Do Price Increases or Money Supply Increases Misallocate Resources?

Most economists and economic commentators believe that inflation is defined as general increases in prices of goods and services. Thus, they hold that anything that contributes to price increases sets inflation into motion.

A decline in unemployment or an increase in economic activity are seen as potential inflationary triggers, while other factors, such as increases in commodity prices or workers' wages, are also regarded as inflation triggers. Many experts also believe that inflation causes speculative buying, generating waste. By popular thinking, inflation also erodes the real incomes of pensioners and low-income earners and causes a misallocation of resources. Inflation, it is argued, also undermines real economic growth.

Why should a general rise in prices hurt some groups of people and not others? Or how does inflation lead to the misallocation of resources? Why should a general rise in prices weaken real economic growth? For one, a price of a good is the amount of money paid for the good, and this suggests that for a given amount of goods, a general increase in prices can take place in response to the increase or inflation in money supply.

Most economists, when discussing the issue of general increases in prices, which they label inflation, rarely mention the word money. The reason is the lack of an accurate statistical correlation between changes in money and changes in various price indexes such as the Consumer Price Index (CPI). A statistical correlation, or lack of it, between two variables shouldn't be the determining factor in establishing causality. Instead, one must figure out the structure of causality by means of reason and logic.

The Essence of Inflation

Inflation is an act of embezzlement by means of increasing the money supply. According to Ludwig von Mises:

To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call "inflation" the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying "catch the thief". The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices.

Increases in the money supply through the exchange of nothing for something divert wealth away from wealth generators towards the holders of the newly generated money. This is what sets in motion the misallocation of resources, not price rises as such. Real incomes of wealth generators decline not because of general rises in prices, but because of increases in money supply, that diverts wealth from them.

When money is generated out of "thin air," the holders of the newly generated money can divert goods to themselves without producing anything themselves. As a result, wealth generators who have contributed to the production of goods discover that the purchasing power of their money has fallen, since fewer goods are left in the pool.

Once wealth generators have fewer goods at their disposal, this hampers the formation of wealth. As a result, economic growth is going to come under pressure. General increases in prices, which follow increases in money supply, only point to an erosion of wealth. Price increases however did not cause this erosion. Likewise, increases in the money supply and not increases in prices erode the real incomes of pensioners and low-income earners, who tend to have fixed incomes, are the last receivers of the newly pumped money.

Oil Prices and inflation

If the price of oil goes up and if individuals continue to use the same amount of oil as before, individuals will be forced to allocate more money to oil. If one's money stock remains unchanged, less money will be available for other goods and services, which would drive down on average the prices of other goods and services. 

Note that the overall money spent on goods does not change; only the composition of spending has altered, with more on oil and less on other things. Hence, the average price of goods remains unchanged.

The growth rate in the prices of goods and services will be constrained by the growth rate of money supply, all other things being equal, and not by the growth rate of the price of oil. Therefore, it is not possible for increases in the price of oil to set in motion general increase in the prices of goods and services without the corresponding support from money supply.

Can Inflation Expectations Trigger a General Price Rise?

According to some economists (including Paul Krugman), once individuals start to anticipate higher inflation in the future, they raise their demands for goods at present thus bidding the prices of goods higher. According to the former Fed Chairman Ben Bernanke inflation expectations are the key driving factor behind increases in general prices,

The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations. The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an deanchoring of those expectations would be destabilizing for growth as well as for inflation.

Also, workers expectations for higher inflation prompt them to demand higher wages. Increases in wages in turn lift the cost of producing goods and services and force businesses to pass these increases on to consumers by raising the prices of goods and services.

While businesspersons take into account various costs of production when setting prices, the final decision maker as far as the price of a good is concerned is the consumer. The consumer determines whether the price set is "right," so to speak. If the money stock did not increase then consumers will not have more money to support general increase in the prices of goods and services. 

So irrespective what individuals' expectations are, if the money supply did not increase, then individuals' monetary expenditure on goods cannot increase either. This means that no general strengthening in price increases can take place without the increase in the pace of monetary pumping, all other things being equal.

Can Prices Be Stable under Inflation? 

If for a given stock of goods an increase in the money supply occurs, this means that more money will be exchanged for a given stock of goods, all other things being equal. The purchasing power of money in these situations will fall, increasing the prices of goods. In this case, a general increase in prices will be associated with inflation. 

But consider the following case: the growth rate in money is in line with the growth rate in goods supply. Consequently, the prices of goods on average do not change. Is there inflation or not? For most commentators, if an increase in the money supply is exactly matched by the increase in the supply of goods no increase in general prices is going to take place and therefore no inflation is going to emerge. This way of thinking is erroneous since inflation has taken place—i.e., the money supply has increased.

The exchange of nothing for something that the expansion of money sets in motion cannot be reversed by an increase in the supply of goods. The increase in the money supply will set in motion all the negative side effects that money printing does, including the menace of the boom-bust cycle, regardless of the increase in the supply of goods.

According to Murray N. Rothbard,

The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.

Conclusion

Contrary to the popular definition, inflation is not about general rises in prices but about increases in the money supply. General increase in prices as a rule develops because of the increase in money supply. The harm that most people attribute to rises in prices is in fact due to increases in money supply. Hence, policies that are aimed at countering inflation without identifying what is it all about only make things much worse.