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Thursday, April 1, 2021

Is Money Supply Growth The True Definition Of Inflation?

One of the more unusual diversions in the discussion of inflation is the argument made by Austrian economists that inflation is defined as growth in the money supply. I outline the reasons for my disagreement in this article.

(Note: This is an unedited draft from a manuscript that discusses inflation.)

Shostak: Defining Inflation

The article “Defining Inflation” by Frank Shostak and published at the Mises Institute provides a succinct overview of the position of at least some Austrian economists. As a disclaimer, I am not an expert on the Austrian school, but it is safe to say that there numerous doctrinal splits, and “popular Austrian” economics one encounters on the internet and/or financial market commentary can be removed from the academic roots. In any case, I have seen views similar to Shostak’s article repeated many times over the years.

Shostak argues:
The fundamental problem here is a failure to define the problem properly.  For example, the definition of human action is not that people are engaged in all sorts of activities, but that they are engaged in purposeful activities--purpose gives rise to an action. 
Similarly, the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services.
So “inflation” is not about prices, rather the money supply. He quotes Ludwig von Mises, who makes a stronger claim about the term.
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. 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.
That is, von Mises argues that inflation meant money supply growth, presumably until wrong-thinking people showed up.

There are two legs to the response to this claim. The first is that it is a mischaracterisation. The second is that the claim does not matter. I take these in turn.

Are the Austrians Correct?

The author who writes a blog under the pen name “Lord Keynes” discussed the Austrian claims in an article “Austrians and the Definition of ‘Inflation’ Again.” I generally prefer not to use blogs as references in my books as they can disappear, but in this case, the author did a good job digging up references for an obscure scholarly debate, and I doubt that I could find a better source.

In his discussion, he uses word usage counts to note that both the phrases “inflation of currency” (e.g., money supply) and “inflation of prices” both appeared in texts from the early 1820s. He provides a number of examples of “inflation” being used with respect to prices (including by Jean-Baptiste Say), but the following quotation from Nathan Hale from 1840 is fairly clear.
The question recurs, what were the causes of the unusual mania of speculation — the excessive and long continued inflation of prices, and the confidence that this inflation, after it was known to be excessive, would continue, and the expectation that it would still further increase?
I am not a scholar of 19th century economic thought, and so I am not able to offer a definitive opinion on the “original” definition of inflation. We need to keep in mind that von Mises provides no actual evidence for his assertion, whereas “Lord Keyes” was able to provide phrase usage information. In any event, the reader needs to step back and ask: how is usage of the word “inflation” relevant at the present time? The English language evolves in strange ways, and some words have come to mean the opposite of their original meaning.

In the relatively recent past, I saw how the term “bubble” was relatively uncommon in the 1990s, but it has become used widely. It has a related implication to “inflation” – which is blowing air into something, causing it to expand. Even if the very first usage was in reference to money, it is easy to see that the term would be applied to practically everything.

English is Defined by Usage

The Austrian linguistic crusade to define “inflation” as an increase in the money supply is an attempt to contravene the reality that the English language is defined by usage. In financial market and economic discussion, inflation has evolved to be easily understood from context, even though it has multiple uses. (As noted in {another section of the manuscript}, it can refer to the general price level, or specifically consumer prices, depending on the context.) The expansion of the money supply is normally referred to as “money growth” (or a variety of equivalent phrases).

Nobody is going to be happy to start saying “rising consumer prices,” since it does not fit into sentences that we want to write. “How’s your rising consumer price model going, Brian?” is a sentence that will never look anything other than clunky.

Conversely, outside of “hard money” circles, there is less interest in money growth, so it will not get the high demand “inflation” label.

Is There a Reason to Care?

Shostak’s argument was that money growth should get the title “inflation” since money growth is what matters. He argues (somewhat implausibly) that the standard definition cannot explain why inflation is bad. Surely a small increase in prices is not that disruptive to real activity (which many post-Keynesians would agree with). He observes “… surely it is possible to offset its effects by adjusting everybody's incomes in the economy in accordance with this general price increases.”

