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”