Money and inflation

The price of any good is a reflection of the supply of, and demand for, that good. It is important to recognise the manner in which this holds true for money. If the supply of money rises faster than its demand, then the purchasing power of money (the quantity of goods a unit of money will buy) falls. In other words, when the quantity of money increases faster than the quantity of goods, the prices of those goods will tend to rise.

Potato farmers know that the price they receive per bushel is inversely proportional to the total quantity produced and offered for sale. Similarly,

If the supply of caviar were as plentiful as the supply of potatoes, the price of caviar – that is, the exchange ratio between caviar and money or caviar and other commodities – would change considerably. In that case, one could obtain caviar at a much smaller sacrifice than is required today. Likewise, if the quantity of money is increased, the purchasing power of the monetary unit decreases, and the quantity of goods that can be obtained for one unit of this money decreases also. (Mises 1979, p.55)

If farmers were willing, each year, to put more and more resources into producing potatoes (or caviar), then we could expect the supply to go up. If, however, consumers are not willing to increase total expenditure on potatoes, then the farmers won’t be able to sell all their potatoes unless they reduce the price. From the perspective of each farmer, each potato produced can be traded for less than before. In terms of potatoes, the farmer sees the prices of most other goods to be rising. Thus, by inflating the quantity of potatoes, farmers are also inflating the average of all other prices in terms of potatoes.

That is potato inflation. It wouldn’t take farmers long to recognise that their actions were causing price inflation, as measured in potatoes. (Measured in money, therefore, the price of potatoes would be falling.) Further, given the effect on their profitability, many farmers would reduce their production, with the net effect of reducing the potato inflation.


What is easy to see in the potato example should also be easy to see for money. Inflation is caused by increases in the quantity of money relative to all other goods. Inflation is reduced by reducing the rate of increase of the quantity of money. The direction of causation seems clear.

Would anyone claim that the falling purchasing power (price) of potatoes causes an increase in the production of potatoes? Not likely. But in the case of money, this is a widespread view. What is it about the institutional structure of money production that creates such a reversal in the perception of causation? It is largely due to a failure to recognise responsibility points (as discussed above) in monetary policy; but this failure is itself a product of the confused and intertwined histories of central banking and economic thought.

A century ago, when gold was the money (1) in most countries, it was much easier to see the causal link from gold to prices. New discoveries of large, exploitable gold deposits were often followed by rising prices. But such discoveries rarely occurred without effort; and mining the gold required time, effort and resources. Everyone would have liked to have been the discoverer of more gold, but there were natural limits on this.

Even if a new gold deposit is discovered, the cost of mining, milling and refining might be higher than the value of the gold produced. Only later, as the level of economic activity increases relative to gold supply, and the purchasing power of gold rises sufficiently, would it be cost-effective to mine that deposit. Technological advances would also assist exploitation of deposits, but such advances also require effort, resources, and new ideas.

When gold was money, there was no way to cheaply increase the quantity of gold. In centuries past, alchemists tried to combine seawater with phlogiston (and a few other secret ingredients) to produce gold, but never quite managed to find the magic formula. Even striking coins with the king’s countenance did not fool people for long if the coins contained less than the correct amount of gold. A favourite trick of money-hungry state treasuries was to melt down coins and remint them with base metals mixed in to reduce the gold content. People would even clip bits of gold off the edges of coins or, more discreetly, “shave” gold particles smoothly from the circumference. (This eventually gave rise to the defensive practice of minting coins with serrated edges to obviate any shaving.) Thus, currency debasement has a long history, as does its freelance counterpart called “counterfeiting”. (2)

It was still difficult to debase the coinage for long when the money was a simple commodity, and when people had a choice about accepting it in payment. The imposition of fiat monies generally resulted in inflations and failure until conditions became more favourable in the past century.

(1)    Silver has also been used, through many centuries, as a monetary metal. Its use continued, often alongside gold, into the twentieth century.

(2)    Counterfeiting is a form of copyright infringement or pirating, whether done by governments or by private offenders.

Source: This article is an extract from the book Real Money, published by the Free Market Foundation and may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and are not necessarily shared by the members of the Foundation.

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