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Source link: http://archive.mises.org/16955/just-what-is-inflation/

Just What Is Inflation?

May 15, 2011 by

Justin Lahart with the Wall Street Journal wrestles with the definition of ‘inflation’ in his article “Using a Dictionary to Define Inflation Can Spell Trouble.”  Lahart writes that up until 2003, Webster’s defined inflation as printing money.  Since the 2003 edition, Webster’s defines inflation as “a continuing rise in the general price level.”

Mainstream economists say that only those out-of-step define inflation as increased money creation.  “They were quite far behind the times,” says Harvard economist Greg Mankiw. In his widely used economics textbook, he defines inflation simply as “an increase in the overall level of prices in the economy.”

Lahart traces the I-word back to 1755 when “The state of being swelled with wind; flatulence,” defined inflation.

In 1864, Webster’s American Dictionary of the English Language defined inflation as “undue expansion or increase, from over-issue; — said of currency.”

And so on from there until 2003.

“This semantic innovation is by no means harmless,” Mises wrote in Planning for Freedom.   Mises points out that it’s impossible to fight an evil that you can’t name.  The public gets lost when a detailed analysis is required and continually referring to this analysis is bothersome, besides being ineffective.  “As you cannot name the policy increasing the quantity of the circulating medium, it goes on luxuriantly,”  Mises wrote.

However, what is most damaging is that when policy makers fight the consequences of inflation–a rise in prices–they make matters worse, not realizing “the causal relation between the increase in money in circulation and credit expansion on the one hand and the rise in prices on another.”

Mr. Lahart writes that “there has been a shift in American thinking of the purpose of dictionaries: Rather than defining words as some experts thought they should be used, dictionaries have moved toward defining words as people actually use them.”

So what we have is a generation of people (economists and otherwise) who don’t understand what inflation is.

When questioned about rising gasoline prices, Fed Chair Ben Bernanke said during the Federal Reserve’s first press conference.

This is a very adverse development. It accounts for almost all of the inflation. There’s not much the Federal Reserve can do about gas prices, per se, without derailing growth entirely.

The Fed cannot create more oil. What we can do is basically try to keep higher gas prices from passing into other prices and wages, and creating a broader inflation that would be harder to extinguish. Our view is that gas prices will not continue to rise at the recent pace. That will provide some relief on the inflation front.

Just look it up in Webster’s: the Fed has nothing to do with prices.

{ 24 comments }

Grant May 15, 2011 at 7:01 pm

So frustrating, especially for those–like me–who teach economics. An increase in price is NOT inflation. It’s the symptom. It’s like saying a fever is an infection. Totally back-ass-wards.

Mike Sproul May 15, 2011 at 7:10 pm

The problem with defining inflation as an increase in the money supply is that the money supply can rise with no effect on the value of the money. The fed increases its issuance of paper dollars, but at the same time increases its assets by an equal amount. Private banks issue more checking account dollars, but at the same time their assets rise by an equal amount. Credit card companies to the same thing, and so do stores that issue gift certificates.

matt470 May 16, 2011 at 6:07 am

I disagree. With Fractional Reserve Banking the supply of money increases more than the value of the “reserve” asset – i.e. the reserve is only a fraction of the money supply.

J. Murray May 16, 2011 at 7:36 am

Don’t bother, this guy thinks that so long as you put any old thing you can define as an “asset” in recievership in exchange for a note, money will never lose value. Never mind if that “asset” is a rapidly depreciating one, the model doesn’t account for that aspect of assets and thus doesn’t happen in reality.

Mike Sproul May 16, 2011 at 8:59 am

Reserves are only a fraction of assets. If a bank has issued 100 currency units (dollars) against which it holds 10 oz of silver as RESERVES, plus various other ASSETS (land, bonds, etc) worth 90 oz., then the $100 is backed by 100 oz. worth of assets, and each dollar is worth 1 oz. If things change, and there are 200 dollars laying claim to assets worth 150 oz., then each dollar will be worth 150/200=.75 oz.

matt470 May 17, 2011 at 7:40 am

My best instincts tell me to take J.Murray’s word and not bother but I can’t help myself as you seem not to understand FRB.If I go into a bank to take out a loan, the bank doesn’t first check that is has the funds available from other to depositors to loan me the money, rather it checks whether it has enough reserves to meet the fractional reserve requirement. If the FRB requirement is 10% and the bank has $1000 dollars of reserves it can lend me $1900 and safely remain within it’s reserve requirement (1 – 10% = 90% increase – see The Mystery of Banking by Murray Rothbard ch11).
This means the supply of money has just increased by $900 from this new loan it has written and this new money is not directly backed by assets or reserves.

