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According to many mainstream economists, a lack of good correlation between the monetary growth and the growth rate of various price indexes casts doubt on the commonly held view that the key source of inflation is increases in money supply.

It is also argued that before the 1990, the relationship between money supply and inflation was positively correlated. However, from 1990 onwards in the US and other major economies this correlation ceased to exist.

Some commentators have concluded that while in the past the increase in money supply had an effect on inflation this is not the case at present.

We suggest that the lack of correlation between the growth rate of money supply and the inflation rate does not prove that money has nothing to do with inflation.

The main issue here is not about the strength of the statistical correlation but about the definition of what inflation is all about.

Observe that by popular view inflation is defined as increases in the prices of goods and services, which is depicted by the growth rate of various price indexes such as the consumer price index (CPI).

Some economists such as Ludwig von Mises and Murray Rothbard, following in the footsteps of classical economists, regard inflation as increases in money supply. So how are we to decide about the correct definition of inflation? Is it about increases in the money supply or increases in prices?

The Essence of Inflation

The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. A definition is to tell us what the fundamentals of a particular entity are. To define a thing we need to go to the origin of how it has emerged.

For Mises and Rothbard the subject matter of inflation is not just increases in the prices of goods and services but an act of embezzlement.

Historically inflation originated when a country’s ruler such as the king would force his citizens to give him all their gold coins under the pretext that a new gold coin was going to replace the old one. In the process the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens. On this Rothbard wrote,

More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks”, but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses.

(See also "Easy Money, Easy Morals" by Joseph Salerno.)

On account of the dilution of the gold coins, the ruler could now mint a greater amount of coins and pocket for his own use the extra coins minted. What was now passing as a pure gold coin was in fact a diluted gold coin.

The increase in the number of coins brought about by the dilution of gold coins is what inflation is all about.

Note that what we have here is an inflation of coins i.e. an expansion of coins. As a result of inflation, the ruler can engage in an exchange of nothing for something (he can engage in an act of diverting resources from citizens to himself).

Under the gold standard, the technique of abusing the medium of the exchange became much more advanced through the issuance of paper money un-backed by gold. Inflation therefore means an increase in the amount of receipts for gold on account of receipts that are not backed by gold yet masquerade as the true representatives of money proper, gold.

The holder of un-backed receipts can now engage in an exchange of nothing for something. What we have is a situation where the issuers of the un-backed paper receipts divert real goods to themselves without making any contribution to the production of goods.

In the modern world, money proper is no longer gold but rather paper money; hence inflation in this case is an increase in the stock of paper money.

Observe that we do not say as monetarists are saying that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.

If we were to accept that inflation is increases in money supply then we will reach the conclusion that inflation results in the diversion of real wealth from wealth generators towards the holders of newly printed money.

We will also reach the conclusion that monetary pumping i.e. inflation is bad news for the wealth generating process. No empirical study is required to confirm or to refute this.

How can we then reconcile strong monetary pumping with moderate increases in prices, which is labeled as low inflation?

The price of a good is the amount of dollars paid for the good. If the growth rate of money is 5% and the growth rate of the supply of goods is 1% then prices will increase by 4%. If however, the growth rate in the supply of goods is also 5% then no increase in prices is going to take place, all other things being equal.

If one were to hold that inflation is the increase in the CPI then one will conclude that despite the increase in money supply by 5% inflation is 0%.

However, if we were to follow the definition that inflation is about increases in the money supply then we will conclude that inflation is 5%.

From the above example increases in the money supply need not always be followed by general increases in prices.

Prices are determined by both real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. While the money growth i.e. inflation is buoyant, prices might display low increases.