Increase in the money supply sets in motion the misallocation of resources
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. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation.
In short, what today is called inflation is the general rise in prices, which is in fact only the outcome of inflation.
Consequently, anything that contributes to price rises is now called inflationary. Moreover, it is held that if this inflation rises above some arbitrarily set target — 2 percent, for instance — then this “excessive” inflation must be opposed.
Thus a fall in unemployment or a rise in economic activity are all seen as potential inflationary triggers. Some other triggers such as rises in commodity prices or workers wages are also regarded as potential threats should inflation exceed the “target” rate.
If inflation is indeed just a general rise in prices, then why worry about it ever? What kind of damage does it do?
According to the popular way of thinking, general price increases cause speculative buying, which generates waste.
It is also maintained that price inflation erodes the real incomes of pensioners and low-income earners and causes a misallocation of resources.
Despite all these assertions regarding the side effects of what they define as inflation, popular thinking doesn’t tell us how all these bad side effects are caused.
Why should a general rise in prices hurt some groups of people and not others? Why should a general rise in prices weaken real economic growth? Or how does inflation lead to the misallocation of resources?
Furthermore, if inflation is just a rise in prices, surely it is possible to offset its bad side effects by adjusting everybody’s incomes in the economy in accordance with this general price increase.
Once however, it is established that inflation is about increases in the money supply then all the above questions are easily answered.
Note what we are not saying. We don’t say that inflation is rises in prices caused by rises in money supply. What we are saying is that — properly understood — an increase in the money supply is what constitutes inflation.
Observe that increases in the money supply set in motion an exchange of nothing for something. They divert real wealth away from wealth generators towards the holders of the newly created money.
This increase in the money supply — not changes in prices — is what sets in motion the misallocation of resources.
Moreover, the beneficiaries of the newly created money (i.e., money out of “thin air”) are always the first recipients of money, and so they can divert a greater portion of wealth to themselves.
Obviously, those who either do not receive any of the newly created money, or get it last, will find that what is left for them is a diminished portion of the pool of real wealth.
Additionally, real incomes fall not because of general rises in prices as such, but because of increases in the money supply, which gives rise to non-productive consumption. In other words, inflation (i.e. increases in money supply) undermines the production of real wealth, which over time lowers individuals’ living standards.
General increases in prices, which follow increases in money supply, is an indication — as it were — that the erosion of peoples’ purchasing power has taken place.
In this case, it is not the symptoms of a disease, but the disease itself, that causes the physical damage. Similarly, it is not a general rise in prices but an increase in the money supply (i.e. inflation) that inflicts the physical damage on wealth generators.