All Commentary
Monday, September 1, 2008

Inflation 101: Cause Versus Transmission

Inflation Must Result When the Quantity of Money Increases

Howard Baetjer, Jr. is a lecturer in economics at Towson University.

It’s always a pleasure for a teacher to receive a note from a former student showing that he or she has taken key lessons to heart. I had such a pleasure last winter when Joey, who had taken Money and Banking with me last fall, sent me a good question about an article in the Washington Post.

The Post article (January 21) stated, “Many . . . economists think . . . an inflationary spiral is unlikely because a slowing economy would mean less upward pressure on prices.

Joey asked: “If our economy is slowing, yet we are still printing money, won’t that only increase inflation even more? After all, we will have more money in circulation with less being produced; that sounds like the grounds for inflation to me. Am I missing something?”

Joey zeroes in on the difference between the primary, underlying cause of inflation and secondary factors that can influence not whether, but when, how, and how fast inflation occurs. In particular he implies that “printing money” is the essential cause of inflation and challenges the notion that recessionary forces necessarily reduce inflation. He is correct on both counts. (For the record, in earlier usage, inflation is printing money, with rising prices the effect.)

With inflation in the United States rising and a recession perhaps already in progress, now is a good time to sort out these issues once again. What causes inflation? Who or what is responsible? Do recessions slow inflation?

Let’s first clarify the underlying cause of all inflation.

The single most important principle with respect to inflation is Milton Friedman’s now-famous aphorism: “Inflation is always and everywhere a monetary phenomenon,” he wrote in Money Mischief. Central bankers, economists, and economic journalists should use this as their screensavers. “Inflation occurs,” Friedman continued, “when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation.” This can occur either by actually printing money or by “the magic of the bookkeeper’s pen”—creating new deposits on the banks’ books.

To understand Friedman’s aphorism, consider this thought experiment (which I proposed last year in The Freeman): Suppose that tonight, as we sleep, Harry Potter flies across the country and waves his magic wand in a money-doubling charm. The charm has no effect on the amounts of goods and services; it affects only money. Every nickel becomes a dime, every quarter becomes a 50-cent piece, every dollar becomes two, every ten-dollar bill becomes a twenty, every checking account doubles its balance. What would we expect to happen to prices over the next day or two?

Even if no one knew that everybody else’s money holdings had also increased, we would expect to see prices rise substantially over the next weeks and months as sellers discover that they can charge more for their goods than they could yesterday. Picture automobile dealerships: as people perceived an apparent sudden increase in “wealth”—it’s not wealth, it’s just money, but they don’t know that yet—many of them would head out excitedly to buy a new car. The dealerships would see many more customers than before, willing to pay much more than before. Very quickly the dealers would raise their prices, realizing that they can charge more for the cars on their lots (which are no more numerous than before). A similar process would occur at every store, market, online retailer, and real-estate agency in the land, and very quickly prices of just about everything would approximately double. After all, with the same amount of stuff to buy but twice the money to buy it with, what else would we expect?

Inflation is always and everywhere a monetary phenomenon. That means that if inflation is occurring, the quantity of money must be (or have been) increasing. Correspondingly, if the quantity of money is increasing (more rapidly than output), then inflation must surely result.

Increasing the Money Supply

Next, what increases the quantity of money and how? In the United States, the Federal Reserve System—and only the Fed—controls the quantity of money. Therefore the Fed—and only the Fed—is responsible for any inflation that occurs in the United States.

Some readers may remember discussions in their macroeconomics courses of “demand-pull inflation” or “cost-push inflation,” which suggest that inflation can be caused by too much consumer demand or excessive wage agreements with unions. This is mistaken. Rising consumer demand or wage demands can transmit inflation into the economy, but not cause it. The cause is an increase in the quantity of money, and the Fed controls the quantity of money.

(It is true that the Fed’s control over the quantity of money is not total; other factors such as the currency ratio and the required and excess reserve ratios influence the quantity of money a little. But their effect is trivial compared to the Fed’s control of what is known as the monetary base. The difference is analogous to that between the tide and other factors in determining the water level in a bay: while wind-caused waves and boat wakes alter the water level a little over short periods of time, the level is fundamentally determined by the tide. Furthermore, historical changes in the currency and excess reserve ratios have largely been a response to changes in the monetary base; they have not come about independently.)

