Econ 101: Spike in Money Supply Caused Inflation

     Often we see headlines about inflation and hear financial analysts commenting on it. “Good Morning America’s” Chris Cuomo warned on August 21 that “America is waking up to nationwide sticker shock, an unexpected spike in inflation now at a 17-year-high.”

      But like that segment on ABC’s morning show, seldom does anyone define inflation. Inflation is a decline in the value of money. This simple definition gives us insights into what causes inflation and why we might be concerned about it. It also provides insight into how we attempt to measure inflation.

     Milton Friedman was famous for pointing out the inflation is everywhere a monetary phenomenon. If the amount of goods stays the same and the monetary authority increases the amount of money, then it will take more money to buy the same amount of goods, which means that prices will rise.

     This is why we sometimes define inflation as a rise in the general price level. This simple point should make it clear that inflation cannot be caused by monopolies, or unions, or decreasing taxes. It is always caused by the supply of money rising faster than the supply of goods.

     If the supply of goods falls and the amount of money remains the same, then you have the same effect so it is possible for a restriction in production to cause inflation if the monetary authority does not decrease the money supply in tandem with the reduction in production.

     The federal government attempts to measure inflation through the use of various indices. The most popular of these is the consumer price index (CPI), of which there are sub-indices. The basic idea is to see how much a basket of goods cost in a base period, currently 1982-84, and compare it to today’s cost of the same market basket.

     Right away you can see some problems in this. For example, a 1982 computer will not be the same as a 2008 computer. An iPod will not be in the 1982 market basket whereas it might well be in the typical market basket today.

     As prices of some goods rise and the prices of other goods fall the average consumer will substitute towards the goods with falling prices and away from goods with rising prices. Since some government payments, such as Social Security, are indexed to the CPI, there is some political interest in how this measure is determined as well.

     So although the media may imply that the CPI is accurate to within a tenth of a percent – CNBC’s Melissa Francis called it a “great gauge on inflation” on “Today” August 13 – it is a rough measure of how money is holding its value.

     Some economists, such as Brian Wesbury of First Trust Portfolios, recognized some time ago that the Federal Reserve was increasing the amount of money as a mechanism to solve the credit crisis, which was to a certain extent caused by prior Fed policy (See: Econ 101: Is the Fed a Source of Our Economic Problems?) and warned that we would be seeing a rise in inflation as a result.

     We have now begun to witness the rise in inflation. First, prices of commodities, such as gold and oil, began to jump as investors sought to hold their wealth in something that would hold its value rather than dollars. A rise in the price of particular commodities is not in itself inflation because the price of other goods could be falling. But it can be a leading indicator: a sign that inflation is expected.

     Now we are witnessing a rise in the CPI. The year to year rise in the CPI has gone from 1.3 percent in October of 2006, to 5.6 percent in July of 2008. The current 12 month average rise in the CPI is the greatest since January of 1991.

     Regardless of the imperfections of the CPI as a measure of inflation, this is a clear indication of a fall in the value of our currency. The dollar has fallen in value against other currencies as well, in particular the British pound and the Euro. Every country that pegs its currency to the dollar is also experiencing inflation. 

     Inflation causes a number of problems. First, even at low levels it distorts the price signal that is vital to the efficient allocation of resources. Producers have difficulty telling if the increase of price in their particular product is due to an increase in its relative value to consumers or due to a fall in the value of the dollar.

     A decline in the value of the dollar alters the terms of trade with foreign countries introducing risk in international trading. This reduces the gains from trade. To the extent that inflation is unanticipated, lenders lose and borrowers win, so the incentive to lend declines as the risk in lending rises.

     Those who have saved, such as retirees, then find the value of their savings reduced through what is effectively an inflation tax. This makes it more difficult to accumulate a larger stock of capital and thus reduces economic growth. If the currency loses value sufficiently fast, as in the case of Zimbabwe where prices are rising at the rate of 11 million percent, it will no longer be accepted as a medium of exchange and the economy will resort to barter.

     The primary job of the Federal Reserve should be to preserve the value of the dollar so it can serve as a reliable medium of exchange and a store of value. This is now the case with a number of countries including Canada and New Zealand.

     The monetarists and the Austrians are correct in saying that expansionary monetary policy distorts the price signal and incentives to invest in the capital stock, and, rather than leading to economic growth in the long run, causes inflation and business cycles.

Dr. Gary Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College and a Business & Media Institute adviser.