Um Louis M3 usually drives M1. This happens under the gold standard, competitive issue and fiat. Your definition of fiat money isn’t sound as it is not exclusive enough.

  26. .

    “.”: Does the GDP increases you refer to include increased government spending?

    The Government cannot permanently/sustainably inflate GDP figures with it’s own spending.

    People say GDR is better but isn’t measuring income. It is measuring revenue and the ratio of the two implies the level of complexity in the structure of production.

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