Many believe that the key cause of a general increase in prices is so-called inflationary expectations. For instance, if there is a large increase in the price of oil, individuals will start forming expectations for higher inflation ahead. Consequently, individuals will speed up their purchases of goods and services at present, thereby raising the demand for goods and services, all other things being equal. This is supposed to set in motion general price increases.
“The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations,“ he said. ”The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.”
Note that what matters, according to this view, is underlying price increases. Because of this, Federal Reserve policymakers and many economists are of the view that in order to track the underlying price increases—labeled as inflation—one must pay attention to the core inflation. Core inflation has to do with percentage changes in the consumer price index.
Can General Increases in Prices Happen Without the Increase in Money Supply?
According to mainstream thinking, a change in the price of a commodity, such as oil, can set in motion persistent inflation. It is believed that the emergence of inflation in response to the increase in the price of oil requires increases in expected inflation. Bernanke is of the view that “a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent ‘wage-price spiral.’”However, without the preceding increases in money supply, all other things being equal, there cannot be a general increase in prices, which is often labeled “inflation.” The price of a good is the amount of dollars paid per unit of a good (in a money economy using dollars). Hence, for a given quantity of goods, if the stock of money remains unchanged, the amount of dollars employed per unit of a good will also remain unchanged, all other things being equal.
Let us say, for example, that because of a strong increase in the price of oil, individuals have raised their inflationary expectations. If the money stock remains unchanged, then no general increase in the prices of goods and services is going to take place, notwithstanding the increase in inflationary expectations. If more money is spent on oil and energy-related products, less money will be left for other goods and services. All that will happen is that the prices of oil- and energy-related goods will go up while the prices of other goods and services will go down.
It is increases in the money supply that underpin the underlying rises in prices and not inflationary expectations. Without the support from the money supply, all other things being equal, no general increase in prices can take place notwithstanding inflationary expectations. Furthermore, what matters as far as inflation is concerned is not its manifestation in terms of increases in the prices of goods and services but the damage it inflicts to the wealth-generation process. Increase in money supply—which is inflation—sets in motion an exchange of nothing for something and distorts the price and production structure. This diverts wealth from wealth-generators to non-wealth-generators.
Some economists, such as Milton Friedman, maintain that if price inflation is “expected” by producers and consumers, then it causes very little damage (see Friedman’s “Dollars and Deficits,” pp. 47–48). The problem, according to Friedman, is with unexpected price inflation, which causes a misallocation of resources and weakens the economy. According to Friedman, if a general rise in prices could be stabilized through a fixed rate of monetary injections, individuals would then adjust their conduct accordingly. Consequently, he held, expected general price increases—which he labeled expected inflation—would be harmless, with no real effect. He regards the money supply as a policy tool that can stabilize general increases in prices, thereby promoting economic growth. According to this way of thinking, all that is required is fixing the money growth rate at some percentage. The rest will follow suit!
The fixing of the money supply’s growth rate at a certain expected percentage does not alter the fact that the money supply continues to expand. It will lead to the diversion of resources and distortion of the price and production structure, reduce purchasing power, and produce business cycles. Hence, the policy of stabilizing prices will generate more instability!
Contrary to popular thinking, inflation is not about increases in prices but about increases in money supply. Also contrary to various commentators, inflationary expectations—in the absence of increases in money supply—cannot cause a general increase in the prices of goods and services.