This argument is hard to take too seriously. Even as an elementary school child in the 1970s, I knew why inflation was politically unpopular: not everyone’s earnings were indexed to inflation. People living on a fixed income were hardest hit. Meanwhile, I cannot recall any modern economist that favours widespread indexation, since it just locks in a spiral of rising prices.

He then explains:
However, if we accept that inflation is an increase in the money supply, and not a rise in prices, all these assertions can be easily explained. It is not the symptoms of a disease but rather the disease itself that causes the physical damage. Likewise, it is not a general rise in prices but increases in the money supply that inflict the physical damage on wealth generators.
The problem with this is obvious to anyone who is not wedded to hard money doctrines: a rise in the money supply by itself has no effect on my personal situation. It does not directly influence what I can buy or sell, nor does it necessarily have a direct effect on prices. The only way that Shostak’s logic holds is that growth in the money supply implies that prices must rise. This takes us to the topic of the Quantity Theory of Money, which is discussed in {another section of the manuscript}.

Concluding Remarks

This debate is an example of the limitless capacity of economics to create pointless controversies that partisans take extremely seriously.

References and Further Reading

(c) Brian Romanchuk 2021


  1. Maybe you should draft a chapter that looks at inflation from the other side: If the Austrians are right, what factors in modern economies suck away new money supplies nearly as fast as they are created?

    I would suggest looking first at the foreign trade sector. Next I would suggest looking at the way we (in the USA) fund retirement plans.

    Finally, I would look at the effect of borrowing from one's self, as when government borrows from the central bank. This last suggestion may be psychological in effect: What happens to the economy when the self borrowing stops?

    1. They’re not right. There’s no reliable relationship between what you are describing and inflation.

    2. Here's the possible relationship: Money can be created and used to accomplish some spending purpose. That same money can be removed from active use by the subsequent money owner. Any corresponding evidence of near term inflation would come from that single first use. Not much data is generated; it's all logical theory.

    3. My book is about what we are certain about with respect to inflation, not chasing after unproven theories.

  2. Probably the main reason for confusion on the definition of the word inflation is that it actually USED to be defined as an increase in the money supply - at least in the Oxford Dictionary. Roughly 20 years ago they were still defining it that way and I contacted them and told them to get with it and change to the new defionition, i.e. "rising prices" or something like that.

    If Austrians are still using the old definition, that's just the hundredth bit of evdience that Austrians are slow off the mark.

    1. That’s interesting, and I might take a look. However, that’s wildly out of line with actual usage, certainly in North America. Changes in the CPI have been synonymous with “inflation” since at least 1970s, when I grew up.

  3. I think it was appropriate that you published this on Aril 1st. I am pretty sure the Austrians originally calling inflation a growth of the money supply was an April Fools day joke gone bad.

  4. Another option is to become a copywriter or copy editor where you're paid to write copies in an effort to promote products and services. work from home work at home

  5. My favorite tool for discussing inflation, is talking about the "total valuation" of gov't currency assets: bonds held by public, reserve at the fed, and cash. Which mostly ends up being the national debt. So the real value of the national debt, is the most indicative number, and much easier to analyze.

    Inflation, as a number, can go arbitrarily high. One quintillion. But really your currency is just rapidly approaching a zero value. Furthermore, inflation is a percentage change over some time period. All of these make for a very confusing way to present the numbers.

    It is much easier to say "The value of circulating currency and bonds declined by half in one month", rather than say, we had an annual inflation rate of 4,096% last month. Furthermore, once you label it an "inflation rate", the expectation is that it will continue, as bill mitchell discusses when he defines inflation as a "continuous rise in the price level".

    The failure to be able to translate between these to frames: the change of one unit over a period, to the aggregate real value, just leads to bad thinking.

    Rather than referring to the QTM, MV = PY with Y and V constant, I prefer to refer to the aggregate value of outstanding government issued assets: Total Savings = Aggregate Valuation = Unit Value * Number of units. An austrian could never deny that the aggregate value is just the unit value times the number of units. It fits with their way of thinking, but breaks their analysis. Because then the valuation is meaningful, whereas austrians tend to think everything in the market should be priced the way they feel. No, your feelings don't really matter here. Unit value = Aggregate value/ Number of units. Ignoring the numerator, or arbitrarily sticking their own fantasy in for the numerator is the austrian's game.

