Which came first, more money or higher prices?

Inflation may be understood in different ways, but Austrian School economists see rising prices as an effect of an increased supply of money.

By , Guest blogger

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    Bundles of money worth two million euros ($2.7 million) are displayed at a police headquarter in Madrid January 18, 2011. Does inflation simply mean that there is an increased supply of money?
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Inflation, as commonly understood, is a general rise in prices, as measured by some index, such as the CPI, RPI or RPIX. On such an understanding, high commodity prices driven by strong demand (or limited supply) are ‘inflation’. So is an increase in a sales tax (like VAT). This is what we are hearing from the Bank of England at the moment.

But is this view of inflation correct? Austrian school economists don’t think so. To them, inflation is an increase in the supply of money. Rising prices are merely one consequence of that underlying phenomenon. As Ludwig von Mises puts it:

 

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Inflation… means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation… As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.

 

It’s clear that this confusion has real policy implications. For example, it makes little logical sense to respond to, say, high oil prices by raising domestic interest rates and tightening monetary policy. The oil price has everything to do with supply and demand, producer cartels, and regional instability, and little to do with monetary policy. But that’s precisely the direction that viewing inflation simply as a matter of rising prices would take you.

It’s the same logic that let the Bank of England get away with years of inappropriately loose monetary policy, inflating a huge asset bubble on the basis that it didn’t matter if the money supply was growing rapidly, since cheap imports from China meant price index ‘inflation’ was relatively stable.

A better approach would be to focus on the money supply itself, and recognize market prices for what they are: a highly sophisticated system for transmitting information and coordinating economic activity, which can be undermined or distorted by changes in that money supply. This in itself provides no complete answer. The question of how to measure the money supply is itself a vexed question, and that’s saying nothing about how you control it once you’ve worked out how to measure it. I have some radical notions, needless to say, but I’ll save those for another blog.

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