When the Fed purchases assets under it’s “open market operations” then it writes a cheque on itself for an asset (this cheque is not backed by anything, simply written out of thin air) and then once that cheque is taken to a bank and deposited it increases that banks reserves by that amount, at which point they can pyramid money on top of those new reserves up to their fractional reserve requirement as demonstrated above.

The main trouble the Fed has had of late (not including completely debauching the currency) is that banks are not lending out to their full capacity of reserves and hence the Fed is having trouble re-inflating the bubble or getting a new bubble started (or in their words “fixing the economy”). This is why they have resorted to quantitative easing which is simply buying newly issued US Govt bonds as assets which is also known as “monetising the debt”. This is pretty much the most inflationary step they can take.

J. Murray May 17, 2011 at 8:04 am

That’s not really the main point behind Mr. Sproul. His thing is the “Real Bills”, which states that so long as you back the bill with some asset “worth”, say, a number of ounces of silver, the money will never devalue. It actually rejects fractional reserve banking, but replaces it with basically the same thing the Federal Reserve is doing now. The ultimate problem with this concept is that it ignores asset depreciation and subjective valuations, so backing $25,000 in bills with a new car because it happened to have sold off the lot for that amount of silver is flawed as other market actors may not value that automobile at $25k and next year that $25k automobile may only have a market price of $18k, meaning 28% of the original bills have just turned worthless as the car cannot be liquidated to provide $25k in silver bullion that the bills supposedly represent. The market will be keenly aware of this and, over time, will request a greater and greater number of bills to offset the risk associated with a depreciating and unequal asset base that’s constantly fluctuating in relation to the silver. Additionally, with a greater number of non-silver assets being used to back new money, the market will also be aware that the chances of being able to liquidate a constantly growing, as a percentage, stock of non-silver assets into silver on demand when banking customers request conversion of their money into silver becomes incredibly difficult. Flash liquidating assets takes a long time and market actors aren’t going to accept a basket of random goods that the bills were backed against as payment. If I show up with $1,000 in silver bullion, I expect $1,000 in silver bullion, not $20 in silver bullion, a vaccum, a painting, and a BluRay player the bank decided was valued at $980. Real Bills turns the banking system into a flea market.

This is inflation, which Real Bills claims cannot happen.

The Federal Reserve also behaves like this when it adds new money into the market. It buys up gold, Treasury bonds, real estate, and other assets to add cash into the market, but this never seems to stop inflation.

Hawks5999 May 15, 2011 at 8:01 pm

Until banks take those dollars out of reserve and actually lend them into circulation the money supply hasn’t actually increased. Inflation by your hallowed Websters definition isn’t happening (look at the M1-2-3 numbers). Price increases in commodities that are driven by increased demand from emerging markets and strained supply from adverse weather and adverse political climates in the Mideast are happening. By your hallowed Websters definition, that isnt inflation.

Hard Rain May 16, 2011 at 5:40 am

Hawks, are there strained supplies for every single commodity? Do these “emerging markets” somehow desperately demand every single commodity simultaneously? Do you discount that, even with a lot of the increased money supply holed up in excess reserves, it is not impossible for the market to act out of the reasonable expectation that these reserves may someday be unleashed, or that simply, fiat currencies are fess less desirable than tangible assets.

hawks5999 May 16, 2011 at 10:37 am

“are there strained supplies for every single commodity?”
Primarily in food and energy for the reasons I gave.
“Do these “emerging markets” somehow desperately demand every single commodity simultaneously”
Well, they need food and energy as desperately as developed markets. In many cases more so as they are developing and consuming more in that development process.
“Do you discount that, even with a lot of the increased money supply holed up in excess reserves, it is not impossible for the market to act out of the reasonable expectation”
No, I’m confident that many market participants act irrationally.
“or… fiat currencies are fess less desirable than tangible assets.”
On principle, I agree with you on this point. However, who is getting paid in tangible assets vs fiat currency? Again, market participants aren’t immaculately rational or self-interested.

