Monetary Inflation And Price Inflation

This chapter explains the connection between the quantity of money and the height of prices quoted in that money. The chapter, therefore, deals with the phenomenon of “inflation,” but as we shall see, the very meaning of this word changed during the twentieth century. (For clarity, we will distinguish the two concepts by using the more specific terms “monetary inflation” and “price inflation.”) We will summarize some of the famous episodes of hyperinflation throughout history, showing the disaster that results when governments run the printing press too aggressively.

Finally, we will highlight the Austrian criticism of the so-called equation of exchange, nowadays usually written as MV = PQ. Although the equation is a tautology, this framework encourages thinking of money and prices in a mechanistic fashion rather than using the tools of subjective value theory. Although it is important to recognize that massive price inflation is always the result of massive monetary inflation, there isn’t a stable relationship between the two; it’s not the case that, say, a 50 percent increase in the quantity of money necessarily leads to a 50 percent increase in prices.

Changing Definitions: Monetary Inflation vs. Price Inflation

Nowadays when the media or government officials discuss “inflation” they mean “the increase in consumer prices.” However, originally the term referred to an increase in the quantity of money (including bank credit). Here is how Ludwig von Mises, in a 1951 speech, discusses the semantic change and its implications:

There is nowadays a very reprehensible, even dangerous, semantic confusion that makes it extremely difficult for the non-expert to grasp the true state of affairs. Inflation, as this term was always used everywhere and especially in this country [the United States], 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. It follows that nobody cares about inflation in the traditional sense of the term. As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil.1

Precisely to avoid confusing modern readers while retaining the ability to diagnose cause and effect, in this chapter we use the more specific terms “monetary inflation” and “price inflation.”

Famous Historical Episodes of Hyperinflation

Milton Friedman is often quoted as saying, “Inflation is always and everywhere a monetary phenomenon.” To give more context, that quotation goes on to say “in the sense that [price inflation] is and can be produced only by a more rapid increase in the quantity of money than in output.”2 Although economists have debated the accuracy of Friedman’s famous assertion, the historical record shows that episodes of rapid price inflation (almost) always go hand in hand with rapid monetary inflation.3 In other words, if there is a genuine hyperinflation, then the government printing press is always involved. In this section we cover three famous historical examples.

The US Civil War

The United States’ Civil War (or War between the States, as some prefer to call it) saw large-scale inflation in both the Union (Northern) and Confederate (Southern) economies, but it was particularly pronounced in the Confederacy. According to one estimate, fully one-third of the Confederate government’s revenue came from the printing press, while only 11 percent came from tax receipts (with the rest covered by floating bonds). As a result, prices in the Confederate states increased rapidly: From early 1861 to early 1862, consumer prices doubled, and by the middle of 1863 they had risen by a factor of thirteen relative to the war’s start. With military defeats in 1864 and 1865 sapping confidence in the Confederate currency, its value eventually collapsed—with prices rising some 9,000 percent cumulatively from the war’s start—leading Southerners to use other monies or even barter. In the North, things were not nearly as bad, with consumer prices “only” rising about 75 percent from 1861 to 1865.4

The Weimar Republic

One of the more (in)famous examples of hyperinflation was the experience of Germany from 1921 to 1923. Because of its massive debts (including harsh reparations payments to the Allies, dictated by the Treaty of Versailles) following World War I, the German government resorted to the printing press to pay its bills. Yet because the war debts were denominated in “gold marks,” this resulted in a vicious spiral, with each round of monetary inflation causing the German paper mark to depreciate against gold (and foreign currencies) even further, leading the German officials to print paper marks with higher denominations on each note in the next round in a vain attempt to stay ahead of the depreciation.5 During the two-year hyperinflation, the total number of marks held by the public increased by a factor of more than 7 billion.6 According to Milton Friedman, money in the hands of the public increased at “the average rate of more than 300 percent a month for more than a year, and so did prices.”7

1 2 3 4
View single page >> |

[This article is part of the Understanding Money Mechanics series, by Robert P. Murphy. The series will be ...

How did you like this article? Let us know so we can better customize your reading experience.


Leave a comment to automatically be entered into our contest to win a free Echo Show.
Monica Kingsley 4 weeks ago Contributor's comment

It's certainly nice when the cause (monetary inflation) is measured by the symptom (price inflation)