Dear Mises.org members,
two friends of mine and I are trying to put together a 'Money & Inflation FAQ' that will serve as an introduction to these topics. In the next posts I will publish our text so far. The last question 'What are the consequences of inflation?' is not ready yet.
Anyway, please feel free to add, correct, change and ask both qua content and qua style. The goal is to have a relatively short and very clear and accessible document that in its final form can be posted on sites such as Mises.org.
What is money?Money is a commonly accepted medium of exchange.
Not everybody would want to trade his car or 40 hours of his labor for a trip to the Bahamas or for a nice home cinema set. So trips to the Bahamas and home cinema sets are not commonly accepted as a medium of exchange. But people would likely want to exchange their car or their labor for a certain amount of money. With that money people can decide for themselves what they want to buy and thus what they are actually trading their car or their labor for. Money thus makes possible this kind of indirect exchange.
What is the origin of money?Because money makes indirect exchange possible, it enables people to engage in many more economic transactions than there are possible in a simple economy of direct exchange.
Imagine a very simple economy without money, an economy with only direct exchange. Murray would like to get a gallon of milk and has a pair of shoes to spare. he then faces two problems:
1) divisibility: Murray will likely think that a pair of shoes for a gallon of milk would be an unfair exchange because the pair of shoes is worth more to him than the gallon of milk would be. So then he would have to find a way to divide his pair of shoes into smaller pieces and exchange some of those pieces for the gallon of milk. This would be a silly thing to do of course. 2) Coincidence of wants: Murray also has to find somebody who has the exact opposite need as he has, somebody who wants (parts of) a pair of shoes and who has a gallon of milk to spare.
So with any economic transaction in an economy of direct exchange people have to solve these two problems, Murray can for example exchange his pair of shoes for Ludwig's 20 pounds of cheese and then use 1 pound of cheese to get 1 gallon of milk from Walter. So both the problem of divisibility and that of coincidence of wants can be solved by trading with other parties before you get the product that the milk man or whoever wants to exchange his milk for. Clearly this is a difficult and time-consuming business, especially when there are a lot of different products in the economy. It would therefore be convenient to have a commodity that pretty much everybody would accept as payment and that is easily divisible and sustainable. Gold and silver fit these criteria: they are wanted as a commodity to make jewellery of, they are easily dividable into coins and bars and they do not decay. Because of these characteristics gold and silver have arisen as the preferred means of payment in societies all over the world. if you want 1 gallon of milk you pay the milk man with a silver or gold coin and the milk man in turn can use that coin elsewhere to buy whatever he wants. (In extraordinary circumstances like in prison or during wars other commodities such as cigarettes are sometimes used as money) So money makes indirect exchange possible because it solves the problems of divisibility and of the coincidence of wants. Money also makes it possible to compare the market prices of all different goods in the economy with one standard, because all goods can be exchanged for a certain amount of gold or silver. That amount we call the money price of a good. 1 gallon of milk would then for example cost 0,5 grams of gold, and a home cinema set would cost 200 grams of gold. In turn the price of money, its purchasing power is expressed in the goods one can buy with it: 200 grams of gold is worth 1 home cinema or 400 gallons of milk. Money then makes transactions in the economy much simpler than they could be in an economy of direct exchange and because of this fact ever more complex transaction of whatever goods for whatever goods are made possible Money is the basis of all modern economies.
What is 'fiat money'?Fiat money is money that is no longer backed by its value as a commodity (like god) and not voluntarily chosen on the market as a medium of exchange but that people are legally obliged to accept as a medium of exchange.
We saw that on a free market money arises as a product that has value as a commodity (gold is used for jewellery for example) but also as a commonly accepted medium of exchange. This type of money we call 'commodity money'. The price of commodity money is determined by the demand for it as a commodity and as a medium of exchange. This fact as well as the fact that the supply of gold tends to grow relatively slowly ensured that the price of gold, its purchasing power (expressed in terms of the type and number of goods you can buy with it) was quite stable. Because in practice it is often difficult to carry gold around and to divide it into the exact amount you need people started to store their gold in banks. These banks then gave people warehouse receipts (bank notes, cheques, accounts, etc.) that they could use to make payments with and that they then could show to the bank to get their gold back. But especially in the last hundred years governments all over the world have severed this direct link between warehouse receipts such as paper money on the one hand and gold on the other. Presently, bank notes are no longer exchangeable for gold. The original role of money as a commodity is no more. Because governments took over the provision of money and because they severed the link between bank notes, cheques, accounts etc. and gold, governments could now simply create more and more money without having to add to the gold stock, something which up until then had put a strong brake on the expansion of the money supply. By expanding the money supply in excess of the expansion in the gold stock money becomes worth less than what it would have been worth had the link between money and gold not been severed. Moreover, governments then forced everybody to accept this money as a means of payment. This is in stark contrast with commodity money that was voluntarily chosen on the market as a means of exchange, Money that has no direct link with the gold supply anymore we call fiat money.