Friedman wrote poetically about the Fed’s power:

It’s simple to state how the money supply is so centrally controlled. It’s hard to believe. . . . [T]welve people out of nineteen—none of whom have been elected by the public—sitting around a table in a magnificent Greek temple on Constitution Avenue in Washington have the awesome legal power to double or to halve the total quantity of money in the country. . . . [T]hey and they alone have the arbitrary power to determine the quantity of what economists call base or high-powered money. . . . And the entire structure of liquid assets, including bank deposits, money-market funds, bonds, and so on, constitutes an inverted pyramid resting on the quantity of high-powered money at the apex and dependent upon it.

Just how does the Fed control the monetary base? It does so through “open market operations.” It buys or sells government securities (U.S. Treasury bills and bonds) on the open market, where banks, insurance companies, and investors of all sorts buy and sell those securities, too. When the Fed buys U.S. Treasury bonds or bills from banks it gives the banks money in exchange—new money. This money goes into the banks’ reserves and thereby increases the monetary base (of which bank reserves are part).

Conversely, when the Fed sells government securities (from its vast holdings of them) to banks, they pay with existing money from their reserves. As they do so, that money leaves the monetary base and disappears. I find it helpful to think of the Fed as a kind of a black hole at the edge of the economy that sometimes draws money out of the economy and makes it disappear, and at other times disgorges money from itself into the economy.

It is really that simple. The Fed controls the quantity of base money by buying and selling Treasury securities.

Open-Market Operations and Interest Rates

Now let’s turn to the relationship between the Fed’s control of the monetary base through open-market operations and its influence on interest rates. After all, when we read of the Fed’s actions, we do not read of its increasing or decreasing the monetary base but of its “raising or lowering interest rates.” Based on what we read in the financial news, we might think that the Fed alters or sets interest rates directly. But it doesn’t. Interest rates are a kind of price, and like all prices they are determined by the interactions of demanders and suppliers. In markets for loanable funds, where the “price” is the interest rate, the demanders are borrowers and the suppliers lenders; their interactions determine (and continuously alter) interest rates. What the Fed does is to affect interest rates by its influence on the supply of money. Its influence is indirect.

Consider, for example, what the Fed does when it “lowers interest rates.” It actually lowers its target for an important interest rate called the federal funds rate (or fed funds rate). This is the interest rate at which banks lend and borrow reserves to and from one another overnight, as normal business fluctuations push their reserves higher or lower than the quantity they would like to hold. This market is called the federal funds market, and its interest rate has become more important since the Fed began using it as its operating target in 1995.

On September 18, 2007, the Fed dropped its target for this interest rate from 5.25 to 4.75 percent. Since then it has lowered it steadily, reaching 2 percent last April 30. That means the Fed intends to influence supply in the fed funds market so that the interest rate hits the targeted rate. This intention is clear from the page of the Fed’s website where it describes its open-market operations. The table there is labeled “Intended federal funds rate” ( They manage to hit very close to their target most days.

How does the Fed influence supply in the fed funds market so as to hit its interest-rate target? It does so by open-market operations, which it carries out daily, sometimes two or three times daily. When the Fed aims to influence the fed funds rate downward, it buys Treasury securities from banks. The money initially goes into the banks’ reserves. The rest of the process must be carried out by the banks.

What banks do with these new reserves depends on the particular situation of each bank, of course. Those that were previously short on reserves will hold on to the new money. But if the Open Market Committee has judged correctly, many banks that receive the new money will find themselves with excess reserves (more than they need to keep on hand) and will seek to lend it out at interest. One market in which they will lend the money is the fed funds market; that is, they will offer to lend reserves to other banks. To induce other banks to borrow the money, they must reduce slightly the interest rate they charge, thereby bidding down the fed funds rate. If the Fed has judged correctly, that downward movement will be just enough to hit its target.

