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Inflation is term thrown around a lot these days. What most people refer to when they say “inflation” is actually the consumer price index (CPI). When historically “inflation” has always been defined as the money supply.
What is the Money Supply? Money in Circulation
The money supply refers to the total amount of money available in an economy at a given point in time. It includes various forms of money, each serving different purposes and degrees of liquidity. It includes physical currency (coins and paper money) held by the public and the reserves held by commercial banks in their accounts with the central bank.
(CPI) Price Inflation Vs Monetary Inflation
The distinction between “price inflation” and “monetary inflation” holds paramount importance. This article aims to shed light on these two concepts, exploring their differences and implications.
What is Inflation: Consumer Price Index (CPI)
Price inflation, refers to the increase in money supply which typically causes a general increase in the prices of goods and services in an economy over time. When the purchasing power of money declines, it takes more units of currency to buy the same goods and services. Rising prices can be caused by various factors, including increased demand, supply shortages, changes in production costs, or changes in consumer preferences.
Impact on Preferences: Driving Risky Actions & Behavior
With lower interest rates, there is more incentive for businesses to borrow/lend more and for investors to invest in riskier assets. Consumer preferences change from the mode of saving for the future, to spending on more indulgent and luxury goods due to a sense of having more money in their pocket.
The Role of Demand-Side Factors:
When there is an increase in consumer spending or government expenditure, it can lead to excessive demand for goods and services, causing their prices to rise. This perspective emphasizes that it is essential to analyze consumer behavior and spending patterns to comprehend the dynamics of price inflation.
Central Banks & Government Policies Causing Monetary Inflation:
Contrary to price inflation, monetary inflation pertains to the increase in the money supply within an economy. In the Austrian perspective, monetary inflation is primarily caused by central banks and government policies, such as quantitative easing, deficit spending, and low-interest rates. This expansion of the money supply can have severe consequences for the economy.
Problems Caused by Governments Increasing The Money Supply
Austrian economists are critical of interventionist monetary policies that fuel monetary inflation. They argue that such policies distort the market signals which lead to malinvestment and economic bubbles. As money supply increases, the value of each monetary unit diminishes, creating a deceptive illusion of prosperity, which eventually results in market corrections and economic downturns.
The Connection between Monetary Inflation and Price Inflation:
From the Austrian perspective, there is a direct connection between monetary inflation and price inflation. When the money supply increases without a corresponding increase in goods and services, more money chases the same quantity of goods, driving prices higher. Thus, it is the increase in the money supply that ultimately fuels price inflation in the economy.
Debunking the Phillips Curve:
The Phillips Curve, a popular economic concept that suggests a trade-off between inflation and unemployment, is challenged by the Austrian perspective. They argue that while monetary inflation may temporarily decrease unemployment, it does not lead to sustainable economic growth. In the long run, excessive monetary expansion only exacerbates price inflation and creates economic imbalances.
The Austrian Solution:
According to Austrian economists, the ideal solution to curbing inflation lies in a free-market approach. They advocate for a sound money system, where the money supply is determined by market forces, such as the demand for money and the available supply of precious metals (like gold and silver). This, they believe, would prevent the destructive consequences of excessive monetary inflation and foster stable economic growth.