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Friday, September 1, 2000

Inflation and Money: A Reply to Timberlake

How Should We Define "Money" and "Inflation"?

Joseph Salerno is a professor of economics in the Lubin School of Business at the Pace University.

In his reply to my October 1999 Freeman: Ideas on Liberty article, Richard Timberlake fails to address or misconstrues most of the substantive issues I raised in my comment on his earlier three articles. Space constraints, however, permit me to respond only to a few of his more important arguments. These involve the evolution of the word “inflation” and the definition of money.

Evolution of the Word “Inflation”

The reader should recall that it was Timberlake himself who, in his first article, described Rothbard as “endowing inflation with a new and unacceptable meaning” (my emphasis) in order to “discover” a nonexistent inflation in the 1920s. I spent a substantial part of my article responding to his erroneous claim and documenting that inflation in Rothbard’s sense has a long and venerable history in monetary thinking.

Now Timberlake shifts ground and argues that the pedigree of a definition of “inflation” is “largely irrelevant to substantive issues.” Whether or not this latter claim is true, he is arguing to a conclusion that does not bear on the issue at hand, an issue that Timberlake himself first raised. But a few sentences later Timberlake shifts ground yet again, now linking Rothbard’s definition with that of some nameless “ancient economists” who he alleges “used the term ‘inflation’ to mean an increase in the stock of paper money together with an increase in prices.” Is Rothbard’s definition of inflation a newly invented ploy or an ancient fallacy? Timberlake cannot have it both ways.

Timberlake is also incorrect in asserting that it was only after the invention of price indices in the mid-nineteenth century that economists were able to “describe the value of money as the inverse of money prices” or to “properly distinguish between increases in the stock of money and general increases in money prices.” In fact, the earlier British classical economists whom Timberlake cites, namely, Thornton, Ricardo, and Mill accomplished precisely these things without recourse to a price index. As Jacob Viner, the great historian of classical economic thought, pointed out long ago, “When [the classical economists] speak of the value of money or the level of prices without explicit qualification, they mean the array of prices, of both commodities and services, in all its particularity and without conscious implication of any kind of statistical average.”[1] In other words, the classical economists recognized that the value of money consisted of the “array” of alternative quantities of particular goods purchasable by the monetary unit, for example, two candy bars or one frozen yogurt cone or one-tenth of a baseball cap, and so on. If we assume that the monetary unit is the dollar, then each of these quantities of goods represents the inverse of the respective good’s dollar price—$.50 per candy bar, $1.00 per frozen yogurt cone, $10.00 per baseball cap. Furthermore, the leading classical economists were insightful enough to recognize that the individual elements constituting the value of money, that is, the reciprocals of particular money prices, were heterogeneous and continually varying in relation to one another. This led some of them to deliberately shun or explicitly criticize the use of a price index, the first of which was developed in England in 1798.[2]

This brings me to Timberlake’s mischaracterization of the modern Austrian case against price indices. According to Timberlake, the thrust of the Austrian case is that price indices are “non-subjective.” But this is not the Austrian objection at all. Quite to the contrary,Austrian economists, like classical monetary theorists, argue that what exists in objective reality at any moment, and what market participants therefore use in their economic calculations, are particular money prices actually paid or expected to be actually paid in the future. As noted above, the value of money is embedded in the structure of individual money prices, and cannot be conceived of apart from it. Any attempt to average this structure into a unitary price level is completely arbitrary because it entails a subjective choice by the statistician among the variety of available methods for constructing indexes. Nor is such a unitary index for measuring changes in the value of money needed by households and businesses in planning their everyday transactions. For as Ludwig von Mises pointed out:

A judicious housewife knows much more about price changes as far as they affect her own household than the statistical averages can tell. She has little use for computations disregarding changes both in quality and the amount of goods which she is able or permitted to buy at the prices entering into the computation. If she “measures” the changes for her personal appreciation by taking the prices of only two or three commodities as a yardstick, she is no less “scientific” and no more arbitrary than the sophisticated mathematicians in choosing their methods for the manipulation of the data of the market.[3]

