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This month's Topic: Inflation.
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Overview of
this
Inflation Page:
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What is money?
Money is a commonly accepted medium of exchange. Not everybody would
want to trade his car or 40 hours of his labor for
a trip to the Bahamas or for a nice hifi set. So trips to the Bahamas
and hifi sets are not commonly accepted as a medium of exchange. But
people would likely want to exchange their car or their labor for a
certain amount of money. With that money people can decide for
themselves what they want to buy and thus what they are actually
trading their car or their labor for. Money thus makes possible this
kind of indirect exchange.
What is the
origin of money?
Because money makes indirect exchange possible, it enables people to
engage in many more economic transactions than there are possible in a
simple economy of direct exchange.
Imagine a very simple economy without money, an economy
with only direct exchange. Murray would like to get a gallon of milk
and has a pair of shoes to spare. he then faces two problems:
1) because he will likely think that a pair of shoes for a gallon of
milk would be an unfair exchange cuz the pair of shoes is worth more to
him than the gallon of milk would be, So then he would have to find a
way to divide his pair of shoes into smaller pieces and exchange some
of those pieces for the gallon of milk. This would be a silly thing to
do though.
2) he has to find somebody who has the exact opposite need as he
has,
somebody who wants (parts of) a pair of shoes and who has a gallon of
milk to spare.
So
with any economic transaction in an economy of direct
exchange people have to solve these two problems, Murray can for
example exchange his pair of shoes for Ludwig's 20 pounds of cheese and
then use 1 pound of cheese to get 1 gallon of milk from Walter. So both
the problem of divisibility and that of coincidence of wants can
be
solved by trading with other parties first before you get the product
that the milk man or whoever wants to exchange his milk for. Clearly
this is a difficult and time-consuming business.
It
would therefore be convenient to
have a commodity that pretty much everybody would accept as payment and
that is easily divisible and sustainable. Gold and silver fit these
criteria: they are wanted as a commodity to make jewelry of, they are
easily divisible into coins and lumps and they do not decay. Because of
these characteristics gold and silver have arisen as the preferred
means of payment in societies all over the world. if you want 1 gallon
of milk you pay the milk man with a silver or gold coin and the milk
man in turn can use that coin elsewhere to buy whatever he wants.
So
money makes indirect exchange
possible because it solves the problems of divisibility and of the
coincidence of wants. Money also makes it possible to compare the
market prices of all different goods in the economy because all goods
can be exchanged for a certain amount of gold or silver. That amount we
call the money price of a good. 1 gallon of milk would then for example
cost 0,5 grams of gold, and a tv would cost 200 grams of gold. In turn
the price of money, its purchasing power is expressed in the goods one
can buy with it: 200 grams of gold is worth 1 tv or 400 gallons of milk.
Money then makes transactions in the economy much simpler
than they could be in an economy of direct exchange and because of this
ever more complex transaction of whatever goods for whatever goods are
made possible Money is the basis of all modern advanced economies.
What is 'fiat
money'?
We saw that on a free market money arises as a product that has value
as a commodity (gold is used for jewelry for example) but also as a
commonly accepted means of exchange. This type of money we call
'commodity money'. De price of commodity money is determined by the
demand for it as a commodity and as a medium of exchange. This and the
only slowly growing supply of gold and silver ensured that the price of
gold and silver, its purchasing power (expressed in terms of the type
and number of goods you can buy with it) was quite
stable.
Because in practice it is often difficult to carry gold around and to
divide it into the exact amount you need people started to store their
gold in banks. These banks then gave people warehouse receipts (bank
notes, cheques, accounts, etc.) that they could use to make
payments with and that they then could show to the bank to get their
gold back.
But
especially in the last hundred years governments all over the world
have severed this direct link between warehouse receipts such as paper
money on the one hand and gold on the other. Presently, bank notes are
no longer exchangeable for gold. The original role of money as a
commodity like other goods is no more.
Because governments took over the provision of money and because they
severed the link between bank notes, cheques, accounts etc. and gold,
governments could now simply create more and more money without having
to add to the gold stock, something which up until then had put a
strong brake on the expansion of the money supply. By expanding the
money supply in excess of the expansion in the gold stock money becomes
worth less than what it would have been worth had the link between
money and gold not been severed.
Moreover, governments then forced everybody to accept this money as a
means of payment. This is in stark contrast with commodity money that
was voluntarily chosen on the market as a means of exchange, Money that
has no direct link with the gold supply anymore we call fiat money.
What kinds of money are there?
Besides
the distinction between fiat money and commodity money, we can
also distinguish between 3 different forms of money based on the ease
with which they can be used as a medium of exchange (=the degree of its
liquidity)
M1:
easily exchangeable value paper such as chartal money (coins and bank
notes) and giral money (what you can withdraw from your checkings
account whenever you like)
M2:
value paper that is somewhat more difficult to use in
exchanges such as saving accounts and short-term bonds
M3:
value paper that is difficult to use in exchanges such as
short term government bonds and short term bonds
What is inflation?
