Monetary inflation

For increases in the general level of prices, see inflation.

Monetary inflation is the term used by some economists to differentiate direct inflation in the money supply (or debasement of the means of exchange) from price inflation which they view as a result or necessary outcome of the former. Originally "inflation" was used to refer simply to monetary inflation, whereas in present usage it often refers to price inflation. The Austrian School of economics makes no such distinction, maintaining that monetary inflation is inflation, there being no difference between the two.

The description of the actual mechanism and relationship between price inflation and monetary inflation varies according to each school, but there is overall agreement among them that there is a cause and effect relationship between supply and demand of money and prices of goods and services measured in monetary terms. Although the system is complex and there is a great deal of argument on how to measure the monetary base or how much factors like the velocity of money affect the relationship, and even more disagreement on what is the best monetary policy, there is a general consensus on the importance and responsibility of central banks and monetary authorities in affecting inflation. Inflation targeting is advised by followers of the monetarist school, while Austrian economists advocate the return to genuine free markets, which would entail the abolition of the state-sponsored and protected central bank, which protects and supports and controls modern fractional reserve banking and advocate instead free banking or (more often) a return to a 100 percent gold standard.

Quantity theory

The monetarist explanation of inflation operates through the Quantity Theory of Money, $MV=PT$ where M is Money Supply, V is Velocity of Circulation, P is Price level and T is Transactions or Output. As monetarists assume that V and T are determined, in the long run, by real variables, such as the productive capacity of the economy, there is a direct relationship between the growth of the money supply and inflation.

The mechanisms by which excess money might be translated into inflation are examined below. Individuals can also spend their excess money balances directly on goods and services. This has a direct impact on inflation by raising aggregate demand. Also, the increase in the demand for labour resulting from higher demands for goods and services will cause a rise in money wages and unit labour costs. The more inelastic is aggregate supply in the economy, the greater the impact on inflation.

The increase in demand for goods and services may cause a rise in imports. Although this leakage from the domestic economy reduces the money supply, it also increases the supply of pounds on the foreign exchange market thus applying downward pressure on the exchange rate. This may cause imported inflation.

The role of the Central Bank and Fractional Reserve Banking

The Austrian School maintains that inflation is always and everywhere simply an increase of the money supply (i.e. units of currency or means of exchange), which in turn leads to a higher nominal price level, as the real value of each monetary unit is eroded, loses purchasing power and thus buys fewer assets and goods and services.

Given that all major economies currently have a central bank supporting the private banking system, almost all new money is supplied into the economy by way of bank-created credit (or debt). Austrian economists believe that this bank-created credit growth (which forms the bulk of the money supply) sets off and creates volatile business cycles (see Austrian Business Cycle Theory) and maintain that this "wave-like" or "boomerang" effect on economic activity is one of the most damaging effects of monetary inflation.

According to the Austrian Business Cycle Theory, it is the central bank's policy of ineffectually attempting to control the complex multi-faceted ever-evolving market economy that creates volatile credit cycles or business cycles. By the central bank artificially "stimulating" the economy with artificially low interest rates (thereby creating excessive increases in the money supply), they themselves induce inflation (often focused in asset or commodity markets) and speculative investment, resulting in "false signals" going out to the market place, in turn resulting in clusters of malinvestments, and the artificial lowering of the returns on savings, which eventually causes the malinvestments to be liquidated as they inevitably show their underlying unprofitability and unsustainability.

Austrian economists therefore regard the state-sponsored central bank as the main cause of inflation, because it is the institution charged with the creation of new currency units, referred to as bank credit. When newly created bank credit is injected into the fractional-reserve banking system, the credit expands, thus enhancing the inflationary effect.

Inflation is one of the three means by which it can fund its activities, the other two being taxing and borrowing. Therefore, the actual cause of inflation is government's need to create new money. The money created then goes to fund various government programs, for instance welfare and warfare.

Given that in almost all modern economies the central government "borrows" money from the central bank to fund deficit spending, in reality there are only two ways a modern government can fund its activities: taxing the populace, or borrowing (either from the central bank, private savers or overseas investors). The issuance of debt-free money from the central government ended in the United States with the cessation of silver certificates.

External links

• Money and Inflation
• Monetary Inflation / Quantity Theory
• ECB: M3 and CPI
• Charts of commodity prices and monetary aggregates
• Money and Commodity prices