Is Money Supply Growth The True Definition Of Inflation?

One of the more unusual diversions in the discussion of inflation is the argument made by Austrian economists that inflation is defined as growth in the money supply. I outline the reasons for my disagreement in this article.

(Note: This is an unedited draft from a manuscript that discusses inflation.)

Shostak: Defining Inflation

The article “Defining Inflation” by Frank Shostak and published at the Mises Institute provides a succinct overview of the position of at least some Austrian economists. As a disclaimer, I am not an expert on the Austrian school, but it is safe to say that there numerous doctrinal splits, and “popular Austrian” economics one encounters on the internet and/or financial market commentary can be removed from the academic roots. In any case, I have seen views similar to Shostak’s article repeated many times over the years.

Shostak argues:

The fundamental problem here is a failure to define the problem properly.  For example, the definition of human action is not that people are engaged in all sorts of activities, but that they are engaged in purposeful activities--purpose gives rise to an action. 

Similarly, the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services.

So “inflation” is not about prices, rather the money supply. He quotes Ludwig von Mises, who makes a stronger claim about the term.

Inflation, as this term was always used everywhere and especially in this country, 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.

That is, von Mises argues that inflation meant money supply growth, presumably until wrong-thinking people showed up.

There are two legs to the response to this claim. The first is that it is a mischaracterisation. The second is that the claim does not matter. I take these in turn.

Are the Austrians Correct?

The author who writes a blog under the pen name “Lord Keynes” discussed the Austrian claims in an article “Austrians and the Definition of ‘Inflation’ Again.” I generally prefer not to use blogs as references in my books as they can disappear, but in this case, the author did a good job digging up references for an obscure scholarly debate, and I doubt that I could find a better source.

In his discussion, he uses word usage counts to note that both the phrases “inflation of currency” (e.g., money supply) and “inflation of prices” both appeared in texts from the early 1820s. He provides a number of examples of “inflation” being used with respect to prices (including by Jean-Baptiste Say), but the following quotation from Nathan Hale from 1840 is fairly clear.

The question recurs, what were the causes of the unusual mania of speculation — the excessive and long continued inflation of prices, and the confidence that this inflation, after it was known to be excessive, would continue, and the expectation that it would still further increase?

I am not a scholar of 19th century economic thought, and so I am not able to offer a definitive opinion on the “original” definition of inflation. We need to keep in mind that von Mises provides no actual evidence for his assertion, whereas “Lord Keyes” was able to provide phrase usage information. In any event, the reader needs to step back and ask: how is usage of the word “inflation” relevant at the present time? The English language evolves in strange ways, and some words have come to mean the opposite of their original meaning.

In the relatively recent past, I saw how the term “bubble” was relatively uncommon in the 1990s, but it has become used widely. It has a related implication to “inflation” – which is blowing air into something, causing it to expand. Even if the very first usage was in reference to money, it is easy to see that the term would be applied to practically everything.

English is Defined by Usage

The Austrian linguistic crusade to define “inflation” as an increase in the money supply is an attempt to contravene the reality that the English language is defined by usage. In financial market and economic discussion, inflation has evolved to be easily understood from context, even though it has multiple uses. (As noted in {another section of the manuscript}, it can refer to the general price level, or specifically consumer prices, depending on the context.) The expansion of the money supply is normally referred to as “money growth” (or a variety of equivalent phrases).

Nobody is going to be happy to start saying “rising consumer prices,” since it does not fit into sentences that we want to write. “How’s your rising consumer price model going, Brian?” is a sentence that will never look anything other than clunky.

Conversely, outside of “hard money” circles, there is less interest in money growth, so it will not get the high demand “inflation” label.

Is There a Reason to Care?

Shostak’s argument was that money growth should get the title “inflation” since money growth is what matters. He argues (somewhat implausibly) that the standard definition cannot explain why inflation is bad. Surely a small increase in prices is not that disruptive to real activity (which many post-Keynesians would agree with). He observes “… surely it is possible to offset its effects by adjusting everybody's incomes in the economy in accordance with this general price increases.”

This argument is hard to take too seriously. Even as an elementary school child in the 1970s, I knew why inflation was politically unpopular: not everyone’s earnings were indexed to inflation. People living on a fixed income were hardest hit. Meanwhile, I cannot recall any modern economist that favours widespread indexation, since it just locks in a spiral of rising prices.

He then explains:

However, if we accept that inflation is an increase in the money supply, and not a rise in prices, all these assertions can be easily explained. It is not the symptoms of a disease but rather the disease itself that causes the physical damage. Likewise, it is not a general rise in prices but increases in the money supply that inflict the physical damage on wealth generators.

The problem with this is obvious to anyone who is not wedded to hard money doctrines: a rise in the money supply by itself has no effect on my personal situation. It does not directly influence what I can buy or sell, nor does it necessarily have a direct effect on prices. The only way that Shostak’s logic holds is that growth in the money supply implies that prices must rise. This takes us to the topic of the Quantity Theory of Money, which is discussed in {another section of the manuscript}.

Concluding Remarks

This debate is an example of the limitless capacity of economics to create pointless controversies that partisans take extremely seriously.

References and Further Reading

• “Defining Inflation” by Frank Shostak (2002-03-06). URL: https://mises.org/library/defining-inflation
• Ludwig von Mises, Economic Freedom and Interventionism, Chapter 20 (“Inflation: An Unworkable Fiscal Policy.”) Text available online at: https://mises.org/library/economic-freedom-and-interventionism/html/p/123
• “Austrians and the Definition of ‘Inflation’ Again,” by “Lord Keynes.” July 8, 2014. URL: http://socialdemocracy21stcentury.blogspot.com/2014/07/austrians-and-definition-of-inflation.html
• Quotation from Hale, Nathan (ed.), Chronicle of Events, Discoveries, and Improvements, for the Popular Diffusion of Useful Knowledge Nathan Hale. S. N. Dickinson, Boston. 1840. p. 11. The text is available online.

(c) Brian Romanchuk 2021