Inflation is a decrease in the price or purchasing power of money.
The
average price of products in the economy will increase. That is, with
the same amount of money as before you will be able to buy fewer
products. It is clear that over say the past 20 years things on
average have become more expensive, so it has been an inflationary
period.
What is deflation?
The opposite of inflation is deflation, a situation in which the price
or purchasing power of money will increase: you will be able to buy
more products with the same amount of money. Such a situation has been
very rare in the 20th century.
What is
the cause of inflation?
Inflation occurs when the amount of money in an economy increases
relative to the number of goods in the economy.
Imagine a very simple economy: there are 100 products in total and 100
units of money (100 dollars for example). The average price of a
product is then:
100 dollars (the amount of money) / 100 products (the amount of
products) = 1 dollar per product.
Inflation means that you get fewer goods for your dollar, i.e. that
things become more expensive. The average price of a product will then
for example become $1,50. The inflation then is 50%.
This
is only possible if a) the amount of money in the economy increases
relative to the number of goods, or b) if the number of goods decreases
relative to the amount of money. A significant shrinkage in the number
of goods in an economy is exceedingly rare, save for a huge natural
disaster or the sudden depletion of an important natural resource. So
inflation almost always occurs because of (a): the amount of money
increases relative to the number of goods.
To
go back to our example, when the average price of a product increases
from $1 to $1,50 and the number of goods in the economy stays the same
then this can only be so because the amount of money in the economy has
increased:
(the amount of money) / 100 = 1,50. Therefore, (the amount of
money) = 150.
What
is the cause of deflation?
Deflation
can be caused by either a money supply that is decreasing
relative to the number of goods in the economy, or by an increase in
the number of goods relative to the money supply.
When economies grow more and more goods come on the market, When the
money supply stays the same deflation will occur. Thus if the money
supply stays the same, then deflation is the normal phenomenon in times
of economic growth: products become cheaper on average. Since our
economies have generally grown over the past 200 years we would expect
a long-lasting deflationary period. That this has not been the case is
attributable to theincrease in the money supply outpacing the increase
in the number of goods.
Sometimes, such as in periods of depression, the money supply decreases
(in a later section we will see how this is possible) while the number
of goods stays the same. In those cases deflation does not indicate
economic growth but has as its cause the contraction in the money
supply.
But
doesn't inflation have other causes?
Although you may hear a lot of other explanations for inflation, some
of which are quite complex, these simply cannot be correct.
Politicians, consumers and unions may blame companies on the free
market for inflation because these increase their prices for products
and services. These shopkeepers in turn may say that they had no choice
because the wholesale stores, where they buy their goods from, were the
ones who increased their prices, and these wholesale stores finally may
out the blame on the higher prices for natural resources like oil.
Employers and politicians may also put the blame for inflation on
unions whose wage demands are too high thereby adding to the costs of a
product of service and causing companies to have to increase their
prices.
Another explanation that is commonly heard is that in times of economic
growth demand increases thereby causing an increase in prices.
At
first sight these explanations sound sensible enough, but upon a second
look we realize that they cannot explain inflation because 3 essential
factors are overlooked:
1. Inflation as said means an average
increase in prices. Save the rare occasion o a huge natural disaster
destroying massive amounts of products or the sudden depletion of an
important natural resource, this is only possible if the amount of
money increases. When for example oil gets more expensive or when
greedy companies raise their prices, this only means that these
products and services will become more expensive relative to all other
products and services in the economy. The average price of all products
remains the same.
2. on a free market, companies, unions
and even oil producers cannot raise their prices without suffering
negative consequences because they face competition. When they raise
their prices, their competitors can take away their customers by
keeping their prices the same and thus by being cheaper than the
company that raised its prices. This is how the free market works.
3. Inflation cannot be caused by economic
growth because the definition of economic growth is that the number
and/or quality of goods in an economy increases. When at the same time
the amount of money stays the same the average price of a product will
decrease and not increase.
Who causes
the money supply to increase?
The only institution that is legally
allowed to create new money that
has to be accepted as a medium of exchange by everybody is the Central
Bank, such as the American Federal Reserve or the European Central Bank.
You
and I could try to make our own kind of money, the Murray, but likely
there will only be very few people who will accept our notes because
they in turn would have a lot of difficulty getting other people to
accept it, and because our notes are not backed by anything that also
has value as a commodity, like gold has. Governments all over the world
have outlawed consumer payments in gold or silver, likely because such
money would be a superior competitor to the government created money
that is no longer backed by gold.
So pretty much the only money that is used in modern economies is the
money that is issued by central banks. When you and I try to copy this
money we run the risk of being arrested for counterfeiting. Only the
central bank is legally allowed to create this money and thus only the
central bank can be the cause of inflation.
