By Dr Frank Shostak
By the popular way of thinking, the key cause that sets a general increase in prices is inflationary expectations. For instance, if there is a large increase in the prices of oil, individuals, it is held, will start forming expectations for higher inflation ahead. Consequently, individuals will speed up their purchases of goods and services at present thereby raising the demand for goods and services, all other things being equal. This it is held is going to set-in motion general increases in prices. According to the former Fed Chairman Ben Bernanke,
Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.
It is held that if inflationary expectations could be made less responsive to various shocks, then over time this would mitigate the effects of these shocks on the momentum of the prices of goods and services.
Most commentators are of the view that by means of central bank policies it is possible to bring individuals inflationary expectations to a state of equilibrium. At this state, it is believed, expectations are going to be anchored or not sensitive to changes in various economic data.
On this way of thinking, once inflationary expectations are anchored, various shocks such as a large increase in the price of oil or food are likely to have a short-lived effect on general increases in prices. According to Bernanke anchoring inflation expectations is of utmost importance to eradicate inflation.
The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations. The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.
Again, once inflation expectations are anchored this means that over time sudden large price increases are unlikely to have much effect on general increases in prices. Note that what matters in this way of thinking is the underlying increase in prices.
It is for this reason that Federal Reserve policy makers and many economists are of the view that to be able to track the underlying price increases, which is labelled as the underlying inflation, one must pay attention to the core inflation – percentage changes in the consumer price index less percentage changes in the prices of food and energy.
It is also held that to make inflation expectations well-anchored individuals must be clear about the monetary policy of central bank policy makers. For most commentators by means of inflation targeting and clear communication by policy makers, the central bank can make inflationary expectations well–anchored i.e., not sensitive to data changes.
Can general increases in prices be set in motion without the increase in money supply?
Note again, that by popular thinking, a change in the price of a commodity such as oil can set in motion persistent inflation. It is however held that the emergence of inflation in response to the increase in the price of oil requires increases in expected inflation. On this, the former Fed Chairman Ben Bernanke is of the view that,
A one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent “wage-price spiral.
We suggest that without the preceding increases in money supply, all other things being equal, there cannot be general increase in prices, which is labelled by popular thinking as inflation.
Now, a price of a good is the amount of dollars paid per unit of a good. Hence, for a given quantity of goods, if the stock of money remains unchanged the amount of dollars employed per unit of a good will also remain unchanged, all other things being equal.
Let us say that because of a strong increase in the price of oil, individuals have raised their inflationary expectations. If the money stock remains unchanged, then no general increase in the prices of goods and services is going to take place, notwithstanding the increase in inflationary expectations.
If more money is spent on oil and energy related products, less money will be left for other goods, and services. Again, a price is the amount of money per unit of a good. All that we will have here is that the prices of oil and energy related goods will go up whilst the prices of other goods and services will go down.
Hence, it is increases in the money supply that underpin the underlying rises in prices, and not inflationary expectations. Without the support from money supply, all other things being equal, no general increase in prices can take place notwithstanding inflationary expectations.
Furthermore, what matters as far as inflation is concerned is not its manifestation in terms of increases in the prices of goods and services but the damage it inflicts to the wealth generation process.
This is inferred from the fact that increases in money supply (this is what inflation is all about) sets in motion an exchange of nothing for something, which generates a similar outcome to what the counterfeit money does. (Diverts wealth from wealth generators to non-wealth generators).
Some economists, such as Milton Friedman, maintain that if inflation is “expected” by producers and consumers, then it causes very little damage (see Friedman’s Dollars and Deficits, Prentice Hall, 1968, pp.47-48). The problem, according to Friedman, is with unexpected inflation, which causes a misallocation of resources and weakens the economy.
According to Friedman, if a general rise in prices could be stabilised by means of a fixed rate of monetary injections, individuals would then adjust their conduct accordingly. Consequently, Friedman held, expected general price increases, which he labelled expected inflation, are going to be harmless, with no real effect.
Observe that, Friedman regards money supply as a tool that can stabilise general rises in prices thereby promoting economic growth. According to this way of thinking, all that is required is fixing the money growth rate at some percentage, and the rest will follow suit.
The fixing of the money supply’s growth rate does not alter the fact that money supply continues to expand although at a fixed percentage.
This, means that it will lead to the diversion of resources from wealth producers to non-wealth producers. Hence, the policy of stabilising prices will generate more instability through the misallocation of resources.
Summary and conclusion
Contrary to popular thinking, we hold that inflation is not about increases in prices but about increases in money supply. Also contrary to various commentators we suggest that inflationary expectations in the absence of increases in money supply, cannot cause a general increase in the prices of goods and services.
