Inflation and deflation are "everywhere and always"1 monetary phenomena--by which I mean, they occur as a result of a change in the quantity of money. Inflation is the decline in the purchasing power of money due to an increase in the supply of money more rapid than the increase in real wealth.2 When the supply of money is kept constant, prices will reflect the existing relationship between supply and demand.3 The greater the supply, the less valuable something is. As economic value is expressed in terms of demand, this means the greater the supply the less the demand. The “equilibrium price” is that price at which all of the existing supply will be purchased (i.e. demanded.) Prices will fall if supply goes up relative to demand and will rise if demand goes up relative to supply. In a system of constant money, changes in prices reflect changes in the supply and demand of the various goods and services4 available for exchange.
Money itself is effected by the law of supply and demand. The greater the supply (the larger the quantity of money) the less valuable money is in terms of goods. In other words, it takes more money to purchase the same supply. Prices rise. The opposite is also true: a contraction in the money supply will lead to falling prices as the existence of less money makes each unit of money more valuable.
So, the quantity (supply) of money has definite effects on prices by its ability to change demand (the willingness and ability to spend money.) When more money is available, a larger amount of money can be offered to purchase the same goods as before. Prices are also affected by the availability of goods. An increased supply of goods will also result in lowering the equilibrium price. To the extent that the increase in supply is due to an increased productivity (increased efficiency in labor and/or materials) the fall in prices will not have an adverse effect on profitability, total sales revenues or ability to repay debts. Quite the opposite. An increase in the supply of goods due to increased productivity is the engine of economic progress and the cause of a rise in the standard of living. Less of one’s labor is needed to obtain the same or greater amount of goods. To equate falling prices due to an increased productivity with a fall in prices due to a contraction in the quantity of money is to equate a beneficial situation with a harmful one. For this reason, defining inflation and deflation simply in terms of a change in prices fails to distinguish between these fundamentally opposite economic situations.
Fear of falling prices, irrespective of the cause of the fall, has misled many economists. The siren of “price stability” has lured both Keynesians and Monetarists onto the rocks of inflationary destruction. In contrast to falling prices due to an increase in the supply of goods, falling prices due to a contraction in the money supply will lead to a fall in total sales revenue, profits and thus a fall in employment and the ability to repay debts-the meaningful definition of deflation. But a large contraction in the money supply can only occur in a system that first allows a large growth in the money supply. This increase or decrease of the money supply out of sync with the production of real wealth is the ultimate cause of the boom and bust of the business cycle. Inflation, an increase in the money supply, stimulates a boom. Deflation, a contraction in the money supply, results in the bust.
What kind of money is vulnerable to significant and recurrent inflation and deflation? Money that is disconnected from the production of actual wealth, ie. fiat money and fiduciary money created through credit expansion. A commodity money, such as gold, can increase in supply, but its increase is limited. This is illustrated by the chart below showing the historical growth of gold as a percent of the world gold stock.
World Gold Production as a Percentage of World Gold Stock 1800-2000
(Source: Salsman, 19955 Click on images to enlarge.)
Total Gold Supply vs. Money Growth Supply Annual Rate of Change 1933-2008
(Source: Gold Fields Mineral Resources, Ltd; KITCO)
This can also be demonstrated by comparing the purchasing power of gold to that of the U.S. dollar.
Purchasing Power of Gold and of the Dollar 1792-1994 (1792= 1.00)
(Source: “Gold and
Or perhaps more dramatically when superimposed as below:
Purchasing Power of Gold and the U.S.Dollar 1792-1994
(Source: “Gold and
Prices can change as a result of shifting supply relative to demand, thus redirecting resources to where the demand is greatest. Or, prices can change because of a change in the quantity of money, leading to the inefficiencies of inflation and deflation. When prices simultaneously reflect both a change in supply/demand and a change in the quantity of money, there is no way to distinguish how much of the change is due to which cause. In this way, a changing quantity of money masks and distorts the signals which are essential for the efficient allocation of resources. Without accurate price signals, savings are malinvested, excessive risk is assumed, consumption exceeds production. Eventually, reality catches up with the falsely inflated values. The deflationary realignment is painful and destructive. To preserve accurate price signals and prevent the inflation/deflation boom-bust cycle, we must have a money which is sound and constant. These are the benefits of a commodity money, like gold.
An essential function of definitions is to enable us to isolate and distinguish different phenomena one from the other in order to think about them more clearly and accurately. Definitions of inflation and deflation that fail to distinguish between the differing causes for a rise or fall in prices can not serve this function. In fact, they do the opposite. Inflation and deflation disrupt economic calculations and are therefore destructive to the creation of wealth. A fall in prices due to increased productivity is accompanied by a rise in the standard of living. Only when this distinction is understood can we hope to respond appropriately to changing economic circumstances.
1. This phrase is from a frequently quoted description of inflation in Monetary History of the United States 1867-1960 by Milton Friedman and Anna Schwartz.
2. An alternate definition is “an increase in the quantity of money at a rate more rapid than the increase in the supply of gold and silver.” Gold and silver simply stand in place as a direct unit of measure of the value of all other wealth—wealth being the material goods made by man; also land and natural resources in so far as man has made them usable and accessible. All definitions are derived from Capitalism: A Treatise on Economics by George Reisman.
3. Demand is defined as the willingness and ability to purchase and is quantified by dollars actually spent.
4. To simply the language, for the rest of the post I will use “goods” to signify both “goods and services.”
5. Salsman, Richard, “Gold and
6. An insignificantly small amount (relative to total existing stock) of gold is actually consumed in medical other commercial uses. The rest remains easily retrievable.
7. Salsman, 1995 p. 128-9
8. Salsman, 1995 p. 31