By
the way, it is remarkable that central banks are often seen as the
institutions that fight against inflation, that keeps inflation in
check. From what we learned above we can conclude that this is
nonsensical.
Why do central banks
create new money?
Although central banks formally are
often independent institutions, in
practice their policy is intended to help governments in achieving
their plans.
The 3 main reasons that governments like to see new money created are
as follows:
1. to increase the expenditures of the
government itself without having to raise taxes or borrow more money.
 Inflation itself is nothing other than an
ingeniously disguised form of
taxation. When the central bank creates new money and through a complex
process that we will discuss in the next section gives it to the
government itself (or to parties that are favored by governments) it
simply means that the money of everybody else in society will become
worth less.
The newly created money can be used by governments to finance wars, pay
off debts or pay government salaries without having to raise taxes. Tax
raises are often unpopular and so it is convenient for governments to
have a mechanism that achieves the same result as taxation, namely
increasing the income of the government, but that tends to go largely
undetected by the general population.
2. the government wants to favor certain
groups in society such as banks or government contractors, at the
expense of all other people: when the central bank creates new money it
can lend to the banks and the first customers they in turn lend the
money to for a low rate have an advantage relative to all other people
in society.
The central bank can also create emergency credit for banks that
otherwise would go bankrupt: because they can borrow credit for a very
low rate they can save their business. central banks thus subsidize
failing banks.
Something similar is the case when the central bank creates emergency
credit that banks can borrow and then lend it at a low rate to big
companies that are having solvency problems. This happened recently
when both the Fed and the ECB created new money that banks lent out to
major stock companies. What then happens is basically a subsidy from
everybody else in society for big Wall Street companies and stock
brokers.
Another way in which governments can favor certain groups is by
spending the money on projects such as wars for which large companies
such as Haliburton get contracting work. These companies thus also
profit indirectly from newly created money.
3. Some economic theories like that of
Keynes state that governments can control, direct and stimulate the
economy on a macro-level by changing the supply of money (mostly
increasing, but also sometimes decreasing it)
How do central
banks create new money?
In the old
days central banks would simply print new money and
distribute it, but nowadays the money creation process is a lot more
complex and the control that the central bank has over the reserves of
regular banks is the central mechanism for money creation.
Central banks can create new money by controlling the reserves of
regular banks. Banks need to have reserves in order to give people who
have lent their money to the bank their money back. But banks no longer
have all the money reserves that their customers have lent them. They
have used a large portion of that money to invest or lend to others.
This we call fractional reserve banking. Banks only have a fraction of
the reserves that they have been entrusted with. So if people have lent
10 million dollars to the bank, they may only have 1 million dollars in
reserve. Central banks have made this odd and fraudulent practice
possible and it in turn can use this fact to control the money supply.
This happens in 4 ways:
1.
It is easy to see that
fractional reserve banking is a potentially volatile situation: if
customers of a bank were to try to get their money back from the bank
en masse the bank would be instantly bankrupt and a lot of people would
lose their money.  In order to avoid such bank runs and
subsequent
bankruptcies the central bank will help banks that are in trouble by
for example giving them cheap credit so that they can add to their
reserves at low costs. Central banking thus makes fractional reserve
banking possible and as a result banks can make profits by lending out
money that they are supposed to keep safe for its customers. This means
that the banks create new money that they are lending out because at
the same time they pretend that they have that money on the accounts of
their customers. They use it doubly.
2. the central bank also
determines the level of reserves that banks must have. The central bank
can legally require banks to have a certain minimum level of reserves.
When central banks then ease this requirement banks can lend out more
money with the same level of reserves, thereby increasing the money
supply. Central banks can also cause a decrease in the money supply by
tightening the reserve conditions for banks: if they have to have a
ratio of 2:10 instead of 1:10 banks have to decrease their lending out
of money by 50 percent, thereby causing the money supply to decrease.
3. the central bank can add
to the reserves of banks by buying goods such as government bonds from
banks directly or indirectly. The central bank then simply creates new
(digital) money and transfers that to the seller in question. When the
central bank buys directly from a bank the bank in question simply gets
the new money on its account thereby increasing its reserves. When the
central bank buys a good from a private party that private party will
get his money from the central bank on the account of a private bank,
thereby also increasing the reserves of said bank. Moreover, because
the bank is allowed by the central bank to lend out several times the
size of its reserves the money supply increases by several times the
size of the received payment.
4.
the central bank can also
add to the reserves of banks by lending money to them for artificially
low interest rates. Whenever the interest rate that the central bank
charges is lower than the market rate (the rate than banks charge
each other for example) then this means that banks will borrow more
money than they would otherwise. The extra money originates from the
central bank. And like before, the banks can in turn lend out several
times the amount of money that they borrowed from the central bank and
so the money supply in the economy increases at several times the size
of the amount of borrowed money. When you read in the newspapers or
hear on the news about interest rates that are being cut or raised it
is this inflationary process that they are talking about.
