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:
1) 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?
2) 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?
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
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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.
Clayton -
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.
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.
Esuric wrote:
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.
Jonathon:
When I say printed money I include anything that can also be converted into cash. Suppose we were on a strict gold standard. To me the monetary base or M0 is the physical amount of gold (Am I correct?). That to me is the true money supply. Not M1, M2 or M3.
I think where we disagree is where you say it's easy to destroy money. Someone owns that money. I don't see how you can destroy it. If my bank account electrons suddenly disappeared I'd be pissed off.
What I think you can do fairly easily is lower the supply of credit by raising interest rates. So you make it harder to get a loan.
In other words I think you can easily reduce the supply of credit or M1,M2,M3 by raising rates. But it's almost impossible to reduce the monetary base or M0.
As far as Japan goes I was under the impression that Japan only increased M0 by something like 10% over 10 years. The US has tripled it's monetary base in the last 2 years.
Here's another way for me to try to explain this. Lowering interest rates will cause a temporary boom in prices followed by a bust where prices actually fall below normal. Printing money, or increasing the monetary base will cause a permanent rise in prices.
P.S. I like this website but I hate this editor.
"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)."
The above is not intuitively appealing to me, and sounds like different things are being combined which shouldn't be.
Doesn't monetary expenditure (or nominal spending) represent the value of things that are traded in an economy? If it does then the value of things that are trading hands in an economy is something separate from price levels. Thus I would think monetary expenditure can increase or decrease without any preceding change in the money supply.
Unless I am misunderstanding what monetary expenditure is, I don't see how monetary expenditure could have such a direct effect on price levels.
I also don't see why the last sentence necessarily must hold true. Are you saying the price of good A cannot possibly rise without a corresponding drop in the price of good B, assuming no change in money supply? Why would that be the case?
The supply of money which affects prices is the supply of money in circulation, whether that be outside money, inside money, or fiduciary media. By the way, "base money" is not just commodity money. In our current fiat standard, some of that fiat currency is base money.
If said commodity money is sitting in reserve, never circulating, then it's more economical to melt it and sell it for other uses. It's also economical to do so if the non-money uses garner you greater value than its money uses. Coin melting was not uncommon. In Europe, gold import from South America actually did adversely affect prices, and the change was not permanent because the new bullion circulated from areas of high concentration to areas of relatively lower concentration (where it would garner a higher utility), so this is also a means by which the supply of commodity money fluctuates.
As far as Japan goes I was under the impression that Japan only increased M0 by something like 10% over 10 years.
I don't know, but Japan was, broadly speaking, in a "liquidity trap".
Lowering interest rates will cause a temporary boom in prices followed by a bust where prices actually fall below normal. Printing money, or increasing the monetary base will cause a permanent rise in prices.
Interest rates are lowered and raised by changes in the supply of loanable funds. The increase or decrease in the supply of money occurs before the rate of interest changes. New stock of commodity money can also artificially lower the market rate of interest. It is what occured to Spain in during the 17th Century.
Jonathon: "I said commodity money is sitting in reserve, never circulating, then it's more economical to melt it and sell it for other uses. It's also economical to do so if the non-money uses garner you greater value than its money uses. Coin melting was not uncommon. In Europe, gold import from South America actually did adversely affect prices, and the change was not permanent because the new bullion circulated from areas of high concentration to areas of relatively lower concentration (where it would garner a higher utility), so this is also a means by which the supply of commodity money fluctuates."
I think if we were on a strict gold standard the monetary base (M0) would be the physical amount of gold whether it was in currency form or not. I think it's the scarcity that matters here. Not what form it's in. I also think the physical amount of gold would be far and away the most powerful force determining prices in the long run. If a mine suddenly "struck gold" and doubled the entire amount of gold in existence I would expect prices to double in terms of gold all things being equal.
The tricky part for me is defining the monetary base with a fiat system.
I think if we were on a strict gold standard the monetary base (M0) would be the physical amount of gold whether it was in currency form or not.
But, what does this matter? What matters is the money that is actually in circulation, being bid towards goods. I also explained how in a commodity standard it's not unlikely that the outside money actually reduce in size as its replaced by inside money (or, as inside money circulates at a much greater rate than commodity money).
I think it's the scarcity that matters here. Not what form it's in.
I don't know what you mean by this, or how it's relevant.
If a mine suddenly "struck gold" and doubled the entire amount of gold in existence I would expect prices to double in terms of gold all things being equal.
As long as that gold entered circulation as money.
Jonathan M. F. Catalán: "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.
The last part of Mises' quote above is in contradiction with your interpretation of it. What, bank deposits need not be in circulation? Increase in the money supply in the broader sense is probably where Mises is going with this. Bank notes (money substitutes) by definition must be in circulation for them to exist at all.
JH2011: 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.
Inflation is an increase in the supply of money. Price inflation is a rise in prices. The fire at the oil production facility is irrelevant... if the price goes up, the price goes up. To the extent that this disruption in the supply of oil slows production in other dependent fields, prices may rise elsewhere too.
The CPI, if done well (it's not) attempts a general look at price inflation across an economy. In reality, we each have our own Price Inflation Indexes based on what we buy. If the price of oysters goes up, but you don't buy oysters, your personal PII is unaffected. However, if you buy tube socks and the price of tube socks goes up, your personal PII goes up. The CPI, if done well, can try to give you an idea of what people across the country are feeling, as an average.
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cr113: "I think if we were on a strict gold standard the monetary base (M0) would be the physical amount of gold whether it was in currency form or not."
Jonathon: "But, what does this matter? What matters is the money that is actually in circulation, being bid towards goods. "
I totally disagree. It costs very little to mint a coin. It's not the minting process, or the coins in circulation that gives a gold coin value, it's the gold itself.
If you made a few coins out of clay would they be super valuable because only a few were in existence?
No, gold does not have objective value. Gold for the value of gold is relevant when talking about non-monetary gold products, but has nothing to do with its monetary value. Gold's monetary value depends entirely on its exchange ratio with relevant economic goods, and therefore has everything to do with the quantity of gold in circulation. This is why if the quantity of gold in circulation falls nominal expenditure falls and thus prices falls, and if the quantity of gold in circulation rises nominal expenditure rises and thus prices rise.
Money that is not in circulation does not affect prices, or the purchasing power of the monetary unit.
It's also important to remember that money is a means of purchasing goods. These goods are either goods which immediately satiate certain desires (consumption goods) or goods which themselves are means by which to satiate future desires (i.e. capital goods).
How is this relevant? Clay's value is subjective. There's no reason why someone else should accept clay coins as money. The introduction of money into the market took several generations. I would suggest reading Menger's Principles of Economics, Mises's The Theory of Money and Credit and/or Human Action on the topic.
DD5,
What, bank deposits need not be in circulation?
I never said they weren't. They aren't de facto in circulation, but they can be if the money in these deposits are being spent electronically (or funds are being withdrawn and spent, et cetera).
By the way, from Human Action (1998),
The endeavours to expand the quantity of money in circulation either in order to increase the government's capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation. (p. 225).