It’s commonplace for Austrian economists to distinguish between price inflation and monetary inflation when speaking of the business cycle. Monetary inflation, an increase in the supply of money by the banking system, can cause price inflation, but not necessarily so. It follows that if no price increases result from an increase in the issuance of fiduciary media, an artificial boom in the capital goods sectors will still result and will eventually reveal itself through falling asset values and rising costs of production. But is this always the case? And if not, is the dichotomy between the two aforementioned types of inflation misleading?

Below are the four definitions of inflation most commonly used or recognized by Austrians and the mainstream:

Increase in the money supply. Increase in the price level. Increase in the supply of money not met by a commensurate increase in the supply of specie (gold or silver). The supply of money increasing beyond the demand to hold it.

Numbers 1 and 2 are what divides the Austrian school from the mainstream, though it’s not certain how important it is today. Old monetarists have sparred with Austrians on the supposed inflationary policies of the Federal Reserve in the 1920s mainly due to the differing perspectives on these definitions. Mark Skousen writes:



In support of the Monetarists, the broad-based price indices show little if any inflation in the 1920s. Average wholesale and consumer prices hardly budged between 1921 and 1929. Most commodity prices actually fell. Friedman and Schwartz conclude, “Far from being an inflationary decade, the twenties were the reverse.”

However, other data support the Austrian view that the decade was aptly named the Roaring Twenties. The 1920s may not have been characterized by a “price” inflation, but there was, in the words of John Maynard Keynes, a “profit” inflation. After the 1920-21 depression, national output (GNP) grew rapidly at a 5.2 percent pace, substantially exceeding the national norm (3.0 percent). The Index of Manufacturing Production grew much more rapidly and virtually doubled between 1921 and 1929. So did capital investment and corporate profits.

He goes on to cite how the evidence for whether there was inflation in the 1920s is “mixed” which further shows the difficulty in deciding whether Austrian economists should reconsider their perspectives on the term. In addition, Mises apparently used the second definition (like the mainstream) in some of his work which is noteworthy because Austrians often reject the notion of an aggregate price level. It is therefore an important question as to whether the idea of a price level is useful in economic theory, particularly in terms of inflation and deflation. Number 3 is Rothbard’s definition in Man, Economy, and State, and is the one most commonly used by supporters of the gold standard when discussing fractional reserve banking. It’s important to point out that number 3 and the price/monetary inflation distinction above are used in different contexts, as was stated above. Although, notice how number 3 is quite restrictive because it asserts that the banking system must hold specie as a reserve, rather than other assets like bonds or financial paper. Finally, number 4 is the most overlooked definition of inflation, but was used by Mises, calling it the money relation. It simply states that an increase in the supply of money can only cause a general rise in prices if it is in excess of the demand to hold money at a given array of prices. Today this concept is referred to as monetary equilibrium, and is rejected by many Austrians due to its affiliation with fractional reserve free banking.

Not too long ago, there was a fierce debate among Austrians of the 100% reserve variety that claimed Mises was against fractional reserve free banking, while those in the free banking group such as George Selgin claimed, not that Mises unabashedly supported free banking, but that he contradicted himself on numerous occasions. His opinions seemed to change between The Theory of Money and Credit (depending on which edition you read), Human Action, and a set of lectures he gave in the 1950s. Perhaps the disagreement on the proper Austrian banking theory is one of the main reasons for the lack of group cohesion on what inflation actually is and how the concept should be approached. The moral arguments for or against a banking system of fractional reserves should not influence the meaning of economic terms like inflation. What should be focused on is the technical merit of such definitions, and how useful they are in reaching valid conclusions on their influence on macroeconomic phenomenon.

Monetary equilibrium is perhaps the best and most useful framework for defining inflation because it applies the supply and demand concept to money, whereas numbers 1 and 3 only deal directly with the supply of money. For example, an non-inflationary expansion of the supply of money can offset monetary disequilibrium in the form of an excess demand for money. Another advantage is that it is a concept which abstracts from the type of money being used, whether it’s gold, dollars, cryptocurrency, or even seashells. Many of the economists at the Mises Institute reject this on Rothbardian grounds, dismissing the claim that when the demand for money exceeds the supply of money at a given array of prices, there will be a harmful real effects and a subsequent fall in prices. This aspect of Mises’ money relation has been addressed, yet there is still significant disagreement on the theory and history of inflation and deflation within the Austrian school. Ideology certainly has an influence on this, but is that the entire explanation? What is certain is that the monetary equilibrium concept is one that is entirely consistent with supply and demand analysis and is therefore microeconomic, and is tied closely with the work of Knut Wicksell, whereas the Rothbardian definition is asymmetric in its treatment of price effects from changes in the supply of money not met by changes in the supply of specie.

Hopefully in the future, Mises’ money relation will become the de facto term used to determine the origin of inflation (and deflation). For this to happen, other areas of price theory such as rigid prices/wages and the money illusion must be accepted by Austrians so that the true effects of monetary disequilibrium can be addressed instead of simply ignored when orthodox economists, or even Austrian-sympathizers, express criticism for the notion of deflation.