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The Path Between Inflation and Deflation


In discussing the two, the goal is to determine money's value in and of itself.

Editor's Note: Matthew Beller is a former employee of the Federal Reserve Board and the Securities and Exchange Commission. He currently works for a private investment firm in Los Angeles, California.

Building a Better Inflation Definition

The debate between inflationists and deflationists has been rumbling along for years now, and still we see breakdowns in definitions and communications. In particular, Professor "Mish" Shedlock recently addressed the definition issue once more on his blog, possibly in response to some issues raised by Frank Shostak in an article for the Ludwig Von Mises Institute arguing that a decline in credit is distinct from a decline in the money supply and unrelated to deflation. Insofar as these missives by Mish and Shostak might be directed at one another, I believe that the two are missing each other, talking about two distinct issues.

The issue at hand is about which definitions of inflation are useful and what, if any, conclusions can be drawn from each. Following Todd Harrison's mantra of maintaining a balanced perspective and seeing both sides of the issue, I see a path somewhere between Mish's and Shostak's stances that will hopefully offer some clarity in the inflation-deflation discussion.

Supply and Demand

Ultimately, the goal of any discussion of inflation and deflation is to determine whether money is becoming more or less valuable in and of itself. We might discuss the whys or the hows, but what we really want to know is if we should be building inflation or deflation expectations into our required returns.

Austrian economists such as Shostak have adopted for inflation the definition of an increase in the money supply (I previously subscribed to this definition myself), but with just a little analysis, we see that this definition is woefully inadequate. That's because it fails to take into account demand for money. Indeed, high-school economics taught us that not just supply, but also demand are what determine the price of a good -- and money is no exception.

If the money supply increases, but the demand for money increases by a greater amount, then we'd actually see the value of money increase. Is it desirable to say that we're experiencing inflation, defined as an increase in the money supply, yet simultaneously witness each unit of money increase in value? I say no. That's why a superior definition of inflation is what occurs when demand for units of money is less than its supply at a given price level (i.e. level of monetary purchasing power).

Think about it this way: If you're trying to figure out the fair price of a stock, you don't look up changes in its shares outstanding or its float (i.e. supply) and call it a day. You also have to look at the company's fundamentals and its recent trading history to understand the demand for the stock at particular prices.

Money's "Price"

We tend to think of money as some omnipresent ether, static in value and a reference point for everything else in an economy. But just as Michelson and Morley proved that ether doesn't exist in the physical realm, it doesn't exist in the economic realm, either.

Prices of commodities are usually quoted in terms of money, so the idea of quoting money's value based on something else might seem strange. Yet, this happens every day. Grocery stores bid 1.01 apples for each of our dollars. NASDAQ participants bid 0.0017 shares of Google (GOOG) stock.

But due to "static price level" central bank policies influenced by Irving Fisher, any time those quotes change, we usually assume that it's because something has changed in the value of the non-monetary item. Perhaps unusual weather interfered with the apple harvest, or maybe Google's management announced a new business unit.
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