What kinds of money are there?Besides the distinction between fiat money and commodity money, we can also distinguish between 4 different forms of money based on the ease with which they can be used as a medium of exchange (=the degree of its liquidity)
M0: easily exchangeable money like physical currency such as coins anhd notes, plus accounts at the central bank that can be exchanged for physical currency. M1: (M0) – (those portions of M0 held as reserves or vault cash) + (the amount in demand accounts ("checking" or "current" accounts where you can withdraw money from whenever you like)) M2: (M1) + (saving accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000)) M3: (M2) + (all other certificates of deposit (CDs), deposits of eurodollars (deposits denominated US dollars in banks outside of the US) and repurchase agreements.)
From this overview we can see that M3 is the broadest category of money also encompassing all the others while M0 is the narrowest.
What is inflation? Inflation is a decrease in the price or purchasing power of money.
The average price of products in the economy will increase. That is, with the same amount of money as before you will be able to buy fewer products. It is clear that over the past 100 years things on average have become more expensive, so it has been an inflationary period.
What is deflation?The opposite of inflation is deflation, a situation in which the price or purchasing power of money will increase: you will be able to buy more products with the same amount of money. Such a situation has been very rare in the 20th century.
[to ne continued below]
What is the cause of inflation?Inflation occurs when the amount of money in an economy increases relative to the number of goods in the economy.
Imagine a very simple economy: there are 100 products in total and 100 units of money (100 dollars for example). The average price of a product is then:
Inflation means that you get fewer goods for your dollar, i.e. that things become more expensive. The average price of a product will then for example become $1,50. The inflation then is 50%. This is only possible if the amount of money in the economy increases relative to the number of goods. As long as the number of goods does not increase more than the money supply does, there will be inflation. This can happen because of changes in the money supply and/or because of changes in the number of goods in the economy (for example a huge natural disaster may destroy a massive number of products causing the same amount of money to chase fewer products) Almost always however inflation occurs primarily because of relatively high increases in the money supply despite increases in the number of products.
To go back to our example, when the average price of a product increases from $1 to $1,50 and the number of goods in the economy stays the same then this can only be so because the amount of money in the economy has increased:
What is the cause of deflation?Deflation is caused by a decrease in the money supply relative to the number of goods in the economy.
When economies grow then more and more goods come on the market. When the money supply stays the same or does not increase as fast then deflation will occur. Thus if the money supply stays the same, then deflation is the normal phenomenon in times of economic growth: products become cheaper on average. Since our economies have generally grown over the past 200 years we would expect a long-lasting deflationary period. That this has not been the case is attributable to the increase in the money supply outpacing the increase in the number of goods. Sometimes, such as in periods of depression, the money supply decreases (in a later section we will see how this is possible) while the number of goods stays the same. In those cases deflation does not indicate economic growth but has as its cause the contraction in the money supply.
But doesn't inflation have other causes?Although you may hear a lot of other explanations for inflation, some of which are quite complex, these simply cannot be correct.
Politicians, consumers and unions may blame greedy businesses for inflation because these increase their prices for products and services. These business men in turn may say that they had no choice because the wholesale stores, where they buy their goods from, were the ones who increased their prices, and these wholesale stores in turn may put the blame on the higher prices for natural resources like oil. Employers and politicians may also put the blame for inflation on labor unions whose wage demands are too high thereby increasing the costs of a product of service and causing companies to have to increase their prices. Another explanation that is commonly heard is that in times of economic growth demand increases thereby causing an increase in prices.
