Inflation for Beginners—I

September 3, 1951

No subject is so much discussed today—or so little understood—as inflation. The politicians in Washington talk of it as if it were some horrible visitation from without, over which they had no control—like a flood, a foreign invasion, or a plague. It is something they are always promising to “fight”—if Congress or the people will only give them the “weapons” or “a strong law” to do the job.

Yet the plain truth is that our political leaders have brought on inflation by their own money and fiscal policies. They are promising to fight with their right hand the conditions they have brought on with their left.

Inflation, always and everywhere, is primarily caused by an increase in the supply of money and credit. In fact, inflation is the increase in the supply of money and credit. If you turn to the recent American College Dictionary, for example, you will find the first definition of inflation given as follows: “Undue expansion or increase of the currency of a country, esp. by the issuing of paper money not redeemable in specie.”

In recent years, however, the term has come to be used in a radically different sense. This is recognized in the second definition given by the American College Dictionary: “A substantial rise of prices caused by an undue expansion in paper money or bank credit.” Now obviously a rise of prices caused by an expansion of the money supply is not the same thing as the expansion of the money supply itself. A cause or condition is clearly not identical with one of its consequences. The use of the word “inflation” with these two quite different meanings leads to endless confusion.

The word “inflation” originally applied solely to the quantity of money. It meant that the volume of money was inflated, blown up, overextended. It is not mere pedantry to insist that the word should be used only in its original meaning. To use it to mean “a rise in prices” is to deflect attention away from the real cause of inflation and the real cure for it.

Let us see what happens under inflation, and why it happens. When the supply of money is increased, people have more money to offer for goods. If the supply of goods does not increase—or does not increase as much as the supply of money—then the prices of goods will go up. Each individual dollar becomes less valuable because there are more dollars. Therefore more of them will be offered against, say, a pair of shoes or a hundred bushels of wheat than before. A “price” is an exchange ratio between a dollar and a unit of goods. When people have more dollars, they value each dollar less. Goods then rise in price, not because goods are scarcer than before, but because dollars are more abundant.

In the old days, governments inflated by clipping and debasing the coinage. Then they found they could inflate cheaper and faster simply by grinding out paper money on a printing press. This is what happened with the French assignats in 1789, and with our own currency during the Revolutionary War. Today the method is a little more indirect. Our government sells its bonds or other IOU’s to the banks. In payment, the banks create “deposits” on their books against which the government can draw. A bank in turn may sell its government IOU’s to the Federal Reserve Bank, which pays for them either by creating a deposit credit or having more Federal Reserve notes printed and paying them out. This is how money is manufactured.

The greater part of the “money supply” of this country is represented not by hand-to-hand currency but by bank deposits which are drawn against by checks. Hence when most economists measure our money supply they add demand deposits (and now usually, also, time deposits) to currency outside of banks to get the total. The total of money and credit so measured was $64,099,000,000 at the end of December 1939, and $174,200,000,000 at the end of June this year. This increase of 171 percent in the supply of money is overwhelmingly the main reason why wholesale prices rose 135 percent from 1939 to June of this year.