The Semantics of Inflation
By Matt Ford Jun 06, 2007 2:45 pm
Inflation's semantic evolution is not without consequence because it encourages people to confuse cause and effect of monetary system phenomena.
If we happen to be left half alive
I’ll get all my papers and smile at the sky
Though I know that the hypnotized never lie
--The Who
The meaning of inflation has evolved significantly over the past 100+ years. Its semantic evolution is not without consequence because it encourages people to confuse cause and effect of monetary system phenomena.
To enhance their financial market awareness, effective market participants should understand the original meaning of inflation as well as its modern connotation.
Semantic Journey
As part of the Federal Reserve Bank of
However, by the early 1900s,
Whatever drove inflation’s connotation towards the concept of general price increases cannot be determined precisely. It is, however, noteworthy that central bank control of money supply was institutionalized during this period with the passage of the Federal Reserve Act in 1913. In addition, the Bureau of Labor Statistics initiated the Consumer Price Index series in 1919, which likely increased national attention on price-based econometrics.
The work of influential economist John Maynard Keynes in the 1920s and 1930s may have cemented the price-based connotation of inflation into the popular mindset. His General Theory (Keynes, 1936) academically separated money supply from its effect on prices. This theory, and the concept of inflation as a price-related rather than a money-related phenomenon, were broadly accepted. Today, it is hard to find an economics textbook that does not define inflation primarily in terms of price increases (e.g., Frank & Bernanke, 2007; Hubbard & O’Brien, 2006).
Why This Matters
Despite the broad acceptance of price-based definitions of inflation, it is wise to also understand the problems that result from these definitions. Accurately operationalizing a price-based connotation of inflation is difficult, and concerns about the validity of price measurement systems are numerous. Establishing the proper measurement domain and objectives (Schulze, 2003), addressing seasonality (Dagan & Morry, 1984), and accounting for substitution, quality improvement, and other phenomena that influence prices in a dynamic economy (Diewert, 1998; Moulton & Moses, 1997) are but a few of the issues when broadly measuring prices.
The more fundamental issue concerns the appropriateness of a price-based definition of inflation in the first place. A rise in prices is an outcome that can be activated by three causal factors: a decrease in the supply of goods on the market, a collective social movement towards less saving and more spending, or an increase in the supply of money and credit (Rothbard, 1962). A price-based measure of inflation is an outcomes measure; it provides no information about the factors that influence price behavior.
Employing a price-based definition of inflation is potentially misleading (Mises, 1949). When driven by the first two factors noted in the paragraph above—a decrease in market supply of goods or a decrease in the propensity to save—price increases result from voluntary changes of preference in the market. These are desirable activities in a free market environment. However, a rise in prices driven by the third factor noted above—an increase in the supply of money and credit—intervenes with the free market mechanism and distorts voluntary preferences and patterns of income and wealth (Rothbard, 1962).
Due to its potentially adverse consequences, money and credit supply require close attention in order to preserve a functioning free market system.
The modern price-based definition of inflation deflects attention from the money supply factor while the original definition of inflation focuses attention squarely on it.
Won't Get Fooled Again
It is both interesting and ironic that Bryan’s (1997) study of the word ‘inflation’ was sponsored by the Federal Reserve Bank of Cleveland. There is perhaps no entity more motivated to deflect attention from a money supply-based definition of inflation than a central bank. Bryan himself noted:
As a condition of the money stock, an inflating currency has but one origin—the central bank—and one solution, a less expansive money growth rate (1997: 1).
Indeed, if Federal Reserve or other government officials set out to purposely reframe inflation to deflect attention away from the Fed’s connection to money supply growth, then it’s hard to argue that such a plan has been anything other than brilliantly executed. Today, we find a dollar whose supply (as measured by M3b and other metrics) is dramatically increasing and produced by fiat, increasing debt and deficits, and a currency that has lost more than 95% of its purchasing power since the Fed’s origin. Yet, despite these consequences, the Fed is largely perceived as a vital institutional element of the US financial system.
While the price-based definition of inflation dominates the popular mindset, viewing inflation as an increase in money and credit supply provides valuable perspective on the health of economies and markets.
References
Dagan, E.B. & Morry, M. (1984). Basic issues on the seasonal adjustment of the Canadian Consumer Price Index. Journal of Business and Economic Statistics, 2(3): 250-259.
Diewert, W.E. (1998). Index number issues in the Consumer Price Index. Journal of Economic Perspectives, 12(1): 47-58.
Frank, R.H. & Bernanke, B. (2007). Principles of economics, 3rd ed.
Hubbard, R.G. & O'Brien, A.P. (2006). Macroeconomics.
Keynes, J.M. (1936). The general theory of employment, interest and money.
Mises, L. (1949). Human action.
Moulton, B.R. & Moses, K.E. (1997). Addressing the quality change issue in the Consumer Price Index. Brookings Papers on Economic Activity, 1: 305-366.
Rothbard, M.N. (1962). Man, economy, & state.
Rothbard, M.N. (2002). A history of money and banking in the United States.
Schulze, C.L. (2003). The Consumer Price Index: Conceptual issues and practical suggestions. Journal of Economic Perspectives, 17(1): 3-22.
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