At first sight these explanations sound sensible enough, but upon a second look we realize that they cannot explain inflation because 3 essential factors are overlooked: 1. Inflation is an average increase in prices. Save the rare occasion of a huge natural disaster destroying massive amounts of products or the sudden depletion of an important natural resource, this is only possible if the amount of money increases. When for example oil gets more expensive or when greedy companies raise their prices, this only means that these products and services will become more expensive relative to all other products and services in the economy. The average price of all products remains the same.
2. on a free market, companies, unions and even oil producers cannot raise their prices without suffering negative consequences because they face competition. When they raise their prices, their competitors can take away their customers by keeping their prices the same and thus by being cheaper than the company that raised its prices. This is how the free market works.
3. Inflation cannot be caused by economic growth because the definition of economic growth is that the number and/or quality of goods in an economy increases. When at the same time the amount of money stays the same the average price of a product will decrease and not increase.
Who causes the money supply to increase?The only institution that is legally allowed to create new money that has to be accepted as a medium of exchange by everybody is the Central Bank, such as the American Federal Reserve or the European Central Bank.
You and I could try to make our own kind of money, the Murray, but likely there will only be very few people who will accept our notes because they in turn would have a lot of difficulty getting other people to accept it, especially because our notes are not backed by anything that also has value as a commodity, like gold has. Governments all over the world have outlawed consumer payments in gold or silver, likely because such money would be a superior competitor to the government created money that is no longer backed by gold. So pretty much the only money that is used in modern economies is the money that is issued by central banks. When you and I try to copy this money we run the risk of being arrested for counterfeiting. Only the central bank is legally allowed to create this money and thus only the central bank can be the cause of inflation. By the way, it is remarkable that central banks are often seen as the institutions that fight against inflation, that keeps inflation in check. From what we learned above we can conclude that this is nonsensical.
Why do central banks create new money?Although central banks formally are often independent institutions, in practice their policy is intended to help governments in achieving their plans.
The 3 main reasons that governments like to see new money created are as follows:
1. to increase the income of the government itself without having to raise taxes or borrow more money. Inflation itself is nothing other than an ingeniously disguised form of taxation. When the central bank creates new money and through a complex process that we will discuss in the next section gives it to the government itself (or to parties that are favored by governments) it simply means that the money of everybody else in society will become worth less, it is like diluting wine with water: there will be more wine but it will be less tasty.The newly created money can be used by governments to finance wars, pay off debts or pay government salaries without having to raise taxes. Tax raises are often unpopular and so it is convenient for governments to have a mechanism that achieves the same result as taxation, namely increasing the income of the government, but that tends to go largely undetected by the general population.
2. the government wants to favor certain groups in society such as banks or government contractors, at the expense of all other people: when the central bank creates new money it can lend to the banks and the first customers they in turn lend the money to for a low rate have an advantage relative to all other people in society. The central bank can also create emergency credit for banks that otherwise would go bankrupt: because they can borrow credit at a very low rate they can save their business. Central banks thus subsidize failing banks by lowering the value of your money. Something similar is the case when the central bank creates emergency credit that banks can borrow and then lend out at a low rate to big companies that are having financial problems. This happened recently when both the Fed and the ECB created new money that banks lent out to major stock companies. What then happens is basically a subsidy from everybody else in society to big Wall Street companies and stock brokers. Another way in which governments can favor certain groups is by spending the money on projects such as wars for which large companies such as Haliburton get contracting work. These companies thus also profit indirectly from newly created money.
3. Some economic theories like that of Keynes state that governments can control, direct and stimulate the economy on a macro-level by changing the supply of money (mostly increasing, but also sometimes decreasing it)
How do central banks create new money?In the old days central banks would simply print new money and distribute it, but nowadays the money creation process is a lot more complex: the control that the central bank has over the reserves of regular banks is the central mechanism for money creation.