Thus from a substantive standpoint, Rothbard and the Austrians object to the definition of inflation as a general rise in the CPI or GDP deflator because this definition obscures the relative changes within the price structure caused by an expansion of the money supply. In other words, an increase in the money supply will cause prices to rise unevenly, with some rising earlier and to a greater extent than others. Indeed, the very notion of a “price level” is a profoundly misleading metaphor, because it suggests the level of a body of water rising and falling uniformly and instantaneously. The more instructive metaphor is that of a swarm of bees, in which the individual bees are never lost sight of as they continually alter their relative positions within the swarm as it changes altitude. In the same manner, as the “price swarm” rises or falls as a result of a change in the supply of money, the relative positions of the individual prices, and therefore of the distribution of individual incomes and demands, undergo continual alteration and remain permanently altered even after the price swarm adjusts to its new height.[4]

The revolution in the price structure that inevitably accompanies any change in the purchasing power of money is instructively illustrated by the experience of the 1920s. As Timberlake recognizes, consumer and wholesale prices gradually declined during this decade due to a productivity-driven increase in the supplies of goods and services that outstripped the increase in the supply of money. However, what he fails to mention is that this expansion of the money supply, as a consequence of its initial injection into credit markets, also increased the prices of capital goods relative to the prices of consumer goods. The relative increase in the prices of capital goods was manifested in the boom in real estate and stock markets, in which titles to aggregates of capital goods are exchanged. In addition, long-term and short-term interest rates, which reflect the differential between capital and consumer good prices, were driven down from 1921 through 1928.[5] Owing to their reliance on a definition of “inflation” that mandates exclusive attention to a nonexistent price level, Timberlake and the monetarists are oblivious to movements in real money prices that crucially affect the economic calculations and plans of entrepreneurs and, therefore, the real production processes of the economy.

Finally, Timberlake invokes a strangely irrelevant “thought experiment” to disprove Rothbard’s claim that a major inflation occurred during the 1920s. According to Timberlake, an inflation could not have occurred between 1921 and 1929 because anyone would prefer $2,000 of income in 1929 dollars to the same income in 1921 dollars, given that prices were lower in 1929 than in 1921. While this is true, it is a textbook case of begging the question by assuming what is to be proved.[6] Obviously, if Rothbard’s definition is assumed to be wrong from the outset and, therefore, inflation is defined as a general rise in prices, and prices have indeed fallen, then it can be validly inferred that no inflation has occurred. But Timberlake’s argument proves nothing against the usefulness of Rothbard’s definition of inflation. I could just as easily argue that if the Fed had not “inflated” the money supply during the 1920s, the value of money would have been even higher in 1929 than it actually was and people would prefer $2,000 of income in the 1929 dollars of this counterfactual world to the same nominal income in actual 1929 dollars. This would hardly prove that Timberlake’s definition of inflation is useless, though I believe it is for the reasons stated above.

The Definition of Money

In discussing the issue of which items to include in the definition of the money supply, Timberlake refers to Leland Yeager’s empirical test for identifying those assets that function as a general medium of exchange. According to this test, when people feel that they are holding too much money they attempt to rid themselves of the excess by spending it on various goods and services, thus causing money prices in these markets to begin to rise. The extra spending and rising prices spread throughout the economy will continue until the value of money has been driven down to the point at which people are satisfied with holding the entire existing stock of money because their anticipated transactions will now require greater sums of the less-valuable money. Thus for Yeager, the money supply consists of those things, such as currency and demand deposits, that are routinely spent and accepted as final payment in all markets.

However, demand deposits do not pass Yeager’s test just because checks drawn on them are spendable or because they operate as an independent medium of exchange alongside currency. Rather, demand deposits can be considered part of the money supply because they are interchangeable at par and on demand into currency, that is, Fed notes, which in our present system is the ultimate embodiment of the general medium of exchange. But once this is realized, it becomes immediately clear that noncheckable savings deposits at commercial and savings banks as well as the share accounts of savings and loan associations operate likewise as instantaneously redeemable, par-value claims to definite quantities of currency.[7] The fact that the owner of a savings deposit in the 1920s could not spend by directly transferring a portion of his deposit balance to a third party via check but had to walk or drive to the bank to redeem it before making his expenditure is a technical detail that does not affect the essence of the economic transaction. Savings deposits and savings and loan share accounts, no less than demand deposits, therefore, offer unconditional access to immediately spendable dollars and thus meet Yeager’s criterion for inclusion in the money supply.

