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Implicit Inflation

June 3, 2010

The problem of inflation is a major concern in economics; it gives rise to economic discoordination and affects the distribution of wealth. Among most economists, inflation is generally seen just as a sustained increase in the level of prices, and not as a broader problem arising initially from monetary disturbances. In his The Theory of Free Banking (1988, p. 99), however, George Selgin reminds us that inflation might be sneaking in even when the price level is constant:

The illusion ends once the excessive money supply has its effects on wage rates and on the prices of other factors of production: an injection of money has the same discoordinating consequences whether it results in absolute inflation (rising prices) or only in relative inflation which, instead of causing prices to rise, merely prevents them from falling in accordance with increased productivity. Relative inflation does not reveal itself in a rising consumer price index, although it does result in an upward movement in the factors of production.

To focus on the effects of inflation (an increase in the price level), rather than on its cause (increase in the money supply above the increase in money demand) affects the diagnosis–whether there is an inflation problem or not.

The price level index, a central indicator used in monetary policymaking, tracks changes in the evolution of consumer prices, but cannot tell us what prices would look like absent any monetary stimulus. As Selgin points out, an increase in productivity should, roughly estimated, result in a 5% drop in the price level. This means an implicit inflation of 5% if the goal of monetary policy is to keep the price level constant. In our current regime of inflation targeting, in which the “ideal” level is 2 percent price growth per year, the implicit inflation would be even higher—roughly 7 percent.

Inflation is measured by looking at certain consumer prices (and weighting them according to some standard) and not for instance by looking at factor or asset prices. The effect of monetary stimulus on other prices is thus not considered an inflation problem even though this stimulus could create significant distortions.

Inflation is a bigger problem than just increases in the general price level of the economy. Changes in the money supply affect relative prices. This is like affecting traffic signals in a big city and expect that there would be no jams or accidents at the cross roads. Thus, the problem of implicit inflation has very important consequences.

The real problem with inflation is the discoordination it causes in economic life. The origin of this problem can be found in monetary manipulation by the central bank. Sound money requires the absence of this manipulation.

To ensure a minimum of monetary disruptions, we need to pay more attention to what the central bank does. Inflation is a serious problem, instead of focusing on a tricky symptom (changes in consumer prices), it would be better to focus where the problem is originated in the first place (monetary changes).

Nicolas Cachanosky is a PhD student at Suffolk University, Department of Economics, and the winner of the 2010 Atlas Sound Money Essay Contest for his contribution “The Endogenous Stability of Free Banking; Crisis as an Exogenous Phenomenon”


  1. Adrián Ravier July 5, 2010 11:35 AM
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    Richard Ebeling posted a piece on Northwood University's blog site, "In Defense of Capitalism & Human Progress," on, 'The Hubris of the Central Banker and the Ghosts of Deflation Past.'

    He explains the different meanings of "deflation" and their impact on the market under the headings of:

    (a) Supply-Side Deflation
    (b) Price-Wage Rigidity Deflation
    (c) Monetary Deflation

    He then discusses what some central bankers such as Ben Bernanke mean by "deflation" and why their cures for this supposed "problem" can be a source of even more instability, imbalance and distortion of market and price relationships.

    I think it might be of interest for this debate.

  2. Nicolas Cachanosky June 14, 2010 4:49 PM
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    Hi Adrian,

    By "counterfeit argument" I meant the following (p. 88):

    "By issuing deposits and notes in excess [...], it is creating and multiplying fictitious claims to property that have no counterpart in real goods [...]. The destruction of such pseudo titles to the money commodity is no less a benign development than the eradication of counterfeit titles to any other type of nonexistent property.
    [...] markets work more efficiently in serving consumers when the creation and exchange of counterfeit property titles to stocks of nonmonetary commodities are suppressed."

    I agree that the deflation argument cuts both ways. This is from the article (p. 88):
    "However, this objection does not take into account the fact that deflationary monetary policy has generally been implemented while the economy is still undergoing an inflationary boom and, therefore, operates to counteract and reverse the tendencies to malinvestment and arbitrary wealth redistribution that have not yet been consummated."

    I guess the two way cut makes reference to fractional reserves causing discoordination. Then that might be another difference with Selgin.


  3. Adrián Ravier June 14, 2010 12:50 PM
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    Thank you Nicolas.

    I understand and agree with the first part of your comment about the differences between Selgin and Salerno. But I think I do not understand part b, especially what you call "the counterfeit argument." You are correct when you say "we can't assure that the deflationary effects on relative prices will be an exact opposite match than the inflation effects." However, I think that Salerno would say that your argument cuts both ways: an increases in M by free banks when deflation occurs because of an increase in the demand for money (a decline in V) does not restore the original pattern of relative prices, but in fact distorts them further.

  4. Nicolas Cachanosky June 10, 2010 10:12 PM
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    Hi Adrian.

    I think differences may be found in bank credit deflation. Salerno (2003) divides this case in two: 1) Bank runs and 2) Contractionary monetary policy, where I find the potentially most important differences.

    The article argues that the government should use superavit resources: send them to the banks and increase their reserves requirements to a 100% ratio. I think there are two important differences here:

    a) The 100% requirement applies to commercial banks as well. Selgin gives an important role to fractional reserves.
    b) The second one is that this deflationary policy is "benign." Two arguments for this. 1) The counterfeit argument and 2) that deflation is cancelled out with an inflationary process that is "still going on."

    Even if the notes were counterfeit they still are money in the market and we can't assure that the deflationary effects on relative prices will be an exact opposite match than the inflation effects. Selgin argues that a free market would stabilize MV and that it should be inconvenient to force it to move away from it.

    Adrian, what do you think?

  5. amartinoro June 3, 2010 4:46 PM
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    Very thoughtful note.
    In my opinion, as well in the opinion of the author and many Austrian economists (which form a tiny fraction of all the economists), there are big misunderstandings in the mainstream on the concept of inflation. They tend to overlook the true costs of inflation. No wonder, given that they look at the effects (more precisely, at only one of the effects), and not at the true cause of inflation.

    Steve Horwitz has an interesting paper on this, called "The Costs of Inflation Revisited" ( One of the few costs of inflation he mentions is that inflation creates an attractive for the political world, because it distorts and makes more difficult the entrepeneurial activity. Thus, it changes the balance between the state and the market.

  6. Adrian Ravier June 3, 2010 1:58 PM
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    Great post!

    I can´t understand why mainstream economists think that we have to fight against deflation. Maybe, this is because they do not make difference between "growth deflation" and "bank credit deflation".

    Joe Salerno has written an article on this topic: "An Austrian Taxonomy of Deflation".

    Is there any difference between Selgin´s arguments on deflation and those by Salerno?