What are the
consequences of inflation?
The main consequences of inflation
stem from the fact that new money is
never spread all over the economy equally and simultaneously, but is
injected at some points (the banking system for example) and time
passes before it has rippled over the economy as a whole and thereby
has adjusted price levels to the new money supply.
Remarks
or suggestions ? please contact us at 
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What do
American experts think about the Credit
Crunsh ?
by
Christopher Laird PrudentSquirrel.com Feb 22, 2007
By William Pesek Jr.Published: June
12th , 2006
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Very Recommended
Reading :
 From both an
economic and monetary perspective, the United States is a house of
cards—impressive on the outside, but a disaster
waiting to happen
beneath the surface. In a relatively short period of time, the country
has gone from the world's largest creditor to its greatest debtor; the
value of the dollar has declined; and domestic manufacturing has given
way to non-exportable services. While these and other issues could
potentially spell disaster for your financial well-being, the situation
could also present unique opportunities—if you're prepared. Now, in Crash Proof, Schiff
provides you with an insightful examination of the structural
weaknesses underlying this impending economic meltdown, and discusses
the measures you can take to protect yourself—as well as profit—during
the difficult times that lie ahead. He also outlines a specific
three-step plan that will allow you to preserve wealth and protect the
purchasing power of the savings you have worked a lifetime to
accumulate.
by Peter D. Schiff
Recorded
at the Austrian
Economics and Financial Markets conference
at The Venetian Hotel Resort
Casino, Las Vegas, 02-18-2005
A 20 minutes
podcast (mp3) explaining the inconsistencies of
fiat money
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The Economics of Fiat Money ( Free Downloads of books and
audio )
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I.
Introduction by Murray Rothbard
II. Money in a Free Society
1.
The Value of Exchange
 2. Barter
3.
Indirect Exchange
4. Benefits of Money
5.
The Monetary Unit
6.
The Shape of Money
7.
Private Coinage
8.
The Proper Supply of Money
9.
The Problem of Hoarding
10.
Stabilize the Price Level?
11.
Coexisting Moneys
12.
Money-Warehouses
13.
Summary
III. Government Meddling With Money
1.
The Revenue of Government
2.
The Economic Effects of Inflation
3.
Compulsory Monopoly of the Mint
4.
Debasement
5.
Gresham's Law and Coinage
6.
Summary: Government and Coinage
7.
Permitting Banks to Refuse Payment
8.
Central Banking: Removing the Checks on Inflation
9.
Central Banking: Directing the Inflation
10.
Going Off the Gold Standard
11.
Fiat Money and the Gold Problem
12.
Fiat Money and Gresham's Law
13.
Government and Money
IV. The
Monetary Breakdown of the West
1. Phase I: The
Classical Gold Standard, 1815-1914
2. Phase II:
World War I and After
3. Phase III:
The Gold Exchange Standard (Britain and the United States) 1926-1931
4. Phase IV:
Fluctuating Fiat Currencies, 1931-1945...
5. Phase V:
Bretton Woods and the New Gold Exchange Standard (U.S.) 1945 1968
6. Phase VI: The
Unraveling of Bretton Woods, 1968-1971
7. Phase VII:
The End of Bretton Woods: Fluctuating Fiat Currencies, Aug-Dec, 1971
8. Phase VIII:
The Smithsonian Agreement, December 1971-February 1973
9. Phase IX:
Fluctuating Fiat Currencies, March 1973-? |
Copyright 1980 by
The Ludwig von Mises Institute
Download
the full
text free here
in PDF,
in .PDB, or
in .LIT
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Murray
Rothbard
Ludwig von Mises Institute,
1994, 158 pgs.
Murray Rothbard begins this
outstanding book by calling attention to a paradox. The Federal Reserve
System enjoys virtual immunity from Congressional investigation. The
few who propose to subject the Fed to even minimal scrutiny, such as
Henry Gonzales of Texas, at once find a consensus arrayed against them
(Pp. 1 ff.). They threaten the stability of the market; since, it is
alleged, only the Fed's independence blocks the onset of uncontrollable
inflation.
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This site deals with the comparison of
Fiat Money vs. the Gold Standard
# Statist Problems-
how government manipulation of the money supply around the world
results in inflation and destruction of wealth;
#
Libertarian Solutions-
only a free-market in money (backed by precious metals)
has historically ensured stability and prosperity.
"Paper
money has had the effect in your state that it will ever have,
to
ruin commerce, oppress the honest,
and
open the door to every species of fraud and injustice."
-
George Washington, January 9, 1787,
in
a letter to J. Bowen, Rhode Island
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