Wednesday, 7 September 2011

CASE 341 - Inflation

Money and Inflation

Price inflation is commonly thought to be caused by "too much money chasing too few goods." The general price level is indeed correlated with the money supply, but correlation should not be confused with causation. In a modern economy, prices are seldom driven by the money supply. More commonly, the money supply reacts to changes in the general price level.

Credit Money versus Commodity Money

It's easy to understand how the money supply can drive prices when a commodity like gold is used as money. In the gold rush days, California was basically on a barter system in which gold traded for goods and services. Gold was an asset for the holder and a liability for no one. As more gold was mined by private enterprise, monetary wealth in California increased. Indeed it increased much faster than the available supply of goods and services, so prices in terms of gold naturally rose.

Gold once comprised the monetary base, but today it is just another commodity. In a modern fiat money system, the monetary base is created by the central bank. However base money is a minor part of the money supply. Most of the money we use is credit issued by private banks in the form of deposits. Bank deposits are accepted as money because of the promise that they can be converted into base money on demand.

A bank loan increases the money supply but does not increase net wealth. The borrower receives a deposit that he can use as money, but he owes the bank that amount. Thus bank money behaves differently from base money. A bank can issue credit up to a prescribed multiple of its own capital. Within that constraint, the growth of bank money depends only on the demand from the public and the willingness of banks to lend. To understand what causes inflation today, we must therefore determine what creates the demand for credit.

Effects Related to the Price of Credit

The amount of bank money created is a function of many economic variables, including the price of credit which the central bank controls. The central bank can easily increase the price of credit enough to make borrowing unprofitable, stifle growth of the money supply, and even reduce total economic output. That would result in increased unemployment and possibly price deflation.

Conversely the central bank can easily reduce the price of credit, but the results are not symmetric. When the economy is operating well below capacity, cheaper credit will usually increase output without a significant increase in prices up to the point of nearly full employment. Thereafter the effects of cheap credit will generally lead to higher prices.

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