Jon May 15, 2011 at 8:51 pm

The definition of inflation is much more than as an “increase in price”. It is not just a rise in price, but more of a fluctuation in price over a period of time, measured by the Consumer Price Index. In addition there are many factors that can cause inflation: increase in the money supply, increase in prices of production materials, international debts and federal taxes. IMO the definition of inflation will continue to evolve because the word encompasses to much.

matt470 May 16, 2011 at 6:14 am

In addition there are many factors that can cause inflation: increase in the money supply, increase in prices of production materials, international debts and federal taxes

You are confusing effects for causes. An increase in the prices of production materials stems from an increase in the money supply (they are bidded up by the extra money in the system). Obviously this is not necessarily so in any individual sector but that is why mainstream economists talk about an increase in the general price level – so when “general” prices of production materials increase then we can be sure that there is more money in the economy driving this.

J. Murray May 16, 2011 at 9:53 am

Additionally, economists miss out on the inflation when a price declines. Improved production processes can cause prices to decline, but inflation keeps the price decline less steep. Also, wiping out non-value added processes in companies will cause prices to fall and tends to happen during a recession, so the system frequently confuses this price fall, which can be limited due to inflation, as deflation.

HL May 16, 2011 at 12:38 am

Flatulence. Perfect.

Rick Weinle May 16, 2011 at 9:51 am

Rising oil price due to changing supply or demand is a micro issue.
Cost push is also a micro issue.
Inflation can only be understood when viewed as a macro issue.

Bart May 16, 2011 at 10:30 am

I’ve given up on trying to use the word correctly. I just say “monetary inflation” now to avoid arguments over the definition.

GSL May 16, 2011 at 10:42 am

We wrote about this just last week. We (hopefully) showed how tricky policy analysis can get if you don’t understand what inflation actually is.

Mississippi Guesser May 16, 2011 at 11:28 am

From your article, “Prices can rise for three different reasons: an expansion in a good’s supply, a contraction in the demand for that good, or an expansion in the supply of the commodity society uses for money.”

I thought when supply increases, prices fall. Also, when demand decreases, prices fall.

J. Murray May 16, 2011 at 11:32 am

He got it backwards. However, with price fixing, in a situation where the price is fixed above market clearing rates, a good’s supply will typically increase, demand will typically contract, and there will be pressure to expand the money supply to allow people to “afford” the price-fixed commodity like California energy.

EconAndre May 16, 2011 at 11:05 am

You have to be careful about dictionary definitions because they change. One dictionary I like is Noah Webster’s 1828 dictionary for general purposes.

Clarification comes from separating cause and effect. Inflation is an increase in the money supply. Three main manifestations of inflation are an increase in general prices, an increase in asset valuations, and an increase in one’s trade deficit. See financialsense.com for more information. Also, the 1755 definition begs for the application of some classic jokes to the subject of monetary economics.

Dani May 19, 2011 at 12:37 pm

Would love to hear some of those jokes!!

Curb Your Risk May 16, 2011 at 11:46 am

I disagree with the definition of inflation as rising prices. I agree with Grant above….inflation is the effect of the cause. Now the way I look at it is inflation is only rising prices IF the price increase is sustainable…otherwise it is merely a spike which is corrected by the function of supply and demand. In order to get sustained price increases, you need the ability to pay for those spikes. Therefor, I would rather use the idea of rising wages as the true definition of inflation. During the late 1990′s and early 2000′s we saw this, but it was rising wealth (perceived wealth actually) which led to some of the biggest inflation pushes we saw. No one complained, as everyone was benefitting from increased home prices, which allowed us to use our home as an ATM… we did not have increased wages, but we did have the perception of increased wealth…Unfortunately most of those inflationary pressures are still with us today. OTHERWISE….it is simply rising wages equals sustained inflation.

J. Murray May 19, 2011 at 12:42 pm

Rising wages isn’t a good indicator either because it lumps in genuine productivity improvements in with inflation. Inflation can’t be determined by proxy because it’s impossible to filter out all the other factors that cause pricing changes. The only way to determine inflation by proxy is if you can know what the price would have otherwise been had the driver of what is being referred to as inflation did not happen.

billwald June 10, 2011 at 2:42 pm

Runaway inflation harms most every person.

But few percent of money inflation is a non issue to 70% or 80% of the world’s population because they live from paycheck to paycheck at best. The only thing that matters is how many hours they need to work to pay the basic bills. The world needs fair jobs and fair paychecks, not free trade.

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