Linking the Fed to Inflation

At last we are able to link this discussion back to inflation. For the Fed to hold the interest rate down, it must create new money. If it does so too rapidly or for too long, it causes inflation (a general price rise). Recall Friedman’s words: “Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation.” This is what Joey had in mind with his perceptive question: “If our economy is slowing, yet we are still printing money, won’t that only increase inflation even more?”

Money growth will always and everywhere underlie inflation over any long period of time. But in the shorter periods that make up that long term, people’s expectations will greatly influence how promptly the underlying cause of inflation—growth of the money supply more rapid than the growth of output—brings about its inevitable effect of rising prices.

Recall the passage that made Joey scratch his head: “Many other economists think such an inflationary spiral is unlikely because a slowing economy would mean less upward pressure on prices.” A slowing economy might mean less upward pressure on prices, but it might not. That will depend largely on people’s expectations. Let’s distinguish three scenarios in which inflation becomes progressively higher.

Three Scenarios

The unperceived-problem scenario—when we don’t expect inflation to rise. When the money supply grows only a little faster than output, most people don’t notice that prices in general are rising. Prices of most things are constantly rising or falling a little due to changing market conditions, so very small general price increases caused by excessive money growth are obscured from view by normal price fluctuations. The new excess money pushes prices up, but slowly and only after a lag.

A central bank can take advantage of people’s ignoring such small inflation. As long as they don’t notice and therefore don’t expect inflation, the central bank can speed up its increase in the money supply for a while, with no immediate effect on overall prices. (Indeed, if the monetary authority withdraws newly created money from the economy relatively soon after it’s created, price levels overall may not rise at all.) The faster price increases that must result from a sustained speeding up of money growth will occur only after a lag during which people gradually adjust their pricing to this unexpected change. Hence rates of price changes tend to lag behind the higher rates of money growth.

This seems to be the scenario the “many economists” in Joey’s article consider us to be in at present. In the short run a slowing economy would lead people to raise prices less than they otherwise would, until and unless they start to worry about getting behind an inflation. If they are not worried about inflation—if they don’t expect it—then during a recession many businesses may lower prices to boost lagging sales, and some employees may hold off on asking for raises until business improves.

The problem scenario—when we worry about rising inflation. But the central bank cannot long accelerate the growth rate of the money supply without driving up prices. Eventually people holding the new money do bid up prices; other people start to notice that prices in general are increasing; and everyone starts to expect further increases. When people start to worry that the prices they receive (their wages and salaries, or prices for what they sell) are not rising as fast as the prices they pay (for food and clothing, or for labor and supplies), then they all start to push up the prices they charge in order to keep up. Consumers ask for pay increases, and businesses increase the prices they charge. The rate of price changes tends to catch up to the higher rates of money growth.

Of course our salaries and wages are input costs to the businesses that pay us, so when we demand higher pay to keep up with rising prices, we increase our employers’ costs, motivating them to increase their prices to keep pace. This is the dreaded inflationary spiral. Once it begins, it can be hard for the monetary authority to convince any of us to slow it down. No one wants to be the first to risk falling behind.

It was this scenario in which the U.S. economy found itself in the 1970s, when we had “stagflation”: a long recession, yet with high inflation. Here, too, the slowing of the economy might keep inflation rates a bit lower than they otherwise would be, but it certainly would not stop inflation. In fact, another current of causation runs the other way. One of the inevitable consequences of inflation is to degrade the price system’s function of coordinating people’s efforts and enterprises. By impairing that coordination, inflation slows economic growth.

The big-problem scenario—when we all try to get ahead of increasing inflation. When people get concerned about their money’s loss of value as prices rise, they strive to change the prices and wages they receive in anticipation of future inflation. When expectations are like this, rates of price changes can outrun rates of money growth. The slowing of the economy that must certainly result from a bad inflation such as this will do nothing to slow that inflation.

Presumably the “many other economists” referred to in the Washington Post article believe that we are still in the unperceived-problem scenario. Perhaps we are. But if Fed chairman Ben S. Bernanke and his colleagues on the Open Market Committee create too much money, we’ll surely switch into the problem scenario. If we do, Bernanke will be embarrassed, because he subscribes to Milton Friedman’s famous principle.