Rothbard clarified this point with the following example. Let us assume that as a result of the development of a sudden and widespread cultural aversion to the number 5 among the nonbank public, five-dollar bills are no longer accepted in exchange. When someone now wishes to exchange some of his five-dollar bills, he must first travel to the bank to convert them into dollar bills of other denominations. Now as long as these bills remain interchangeable at par and on demand into dollar bills of other denominations, no one would have reason to object to their inclusion in the money supply. Indeed, they would pass Yeager’s test: thus, if a helicopter were sent forth by the Fed to shower the country with additional billions of dollars in five-dollar bills, money prices and incomes would soon begin a general rise as the populace scrambled to spend their surplus cash balances. But as Rothbard pointed out, savings deposits are in precisely the same situation as the five-dollar bills in this example: other things equal, an increase in their total would create an excess supply of spendable dollars in the economy initiating an adjustment process that lowers the value of money. In fact, in the 1920s bank credit expansion resulted in a disproportionate growth in”time,” or savings, deposits vis-à-vis demand deposits, because businessmen were induced by the payment of interest on savings deposits to hold the less active portion of their balances in this type of bank account.[8]

Timberlake offers a second test that allegedly supports his narrower definition of the money supply. According to this econometric test, a particular type of asset is to be included in the definition of the money supply if its inclusion improves the positive correlation between the empirical monetary aggregate and total dollar spending on final goods and services or gross national product. The logic of this test implies that if the addition of the supply of peanut butter to the monetary aggregate being tested improved its “explanation” of total spending, then peanut butter would be considered part of the money supply. But this positivist test is in direct conflict with Yeager’s test, which is designed to identify only those assets as money that function essentially as a general medium of exchange, that is, which are purchased in anticipation of being resold for other goods in the future. Thus Yeager’s essentialist test would exclude peanut butter because, in our economy at least, it is a consumer’s good, an excess supply of which results in a fall in its own money price and not directly in an increase in the money prices of other goods. In fact, in the same article that Timberlake quotes from, Yeager strongly criticizes precisely the very positivist approach to defining money that Timberlake defends.


  1. Jacob Viner, Studies in the Theory of International Trade (New York: Harper & Brothers Publishers, 1937), p. 314.
  2. Ibid., pp. 312-14.
  3. Ludwig von Mises, Human Action: A Treatise on Economics, Scholar’s Edition (Auburn, Ala.: Ludwig von Mises Institute, 1999), pp. 223-24. Mises’s point is most recently illustrated in the discussion of how to change the CPI to improve its “measurement” of inflation. Needless to say, the suggested changes, just as the earlier exclusion of food and energy prices on the grounds of their alleged “volatility,” are themselves based on the subjective preferences of economists and statisticians. Of course, it is absurd to suggest that American households and businesses discount the recent run-up in gasoline prices in allocating their expenditures just because they are volatile.
  4. The suggestion that the concept of a price swarm is superior to that of a price level is due to the brilliant but neglected monetary theorist Arthur W. Marget, The Theory of Prices: A Re-examination of the Central Problem of Monetary Theory, 2 volumes (New York: Augustus M. Kelley Publishers, 1966 [1938-1942]), vol. 2, pp. 330-36.
  5. Sidney Homer, A History of Interest Rates, 2nd ed. (New Brunswick, N.J.: Rutgers University Press, 1977), pp. 354, 372.
  6. Antony Flew, Thinking Straight (Amherst, N.Y.: Prometheus Books, 1977), pp. 65-66.
  7. As I pointed out in my previous article, savings deposits and S&L share accounts were, for all intents and purposes, effectively convertible into currency on demand. Moreover, just as in the case of demand deposits, after 1934 the par-value interchangeability between savings deposits and S&L share accounts on the one hand and currency on the other was insured by an agency of the federal government. This occurred for credit unions only after 1971.
  8. On this neglected aspect of the 1920s inflation, see C. A. Phillips, T. F. McManus, and R. W. Nelson, Banking and the Business Cycle: A Study of the Great Depression in the United States (New York: Arno Press, 1972 [1937]), pp. 95-101; Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Eco nomic History of the United States, 1914-1946, 2nd ed. (Indianapolis: Liberty Press, 1979), pp. 139-43. Not coincidentally, the authors of these two volumes were heavily influenced by Austrian monetary and business-cycle theory.