Central banks can create new money by controlling the reserves of regular banks. Banks need to have reserves in order to give people who have lent their money to the bank their money back. But banks no longer have all the money that their customers have lent them in reserve. They have used a large portion of that money to invest with or lend to others. This we call fractional reserve banking. Banks only have a fraction of the reserves that they have been entrusted with. So if people have lent 10 million dollars to the bank, they may only have 1 million dollars in reserve. Central banks have made this odd and fraudulent practice possible and it in turn can use this fact to control the money supply. This happens in 4 ways: 1. It is easy to see that fractional reserve banking is a potentially volatile situation: if customers of a bank were to try to get their money back from the bank en masse the bank would be instantly bankrupt and a lot of people would lose their money. In order to avoid such bank runs and subsequent bankruptcies the central bank will help banks that are in trouble by for example giving them cheap credit so that they can add to their reserves at low costs. Central banking thus makes fractional reserve banking possible and as a result banks can make profits by lending out money that they are supposed to keep safe for its customers. This means that the banks create new money that they are lending out because at the same time they pretend that they have that money on the accounts of their customers. They use it in a double way.
2. the central bank also determines the level of reserves that banks must have. The central bank can legally require banks to have a certain minimum level of reserves. When central banks then ease this requirement banks can lend out more money with the same level of reserves, thereby increasing the money supply. Central banks can also cause a decrease in the money supply by tightening the reserve conditions for banks: if they have to have a ratio of 2:10 instead of 1:10 banks have to decrease their lending out of money by 50 percent, thereby causing the money supply to decrease.
3. the central bank can add to the reserves of banks by buying goods such as government bonds from banks directly or indirectly. The central bank then simply creates new money and transfers that to the seller in question. When the central bank buys directly from a bank the bank in question simply gets the new money on its account thereby increasing its reserves. When the central bank buys a good from a private party that private party will receive his money from the central bank on his account at a private bank, thereby also increasing the reserves of said bank. Moreover, because the bank is allowed by the central bank to lend out several times the size of its reserves the money supply increases by several times the size of the received payment.
4. the central bank can also add to the reserves of banks by lending money to them at artificially low interest rates. Whenever the interest rate that the central bank charges is lower than the market rate (the rate than banks charge each other for example) then this means that banks will borrow more money than they would otherwise. The extra money originates at the central bank. And like before, the banks can in turn lend out several times the amount of money that they borrowed from the central bank and so the money supply in the economy increases at several times the size of the borrowed money. When you read in the newspapers or hear on the news about interest rates that are being cut or raised it is this inflationary process that they are talking about.
What are the consequences of inflation?
---A friend of mine is writing this last section, but here are some preliminary remarks---
The main consequences of inflation stem from the fact that new money is never spread all over the economy equally and simultaneously, but is injected at some points (the banking system for example) and time passes before it has rippled over the economy and prices adjust to the new money supply.
If we all were to wake up tomorrow finding out that the central bank put 2 new 0s on each credit account, debt, bank note, coin and so on (thus turning $1 into $100) this would be a case of inflation, because the purchasing power of a single dollar would have decreased greatly. But at the same time since we now each have an equivalent increase in our money supply this would actually not be harmful, just pointless.
But this is not how new money enters the economy. Instead some parties get their hands on the new money first when that money everywhere else in the economy is still worth as much as before (and they also get it at a discount rate). Only as more and more transactions are made with this new money will price levels in the overall economy adjust and will consumers, businesses and other find out that their old money is now worth less because the money supply has been diluted.
So what in fact takes place is a redistribution of wealth from everybody who has money to those who get the new money and those who owe others money (since now they have to pay back relatively less). Moreover, because it takes time for prices to adjust economic calculation is hindered. Finally, because the price mechanisms of money (interest rates) is disturbed by artificially cheap new money (low interest rates) there will be an imbalance between supply and demand for money resulting in among other things the business cycle.
As far as consequences of inflation, one should note the deterioration of products. Because the price of something is readily seen, many businesses take to reducing the quality of their product and keeping the price the same.
You know those Cadbury (or however it is spelled) eggs at Easter time? They are significantly smaller now than in previous years. My friend works for Proctor and Gamble and he can tell you all sorts of stories about how P&G is diluting their products to keep the price in check (yet another reason why inflation is undercounted). Of course, they test all their competitors products and they are doing the same thing as well. And then there is the housing market...
Thought this might be helpful to you. Good luck with the FAQ!
Every decent man is ashamed of the government he lives under - Mencken
Conrad:
Before setting your ideas about money and inflation in print, you should google the real bills doctrine. On the real bills view, there is no such thing as fiat money. All money is backed by the assets of its issuer, and inflation is caused when the issuer's assets fall relative to the amount of money issued.
