The real cause of inflation

By Eric Jurado

THERE is no mystery about the cause of monetary instability. Like other commodities, the value of money is determined by demand and supply. When the supply of money is constant or increases at a slow, steady rate, the purchasing power of money will be relatively stable. In contrast, when the supply of money expands rapidly compared to the supply of goods and services, the value of money declines and prices rise. This is in ation. It occurs when the government prints money or borrows from the central bank in order to pay its bills.

Politicians often blame in ation on such scapegoats as greedy businesses, tax reform law, infrastructure spending, oil prices, or foreigners. But this is a ruse—a diversionary tactic. Persistent in ation has a single source: rapid growth in the supply of money. A nation's money supply is its currency, checking accounts, and savings accounts, etc. When that supply increases faster than the growth of the economy, the result is in ation.

Countries that increase their money supply at a slow rate (5 percent or less) experience low rates of in ation. This is true for large highincome countries like the United States and Canada, as well for smaller ones like Singapore, New Zealand, and Sweden. It is also true for poor countries like the Central African Republic and Mauritius.

As the money supply of a country grows faster, however, so too does the rate of in ation. The money supply in Peru, Uruguay, Ghana, Malawi, Nigeria, and Romania grew at an annual rate of between 20 percent and 40 percent, and most experienced annual in ation rates in the same range. Extremely high rates of monetary growth (70 percent and above) led to hyperin ation, as in Turkey, Ukraine, the Democratic Republic of Congo, Zimbabwe, and Venezuela. As the growth of the money supply in these countries soared, so too did their rate of in ation.

Every country in the world with a low in ation rate in recent decades has had a policy of slow monetary growth. Conversely, every country that has experienced rapid in ation has followed a course of rapid monetary expansion. Historically, this link between rapid monetary growth and in ation has been one of the most consistent relationships in all of economics.

High and variable rates of in ation undermine prosperity. When prices increase 20 percent one year, 50 percent the next year, 15 percent the year after that, and so on, individuals and businesses are unable to develop sensible long term plans. The uncertainty makes the planning and implementation of capital investment projects risky and less attractive. Unexpected changes in the inflation rate can quickly turn an otherwise profitable project into a personal economic disaster. Rather than dealing with these uncertainties, many decision makers will simply forgo capital investments and other transactions involving long-term commitments. Some will even move their business and investment activities to countries with a more stable environment. As a result, potential gains from trade, business activities, and capital formation will be lost.

Moreover, when the government in ates, people will spend less time producing and more time trying to protect their wealth. Because failure to accurately anticipate the rate of inflation can devastate one's wealth, individuals will shift scarce resources away from the production of goods and services and toward actions designed to hedge against inflation. The ability of business decision makers to forecast changes in prices becomes more valuable than their ability to manage and organize production. When the inflation rate is uncertain, businesses will shy away from entering into long-term contracts, place many investment projects on hold, and divert resources and time into less productive activities. Funds will flow into the purchase of gold, silver, art, and objects of passion, in the hope that their prices will rise with inflation, rather than into more productive investments such as buildings, machines, and technological research. As resources move from more productive to less productive activities, economic progress slows.

Inflation also undermines the credibility of government. At the most basic level, people expect government to protect their persons and property from intruders who would take what does not belong to them. But the government becomes an intruder when it cheats citizens in the same way that counterfeiters do by creating money, spending it, and watering down its value. How can people have any confidence that the government will protect their property against other intrusions, enforce contracts, or punish unethical and criminal behavior? When the government degrades its own currency, it is in a weak position to punish, for example, a coconut juice producer who dilutes juice sold to customers or a business that waters down its stock (issuing additional stock without the permission of current stockholders).

Economic progress will also be undermined when monetary policy makers are constantly shifting between monetary expansion and contraction. When the monetary authority expands the monetary supply rapidly, initially the more expansionary monetary policy will generally push interest rates to a low level, which will stimulate current investment and generate an artificial economic boom. The low interest rates will attract investment into projects that appear to be profitable, but will not be sustainable for very long. When the expansionary monetary policy continues, it will generate inflation, which will cause monetary policy makers to shift toward a more restrictive policy. However, as they do so, interest rates will rise, which will retard private investment and throw the economy into a recession. Thus, monetary shifts from expansion to restriction will generate economic instability. The economy will be jerked back and forth between booms and busts. This pattern of monetary policy will also create uncertainty, retard private investment, and reduce the rate of economic growth.

Monetary instability is an essential ingredient of the environment for economic progress. Without monetary stability, potential gains from capital investment and other exchanges involving time commitments will be eroded and the people of the country will fail to realize their full potential.

In sum, the keys to economic stability are growth of money and credit consistent with price stability and avoidance of "speedup and slowdown" policy shifts in response to current economic conditions. As the Nobel Prize winning economist Milton Friedman noted several decades ago, inflation is caused by excessive money growth. Rapid money growth will lead to inflation. Moreover, changes in monetary policy will impact prices, output, and employment with lengthy and unpredictable time lags. Thus, attempts to manipulate real output and employment through persistent shifts in monetary policy will generate instability rather than stability.

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Topics: Eric Jurado , inflation
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