XIII. INFLATION

A. Confusions Resulting From the Definition of Inflation as Rising Prices

1. Too many explanations, causing ignorance in any particular case.

2. Implication of the responsibility of businessmen.

3. Implication of price and wage controls as the solution.

4. Implication of limiting inflation by expanding the quantity of money.

Alternative definition of inflation in terms of the increase in the quantity of money.

B. Validation of the Quantity Theory of Money as the Explanation of Rising Prices

1. The demand/supply test using the formula for the general consumer price level.

2. By the nature of the formula, the price level can rise only by virtue of more D or less S.

3. Reductions in supply must be ruled out as a cause of an inflationary rise in prices because:

a. Supply has actually increased.

b. Even where supply has decreased, the overwhelmingly greater part of the rise in the price level has been the result of more demand.

c. Reductions in supply could explain a sustained, significant rise in prices only if material civilization were in the process of rapidly disappearing, which it isn't.

d. A decrease in supply is often itself merely an indirect consequence of a rapidly rising aggregate demand, rather than being an initiating cause of rising prices.

e. Decreases in supply do not produce the range of price increases people associate with inflation.

f. Decreases in supply do not produce the effects on the relations between debtors and creditors that people associate with inflation.

g. To say that decreases in supply cause inflation is to imply that increases in supply cause deflation and, therefore, depression and poverty. This is a self-contradiction because more supply causes prosperity, not poverty.

4. Thus, the problem of inflation is exclusively one of rising aggregate demand.

5. A rise in aggregate demand is the result of an increase in the quantity of money: recall the examples of the gold mining case and of the issuance of social security checks from Chapter 12 and the discussion of the ways in which more M raises V.

6. Governmental responsibility for inflation.

a. The forced abandonment of gold and the creation of fiat standard money through the open market operation.

b. The encouragement of fractional reserve banking and fiduciary media: expanding the amount of reserves through the open market operation and making reserves more potent.

7. The implied solution for inflation: take the ability to create money out of the government's hands: make the monetary unit something the government cannot create—viz., gold.

C. Alternative Explanations of Rising Prices: The Cost Push Doctrines

1. The cost-push doctrine: the attempt to blame rising prices on rising costs of production. Variants of the cost-push doctrine: wage-push, profit-push, the wage-price spiral, crisis-push.

2. The roots of the cost-push doctrine: the belief that more demand causes more production and supply and can only raise prices at the point of full employment (“demand-pull inflation”). The belief that in the absence of full employment another explanation of rising prices must be found. Rising costs selected as the explanation because in first instance costs often do determine prices.

3. The logical deficiency of the cost-push doctrine: explaining prices on the basis of costs means explaining them on the basis of other prices and ultimately on the basis of mere arbitrary power.

4. The cost-push doctrine is equivalent to blaming inflation on falling supply. All the objections raised against falling supply as an explanation of inflation apply to it.

5. Critique of the wage-push variant:

a. If demand did not rise, wage push would burn itself out in mounting unemployment. The total cumulative effect of wage push would be limited and probably could not stop prices from actually falling.

b. Wage push is a continuing phenomenon only because of governmental decisions to increase the money sup-ply

and expand demand in an effort to avoid or fight the unemployment otherwise resulting from wage push.

Wage push is thus actually a consequence of an expanding quantity of money and more demand.

b. Confirmation by the experience of the 1980s.

6. Critique of the profit-push variant.

a. Even a protected legal monopolist can raise his price only if the demand for his product is growing. In order

to be associated with a problem of inflation, the growth in demand for the monopolist’s product must be part of

a growth in economy-wide demand.

b. The actual effect of the profit motive is to expand production and thus reduce prices; this confirmed even by

the rise in prices in paper money.

c. Inflation is associated with high profits. This is because an expanding money supply and demand increase

sales revenues. The increase in profits is purely in terms of paper money and is usually accompanied by a de-cline

in real profits: the inventory case.

7. Critique of the crisis-push doctrine.

Confusion of non-repeatable, particular price increases with sustained general price increases.

D. Alternative Theories of Rising Prices Continued: The Velocity Doctrines

1. The basic velocity doctrine: the attempt to blame increases in aggregate demand on a higher velocity of circulation of money rather than on a larger quantity of money.

2. Critique of basic velocity doctrine.

a. Velocity not an entity or cause of anything; reflects desire to hold money in reserve.

b. This desire mainly determined by rate of increase in the quantity of money, as explained previously; thus rise in velocity itself mainly a reflection of increase in quantity of money—more rapid the increase, the less is the desire to hold money, and thus the greater is velocity.

c. Independent changes in demand for money and velocity slow and gradual, and largely offset by more complexity of production involving more stages of payment and by more production.

3. Critique of the inflation-psychology doctrine:

a. Inflation psychology not a primary—the product of the fact of inflation; quickly diminishes in the face of a serious attempt to reduce inflation, as the experience of 1980s confirms.

b. Largely describes same factors as make for higher V; but also operates from the side of supply, in the anticipations of sellers: higher wage rates and prices than corresponds to current D. To this extent, like cost-push and with the same limits. Implication here of inflation causing unemployment via wages and prices outrunning rise in D.

4. More on inflation psychology: can appear to lead life of own—can continue for a while even if government sharply cuts back or stops inflating for a while; people go on with low cash holdings or reduce them further, and go on raising prices in expectation of being bailed out by more inflation. At this point, a crisis necessary to break inflation psychology—government must not validate inflationary expectations, not bail people out as demand appears inadequate, as credit fails to materialize and cash holdings prove inadequate. Appearance of crisis easily leads to resumption