What are the Causes of Inflation?

Inflation is a monetary phenomenon. Inflation can be defined as an aggregate increase in the prices or a decrease in the purchasing power of money. A price level change can be sustained or temporary. Inflation is sustained. Increases in the price level from exogenous shocks do not continue to increase prices generally.

In contrast, when monetary policy incorrect, there can be a sustained increase in the price level. The question is what is a monetary policy that creates inflation? There is a second question, how is inflation manifest. There is a third question, is a stable CPI synonymous with money macro equilibrium.

Monetary policy is central bank action. There are two primary types of monetary policy that cause inflation or deflation.

  1. The central bank increases or decreases the quantity of money.
  2. The central bank increases or decreases the interest rate.

Quantity Theory of Money

The quantity of money is the oldest explanation for changes in the price level. Simply stated ceteris paribus for the velocity of money and the real output, the price level will increase if you increase the money supply. The equation is: P = VM/Y

This theory is an old theory, known in Roman times and before because of it is intuitive. If you increase the amount of money in circulation you will see a rise in the price level. The modern economists, John Stuart Mill and David Hume articulated this.

The Federal Reserve Bank in the US and the European Central Bank has kept a fairly steady increase in the money supply. Hyperinflation in developing countries or the interwar experience of Germany, reminded modern central banks of the welfare cost of irresponsible monetary policy connected to changes in the quantity of money.

Definitions of the Money Supply

The most relevant definition of the money supply today is M2. M2 is cash and near cash plus bank reserves. Most people think money is cash, but relevant for monetary stability is M2.

Modest increases in M2 in a growing economy does not cause inflation.

Milton Friedman resurrected the quantity theory of money and advocated rule based monetary policy with the quantity money being the target.

Why the Quantity theory of Money is abandoned?

The theory is correct in the long-run and especially in cases of hyperinflation. However, for the intermediate term a better theory emerged.

Despite modern-day commentaries, we are not simply “printing money”. However, we are doing it metaphorically. This can be understood with an interest rate theory of inflation.

Knut Wicksell the founder of Modern Monetary Theory

Wicksell’s book Interest and Prices in 1898 explained a more relevant theory of price level movements. . The idea is there was an observable bank rate of interest, that is the rate you might see at the bank. This was known as the market rate of interest. However, there was also another rate of interest that this market rate was to be measured against. That was the natural rate of interest.

A level of interest is too low or too high relative to the natural rate. A nominal rate tells us little about the appropriate level or the target for the interest rate. However, the nominal rate is relevant when compared to the natural rate. This is not to be confused with the Fisher rate real rate of interest which is simply, the nominal rate minus the inflation rate.

Money Macro Equilibrium

The natural rate is the marginal productivity of capital if barter ratios were used and when harmonized with the market rate should bring money neutrality, that is no monetary inflation or deflation.

There still may be a change in the price level, even a persistent change but that would be caused by other factors, such as technological improvement.

Why are interest rates important for the prices?

Interest rates are a price. Specifically the price for loan-able funds. Purchasing power that can be used to fund the capital formation process. It is a price that is also inter-temporal. That is purchasing power used today versus the future.

A price – any price including an interest rate, conveys information about time and subjective valuation

Wicksell’s theory shifted the emphasis from a simple relationship between money and capital formation and expansion to purchasing power or credit. We are really talking about what level of credit should be in the market to fund entrepreneurial capital expansion or capital lengthening (Mises, 1912, The Theory of Money and Credit)?

Credit is more relevant in a modern economy because this is what entrepreneurs use, they certainly are not paying in cash, rather money is done in a bank giro system, money transfers and credit.

Therefore if interest is what governs the supply and demand for credit, the central bank tries to bring money to a neutral or equilibrium rate.

The natural rate of interest as a monetary policy target

After the central banks jettison targeting monetary aggregates, interest rate targets are the primary way that central banks achieve their mandated policy objective of price stability.

Misunderstanding of what the natural rate is, has lead central banks to misestimate the natural rate or not consider there might be multiple natural rate of interest. It might be low because rates are low, and this a feedback mechanism.

The Fed uses an interest rate target called R star, this is an empirical estimation of the natural rate of interest. This theory is largely based on economists as Michael Woodford , 2003, Interest and Prices. They believe like Wicksell, that if the natural rate of interest is equal to the market rate, in this case, the Fed Funds rate, money would be neutral and price moments would be worked out in the real sector by supply and demand.

What is wrong with interest rate targeting?

The issue is, these estimates are wholly empirically based. The illusion that they have anything close to the natural rate estimate is manifest everything time a chief economist proclaims “this time is different’. Lets look at the theoretical basis for this central bank theoretical error.

In one rendition of the natural rate of interest Wicksell wrote:

This is necessarily the same rate of interest which wold be determined by the supply and demand if no use were made of money and all lending were effected in the form of real capital

Interest and Price, p.188

This is a monumental error by the Federal Reserve. It is an assumption. The assumption is in an economy where money is ubiquitous, can you make an estimate of the rate of interest in natura? That is a rate of interest is barter ratios are used. How can you have a natural rate of interest, a rate that is hypothetical in a barter economy, if money is everywhere? It is a theoretical paradox with realworld implications.

If you are wrong, you will start a boom and bust cycle as articulated by F.A. Hayek. If money is not neutral and the price of credit is miss-priced than like every other price you will have a loss in surplus. Since there is no market for money unto itself, monetary disequilibrium is worked out through all prices across all markets.

I explain Austrian business cycle here in a natural rate framework. That is how a misunderstanding of the natural rate and how it coordinates investors and savers ex ante causes capital distortions which can be coupled with price distortions.

This is manifest giving wrong signals to entrepreneurs, like traffic lights that do not work.

Rates are too low to harmonize investors and savers ex ante. This is distorting the capital structure.

The result is an equilibrium that is less than optimal. It might seem like everything is functioning as should in the economy, especially with a stable price level defined as the CPI, but it is not.

The economy is in a disequilibrium that cannot be perceived at first glance because the natural rate of interest is at the wrong level. Only after the crisis has started or is this reality manifest.

How inflation is manifest

Typically there is not a traditional rise in the CPI like in old style theories and economies. This is because productivity gains associated with technological innovation has decreased the overall cost of production. Rather inflation is seen in asset bubbles like real estate and the stock market.

Asset bubbles – the new inflation

Business cycles and inflation are connected. Not in the old school Keynesian Phillips curve but with meteoric rise in the stock market. This is fueled by credit and debt brought about by a market rate of interest that is too low.

The cause of inflation, whether it is old style CPI inflation or manifest in asset bubble like the market the Federal Reserve bank’s non-market solution to the money supply. Creating empirical models which are based on wrong assumptions.

Productivity gains results in cost efficiency and a lower CPI.

Why is health care and college so expensive while the CPI does not manifest this? Because everything we observe is in aggregate. Because productivity gains in consumer goods have decreased their relative price, prices with social welfare in places like education and health have inflated.

The bottom line in the Federal Reserve causes price disequilibrium even if inflation is not manifest. This inflation is manifest in a estimate of the natural rate of interest.

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