    You see, at the end of the day, someone must be willing to save that valuation-- doesn't matter if it's equity, debt or currency, issued by public or private parties. The amount of savings in an asset, is tautologically its valuation, which is tautologically its market value. If they aren't they will exchange it, and not so that it merely circulates, but be willing to mark down the price.

    Mosler's theory of the price level is clear: the price of collateral and prices offered by government when it spends are what matters. Not even the deficit or the debt level really matters, in this formulation, if you have price discipline when spending and lending. I believe this is accurate long term, but sometimes you may need to provision yourself, and accept the market prices.

    1. You appear to be discussing the nominal value of governmental liabilities. Nobody doubts that they can be added up. The question is the exchange value versus real goods and services, which is the standard definition of “real value.”

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    3. No I am talking about the real value, not the nominal value. The real value of government liabilities is the only meaningful way to measure and respond to inflation.

    4. The standard definition of “real value” is to divide through by the price index. Which means you need a price index to define the real value.

    5. Yes, you have a price index, but you use that to measure the aggregate value of government liabilities. So you track how much, of the basket of goods(price index), all the government liabilities could buy. The problem comes in only trying to track the unit value. If you don't look at the aggregate value of government liabilities.

      The underlying point of course, is that monetary sovereignty allows your liabilities to function as equity, and go both up in value and down in value in a fluid manner, according to your total real valuation. No regime, which, in the face of inflation, targets their real valuation, is going to have a problem. The unit value of liabilities doesn't really matter, except that affects the behavior of savers, in a feedback cycle.

      Part of the problem with contemporary interest rate policy, is that the bond rate is assumed to be above the rate of inflation. It is easy to stop all inflation, by changing any continuous change in the price level, into an instantaneous one time change in the price level. This would be ideal. So instead of having inflation over several months or years, you instantaneously shrink the real value of outstanding liabilities, by an instantaneous change in the price index/price level. So if you have $10 trillion in nominal and real liabilities(1 to 1) and then you are worried about inflation, you actually want to instantly experience that inflation. So now that $10 trillion, is only worth $5 trillion(even though nominally it is still $10 trillion). By making it instantaneous, you can carry on spending as normal, just whatever percentage of real GDP. But you don't pay interest.

      Now that is ideal, if you want maximum fiscal control. But of course, it's not really realistic. So you just offer a bond rate below the inflation rate, and wait for markets to correct. Maybe not instantaneous, but still not drawn out forever. So the real value of your outstanding liabilities shrinks.

      Obviously, there's an issue here, of not only monetary sovereignty, but also trade sovereignty. Ie if you are very dependent on imports, that ties your hands a lot. I mean monetary sovereignty lets you always manage domestic resources, but sometimes that's not the issue.

      The most extreme example is to just cancel all the existing liabilities, and start over from scratch. But you can't really keep getting away with this. The private sector needs something. Sometimes a one time shock, is better than long drawn out uncertainty. So if you just let your price index change by a factor of 10 overnight, and then your outstanding liabilities are 1 tenth of their previous real amount. Then you

      I mean, these are all is just extreme examples of applying the two following statements.
      1) Interest on bonds is a policy choice.
      2) The price level is a function of prices paid by government when it spends.

      The problem with mainstream narratives, is that they don't see how letting bond rates fall below inflation, allows currency and bonds, to function as a kind of pseudo-equity, so currency and bonds are dynamically valued by markets in real time. Sure issuing more shares can dilute valuation, but only depending on how that capital is spent. The same for monetary sovereignty, but it's a little different because the purpose of government is create positive externalities, and it doesn't have a profit motive. So really, the capacity to save is a function of the extra wealth the government helps to build for the private sector.

      Unlike a private company, the value of a government is not what is on there own balance sheet, but rather the health of private balance sheets, which allows them to save money, and sell goods and services, for the purpose of seeking money. If productive capacity has slack, the desire to save is infinite.

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