A good article on the real bills doctrine is here: http://www.financialsense.com/editorials/blumen/2005/0708.html
2. Inflation, as many economists agree, is an insidious way of taxing and confiscating peoples wealth.
Unsurprisingly enough, Greg Mankiw disagrees. He paints the inflation-as-harm view as a fallacy...
Mike Sproul: Before setting your ideas about money and inflation in print, you should google the real bills doctrine. On the real bills view, there is no such thing as fiat money. All money is backed by the assets of its issuer, and inflation is caused when the issuer's assets fall relative to the amount of money issued.
I thought the real bills doctrine was inherently inflationary...
Let's say I buy a house for a $100k and use it to get a loan for another $100k. The bank happily gives me the money based on the value of the house by printing up a bunch of bills and I go around town merrily spending all this new money. This new money is bound to cause price inflation since there is no real wealth backing it. If I manage to be financially responsible and pay the loan back on time it is *highly* doubtful the bank is going to 'retire' the money based on the fact they no longer have my debt to back the issuance of the currency but more likely to take the $110k and use it to back another loan and also loan out the money they get back from me using the loan they made on the $110k to justify 'reissuing' the original money they printed up based on the value of my house.
As far as I can tell the whole system is built around the 'monetizing debt' principle.
Once the other banks come around asking for something tangible to trade for the new money that was printed and spent by me I don't think they will take kindly to a lecture on how the money is really backed by and IOU so they can't have anything to take back to their vaults to support their own banking operations.
I have a paper entitled "Three False Critiques of the Real Bills Doctrine" that addresses the "inherently inflationary" criticism of the RBD. Briefly, the new money is backed by the house; your net worth (spending power) is not affected by the loan; the lending bank has sufficient assets (i.e., the house) to buy back all the money; the statement that the new money will cause inflation assumes the correctness of the quantity theory, which is the very point in dispute; if the new money did fall in value, then the bank could use the house to buy that money back at a profit; if the new money is more than is wanted in the circulation, then it will reflux to the bank in payment for loans, deposits, etc.
Conrad:What is inflation? Inflation is a decrease in the price or purchasing power of money.
Conrad:Inflation is an average increase in prices.
Inflation is an average increase in prices.
Wrong and wrong! Inflation is an increase in the supply of money, not an increase in the price of goods or a decrease in purchasing power.
Inflation causes an increase in the price of goods and a reduction in money's purchasing power.
This is a very important distinction. Most latter day economists and politicians erroneously talk about inflation as an increase in prices because it divorces the cause from the effect. This allows all sorts of false reasons to be given to explain away such an increase.
Inflation is an increase in the money supply. Period.
Mike Sproul:Briefly, the new money is backed by the house; your net worth (spending power) is not affected by the loan; the lending bank has sufficient assets (i.e., the house) to buy back all the money; the statement that the new money will cause inflation assumes the correctness of the quantity theory, which is the very point in dispute; if the new money did fall in value, then the bank could use the house to buy that money back at a profit; if the new money is more than is wanted in the circulation, then it will reflux to the bank in payment for loans, deposits, etc.
You lost me there.
If I still own the house, which is the case if I keep up on my loan payments, and I also have an extra $100k to spend then how is my spending power not increased by the new money and conversely everyone else's spending power not decreased as the new money filters through the economy causing prices to rise?
You also make the (false) assumption that the bank could sell the house if they needed to back the money it printed up. If this were the case it would be no different than if I sold the house to the bank in the first place, I would not be getting a loan from the bank but a payment for the cost of the home.
I recently read the first chapter of History of Money and Banking in the United States which discusses in length the principal of currency being devalued by the market based solely on the inflationary policies of the issuing bank. Without *real* assets, directly controlled by the bank, and no barriers to open competition the real bills bank's issues currency would most definitely trade at less than par value based on their ability to sufficiently back their currency.
As to them making a profit in buying it up, I don't really see how that is possible without selling the backing assets, which they don't own unless the loan is defaulted, for a more highly valued market currency and using *that* to back their notes. In most day to day trading they would have no liquid backing assets to trade for their issued notes and chances are people would want something more tangible than 'debt' backing their wealth so would immediately get rid of this bank's notes.
Mike Sproul: I have a paper entitled "Three False Critiques of the Real Bills Doctrine" that addresses the "inherently inflationary" criticism of the RBD.
Clickey links are nice...