Defining Inflation

Oh the meaning of words… always problematic if they are not defined in a straightforward manner. Today’s word is “inflation.” It is unfortunate that a dictionary definition will not suffice.

The mainstream definition, that is, the definition commonly accepted in academia is a simultaneous, but not necessarily proportionate, rise in the prices of all goods and services. It is an observational definition that refers neither to a cause nor effect. The price of one good cannot be inflated; it must be the price of all goods and services that rise together.

Austrians, broadly speaking, do not like this definition. In addition, Milton Friedman is always famously quoted for stating that inflation is, “always and everywhere a monetary phenomena.” Indeed, if the prices of all goods and services are rising, the logical implication is that the purchasing power of the monetary unit is falling. Furthermore, purchasing power is falling because of an increase in the supply of money relative to the amount of goods and services in an economy.

Apply the converse of this theoretical insight to the Great Depression and you have the recipe for the monetarist hypothesis. So where does this leave us with a definition for inflation? Most economists certainly associate inflation with the monetarists. In my opinion, it is a loaded word, filled with assumptions and therefore inappropriate.

I propose a strict definition: Inflation is an increase in the supply of money. A medium of exchange that circulates in an economy, and in which all prices are denominated in the terms of this medium, is called money. If any amount new money enters the economy, this is called inflation. Note that this definition has no bearing whatsoever on what the price level is.

However, it was Keith Weiner, one of the young guns of the “New Austrian School of Economics,” who pointed out that this strict definition is problematic at best.

There are essentially two kinds of monetary orders – one based on commodity money and the second on fiat money. Keith pointed out that the market process behind the production of each kind of money is entirely different. Whereas commodity money, historically gold and silver, enters a given economy based on the structure of production and relevant costs associated with mining the precious metal, fiat money enters the economy when central banks buy government debt and facilitate loans.

I could not agree more with the fact that the process by which money comes into circulation is entirely different in the aforementioned systems. Strictly speaking though, the supply of “money” (defined as the commonly accepted medium of exchange) can increase in both cases. What I call the “strict” definition of inflation is simple and straightforward, as the meanings of words should be.

I was (erroneously) under the impression that Austrian economists from the Mises Institute subscribed to this “strict” definition of inflation I just put forth. To make amends, I find it appropriate to quote Guido Huelsmann at length on the topic:

We can define it [inflation] as an extension of the nominal quantity of any medium of exchange beyond the quantity that would have been produced on the free market. This definition corresponds by and large to the way inflation had been understood until World War II. Yet it differs from the way the word “inflation” is used in contemporary economics textbooks and in the financial press. Most present-day writers mean by inflation a lasting increase of the price level or, what is the same thing, a lasting reduction of the purchasing power of money. Let us hasten to point out that, as far as mere vocabulary is concerned, both meanings of the word are perfectly fine, if only they are used consistently. Definitions do not carry any intrinsic merit; but they can be more or less useful for the understanding of reality. Our definition of inflation singles out the phenomenon of an increase of nominal quantity of any medium of exchange beyond the quantity that would have been produced on the free market for the simple reason that this phenomenon is causally related to a large number of other phenomena that are relevant from an economic and moral point of view. As we shall see, inflation in our sense is the cause of unnatural income differentials, business cycles, debt explosion, moderate and exponential increases of the price level, and many other phenomena. This is why we hold our definition to be the most useful one for the purposes of the following analysis. The reader will soon be in a position to verify this contention.

Inflation is an extension of the nominal quantity of any medium of exchange beyond the quantity that would have been produced on the free market. Since the expression “free market” is shorthand for the somewhat long-winded “social cooperation conditioned by the respect of private property rights,” the meaning of inflation is that it extends the nominal money supply through a violation of property rights. In this sense, inflation can also be called a forcible way of increasing the money supply, as distinct from the “natural” production of money through mining and minting. This was also the original meaning of the word, which stems from the Latin verb inflare – to blow up (The Ethics of Money Production, 2008: p. 85 – 86).