The Role of Money in Inflation
and the only options for stopping it (and a final question)
Inflation is often referred to in analogical terms related to fire. It is ’heating up’; it is ‘consuming’ the ‘purchasing power’ of money like a fire consumes wood; it is at its worst a ‘conflagration’.
Many people routinely repeat the mantra that money causes inflation. It does not. Money is fuel that can feed inflation, but it cannot cause it any more than a stack of wood sitting there will cause a fire.
One of the most famous equations in economics is MV = PQ. It is often presented to ‘prove’ how money causes inflation.
To the right of the equal sign are Price and Quantity: multiplying the two yields the value of total output for the economy measured by the current price of everything produced, i.e., the Gross Domestic Product (GDP). To the left are the supply of Money and its Velocity, i.e., the number of times that supply of money ‘turns over’ or changes hands in producing that amount of GDP. That equation does require knowing what constitutes M, and that has been much more difficult to accomplish than the author of the equation, Milton Friedman, ever suspected.
In a general sense, money as a ‘medium of exchange’, anything can be used as money. For purposes of the equation, what counts is money in the form of legal tender: what is officially sanctioned as money. Legal tender is composed of currency and credit deposited by banks in accounts when they make loans — which credit then gets used as money throughout the economy.
[Currency is created when money is created for the central bank to use to purchase debt. As such, the creation of additional currency always adds to the supply of money. Whether lending is adding to the supply of money or not depends on whether for the economy as a whole lending is exceeding the repayment of previous loans.]
That equation implies that if M is increased and V stays the same (or does not decrease proportionately, anyway) then PQ will increase. Since M doesn’t of itself generate Q, the argument goes, the increase in PQ must be found in P. An increase in P in that equation is what inflation is.
The thing is, increases in M don’t necessarily increase P. M can directly affect Q. In fact, it is only in ‘quantitative easing’ (which was invented decades after Friedman created that equation), when currency is created for the central bank to purchase existing debt, that M does not directly affect Q.
When currency is created for the central bank to purchase newly issued debt of the central government, the money received by the central government is disbursed into the economy. Other than paying its employees and disbursing money to other recipients via various programs (money both groups of people then use to purchase goods and services), purchasing goods and services is what government does: so all disbursements of money by government go directly or indirectly to Q (in our equation).
The same is true of money created in lending. Money is not borrowed just to have it on hand. The reason for borrowing is to make purchases, thereby increasing Q.
[Standard economic theory assumes that the purchase of any good generates its replenishment; to the extent that does not happen, over time, purchases actually lead to a decrease in Q — but with concomitant decreases in demand implied, according to standard economic theory.]
So if increases in M don’t cause increases in P, i.e., inflation, what does?
Economists identify two forms of inflation: ‘cost-push’ and ‘demand-pull’. The former refers to increasing costs faced by producers of goods and services and the latter refers to higher prices generated when demand exceeds supply or, put the other way, there is a shortage of supply relative to demand.
Inflation created by shortages of supply should be sort-term: higher prices due to a relative shortage of supply will encourage the generation of additional supply until it is sufficient for prices to stop increasing. (There is the matter of logistics — physically getting products from producers to buyers — but that is another matter.) There can be a whole new regime of prices that is higher than before, but the increase in prices will stop.
Cost-push inflation might or might not be ‘transient’. If the higher costs are due to shortages of raw materials and natural resources that can be offset by additional production of them or substitutes for them that are less expensive (at the new prices), then such inflation can also be temporary. At the same time, decreasing demand due to higher prices faced by consumers, when higher prices faced by producers show up in the things people buy, can help alleviate such shortages. Still, with more and more people in this world who have money to buy more and more stuff, all of which ultimately depends on raw materials and natural resources that are limited in amount and increasingly more difficult (therefore expensive) to produce, cost-push inflation can be a permanent problem.
Demand is where money enters the picture. At higher prices, demand can only be sustained if people have money to continue to make purchases. People can adjust by buying less non-essential things in order to have more money available for purchases of more essential things, but ultimately ongoing inflation, defined as a general rise in prices, requires that people have more money to continue to buy what they need at higher prices.
There are various other things people can do. They can deplete any savings they have. They can tap into whatever source of borrowing is available, such as credit cards. They can sell things they own to get money.
Those options are only good for temporary respite. The only response that can bring ongoing relief is additional income. People can seek additional income by working more hours or a whole other job. People can also seek higher incomes from their employers.
Income can be increased via increases in V. Whenever money changes hands it is counted as income by its recipient. In our equation increases in V must increase Q proportionately. To the extent that inflation is cost-push, increasing V is no help stopping it, but it is not in itself a source of inflation.
Still, in a completely heartless society, inflation could be suffocated out of existence if no employer raised the pay of any employee (to include the employers themselves). All would suffer some material loss and many people would suffer extreme deprivation, but inflation would be extinguished (though, again, within a regime of higher prices).
Actually, heartlessness is the way inflation has been always been defeated. Instead of all people suffering through a relative loss of income (via higher prices with the same income), however, some people are ‘laid off’ (to reduce employers’ costs), reducing their income to zero (absent monetary assistance from government), and others are denied increases in income. In that way total income is greatly reduced (especially relative to increasing prices) and inflation is stopped — with some people suffering extreme deprivation. The difference is that this way other people, those who remain employed with a sufficiently increasing income, are unscathed. (They are presumed to be the ones who are best at their jobs, but we all know how little competence can have to do with it.)
That process is portrayed to the general public as being the result of increased interest rates that decrease demand. Interest rates do increase as a result of inflation, but if total income were keeping up, those higher interest rates would not of themselves stifle demand. It is the decrease in total income (especially, relative to prices) that stops inflation.
So increases in money do not create inflation. More money in the form of higher incomes is necessary for inflation to be sustained. Inflation can only be stopped by increasing supply and/or decreasing demand, one way or another. To the extent that inflation is due to the relative scarcity of raw materials and natural resources, less demand is the only actual solution. The only question, in that case, is whether reduced demand can be achieved equitably.