Inflation classically defined is a rise in the supply of money; Inflation, commonly understood, is a rise in the price of goods and services. It is perhaps this distinction which partly contributes to the mysterious behavior of money, prices and inflation throughout society. Although the distinction of how money affects us personally against how it affects society is what really lies at the heart of monetary mystery and money mischief.
In Money Mischief Episodes in Monetary History, Dr. Milton Friedman writes about various episodes throughout recent history in order to simplify the understanding of the vicissitudes of the monetary phenomena. The first thing to understand about money, no matter what it is (i.e. circular stones, precious metals, pieces of paper or the amount of zeroes on a computer screen), is what the relation of the amount of money has to the price of goods and services throughout an economy. No matter how one may define inflation, Dr. Friedman was correct in stating that inflation is always and everywhere a monetary phenomenon.
As recently mentioned, the classical definition and the common understanding of inflation while seemingly different are actually related. The distinction comes from our personal biases. When the stock of money increases, there is inflation or more appropriately when the rate of money growth exceeds the amount of economic output, there is inflation. This inflation has societal implications. However, what we personally see is a rise in prices. In order to illustrate this distinction, Dr. Friedman brings up a hypothetical community where the average income is $20,000 and the amount of savings is 10%, or 5.2 weeks of their income. Unless mentioned, everything else in this situation is ceteris paribus, all things being equal.
Suppose then one day a helicopter, the helicopter representing a metaphor for the Federal Reserve in the United States, flies over this hypothetical community. The helicopter then drops an amount of money equaling $2,000 per citizen, or the amount of each individual’s savings. What would such an affect be when each individual is now $2,000 richer in nominal terms? Would savings automatically double to an average of cash balances of 10.4 weeks? Probably not as there is no incentive to hold the extra cash balances. In other words, instead of saving, people would spend or consume more. Yet the amount of goods, services and labor has remained equal while the amount of money has increased. The effect of what everyone sees from a personal level is a good one. People have more money to go shopping and businesses have more customers. Yet now is society better or worse off? Initially, the effect will most likely be a lower savings rate in real terms. The reason for this phenomenon is, assuming ceteris paribus, only the nominal values, or the relation between money and prices, have increased. Yet real values have not changed. Assuming this is a onetime event, the most likely outcome will be a similar return to the ex ante position only with higher nominal prices. With more money, consumers will bid up prices and as prices increase, people will save more until savings are back to about 5.2 weeks worth of cash balances. How the transition will play out is anyone’s guess as preferences and prices are always in flux, but society will eventually end up no better or worse off than before.
Suppose now that the helicopter drop is not a onetime event, but rather a continuous event. If such an event occurred, would society better or worse off? Again, from the individual’s point of view, this seems like a bonanza at first. The continuous money growth as real values remain constant will induce more people to spend more and save less. As the amount of credit throughout society increase, people spend more money and businesses are all too happy to cater to more customers. As credit initially increases, the boom begins. This is why business cycles are sometimes referred to as credit cycles. As the inflationary boom continues, more money is spent, less money is saved and customers will continue to bid up prices. Euphoria sets in among the various members of society almost blinding them to what the real prices actually are. Yet real values must eventually come back in line with the effects of the monetary expansion. A bust must necessarily occur to return to the realities of the ex ante world. The bust, a hangover period as some have described it, is period of painful adjustment so that real values can return to equilibrium. Nominal values decrease, unemployment increases and a pain ensues. Society has become worse off.
The primary reason for money mischief as Dr. Friedman pointed out is the distinction between what money means to an individual on the one hand and how the rate of money growth affects society on the other. Dr. Friedman goes through various points in history to illustrate such a point. Episodes such as how the cyanide process increased the global gold supply which was a factor leading to the defeat of William Jennings Bryon in 1896 to how FDR toyed with silver to placate a few powerful Senators. While seemingly insignificant, such a myopic policy had a hand in leading to the triumph of Chinese communists in 1949.
Money and credit are necessary corollaries of economic expansion. That is to say inflation, classically defined, isn’t a bad thing. In fact, it may be desirable to increase the money supply in an effort to ensure the most stable and predictable prices. The challenge is to keep the rate of monetary growth in line with the amount of economic expansion. In the United States, the historical rate of economic expansion has been about three to five per cent. Therefore, should the Federal Reserve keep money growth at a rate of 3% to 5% per annum, stable prices, wages and salaries will be seen over time.