Inflation and Economic Growth

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    I defined inflation to be the increase in the money supply and rising prices were a result of inflation. But I got a response saying that inflation is defined differently. I was wondering how would you reply to following?

    In macroeconomics, inflation is actually considered to be “a sustained increase in the general level of prices for goods and services,” which reduces the purchasing power of each dollar. Inflation does not merely reflect an increase in the money supply because it can be demand-driven rather than supply-driven.

    For instance, if demand for goods & services is growing faster than supply, then prices would be expected to increase. This typically occurs in growing economies.

    Inflation may also be cost-driven. If companies’ costs increase they generally increase prices to maintain their profit margins.

    An increase in the money supply weakens the purchasing power of the dollar (especially relative to foreign currencies), but it is not considered the same thing as inflation.


    Concerning the first paragraph of the response above, of course the purchasing power of money, like the price of any good, can change from either a change in demand or a change in supply. So, perhaps it’s best to used the phrase “monetary inflation” to refer to supply-driven decreases in money’s purchasing power and “price inflation” to refer to fall in money’s purchasing power.

    The second paragraph of the response above fails to mention the fact that for people to increase their demand for all goods, they must either have more money or reduce their demand to hold money.

    The third paragraph makes a similar oversight. Costs of production are determined by prices of inputs. Without more money or reduced demand to hold money, entrepreneurs cannot increase their demands for inputs nor consumers their demand for outputs on all inputs and outputs throughout the economy. Moreover, costs of production are determined by input prices which are themselves determined by output prices, not the other way around. Neoclassical economists call this the marginal productivity theory of input prices.

    The fourth paragraph ignores the purchasing power parity theory of exchange rates. The purchasing power of a given money tends to be the same everywhere it trades, both domestically directly for domestic goods and internationally through exchange for foreign currency which is then used to buy foreign goods. Monetary inflation of a domestic currency, ceteris paribus, generates both domestic price inflation and relative devaluation of the domestic currency against foreign currencies.


    Dr. Herbener,

    I am new to Liberty Classroom, and my understanding is very limited but there are parts of inflation I can’t conceptualize. For instance, years ago my brother asked me how the monetary system knows how much money is in circulation.
    My guess at the time was that it is because 95% of US dollars are digital and the currency loses value almost automatically as the supply increases. Now I’m beginning to think it is more of a domino effect from creators to last users. However, it is difficult to imagine an illegal counterfeiter spending fake currency and some form of currency consciousness recognizing quantity changes in a meaningful way.

    In response to the above:
    If the purchasing power of a given money is the same everywhere it trades how do we differentiate if the cost is an increase in a single product or a loss of currency value?
    For instance, I understand the cost of living in Hawaii is quite high and because of shipping costs every commodity is more expensive. Although the dollar has equal value compared to other currencies, it has less value compared to all or most of the products on the market in that region.

    Please forgive my lack of economics lingo.


    The conclusion that the purchasing power of a given money is the same in every location where the money can be exchanged for goods is a particular case of a general “law of one price.” If a good is divisible into homogeneous units, say troy ounces of pure gold, then each unit will sell for the same price in the same market at the same moment. If, to the contrary, gold was selling for $1,500 an ounce in London and $1,200 an ounce in New York today, then arbitragers could earn profit by buying in New York and selling in London. As they continued to do so the profit would shrink for additional arbitrage because they are increasing the demand in New York, driving the price up there, and increasing the supply in London, driving the price down there. The arbitrage will cease only when there is no additional profit to be earned, that is, when the prices in the two locations are the same, net of transaction costs.

    Money is a nearly perfect example of the law of one price because every unit of money is homogeneous and the transaction costs of transferring money from one location to another is nearly zero. We can, therefore, infer that the purchasing power of a given money is the same in every location where it can be traded for goods.

    It follows that if the price of a given good is higher in one location than another, then there must be a difference in the subjective value people place on the good in one location relative to the other.

    Ludwig von Mises uses the following example to illustrate. The price of a room at a hotel on the top of a ski-resort mountain is higher than an equivalent room at a hotel at the bottom of the mountain. The purchasing power of money, however, is the same at the top and bottom of the mountain.

    The price of goods is higher in Hawaii because the people who live there value living there more highly than living on the mainland. For that reason, they are willing to pay the costs for transportation to have the goods shipped to them.

    Price inflation, however, does not refer to the prices of some goods being higher in one place and lower in another. It refers to changes in the purchasing power of money, that is, in the prices of goods rising all around both in places where they are higher and in places where they are lower. It is true that when the money supply is increased with a given money demand, the prices of some goods will increase more and the prices of other goods with increase less and the prices of some goods will increase sooner and the prices of other goods will increase later, however, price inflation refers to the circumstance that prices overall are higher. Think of the prices in an economy as a swarm of bees. Individual bees are constantly changing their positions relative to each other with some rising and others falling, whether the swarm is stationary, upward moving, or downward moving. Price inflation occurs when the swarm is moving up and price deflation when the swarm is moving down.

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