Money Supply And Inflation Confusion

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“What people today call inflation is not inflation” – Ludwig von Mises.

Simply put the correct definition of inflation is the increase in the quantity of money and money substitutes.

Changes in the cost of living index, whether it’s called a consumer price index or retail price index, is one of the consequences of monetary inflation, but not really what inflation is. This is not semantics. This completely changes the way in which markets and the economy work, and the correct definition provides a far sounder basis for understanding what is happening in the financial world.

Consumer prices are a measure of the cost of living, but this has limited value as a guide. For several reasons:

1. It is very difficult to calculate. How do we decide what goods and services should be in the index, and what data is readily available in a timely manner? Does the end product really reflect our total cost of living?
2. The basket of goods used in the calculation is forever changing as spending habits change, and it is doubtful that proper allowance can really be made for this.
3. Even supposing it is calculated well, it is a lagging indicator, and so has limited use as a policy guide.
4. The index calculations and methodology are forever being changed by governments, who have a strong vested interest in low increases in the value of the index.

For all these reasons cost of living indexes are very far from ideal. Nevertheless, there is always endless discussion about them. Why? Once again our old friend Ludwig von Mises explains:

“Inflation can be pursued only so long as the public still does not believe it will continue. Once the people generally realize that inflation will be continued on and on and that the value of the monetary unit will decline more and more, then the fate of the money is sealed. Only the belief, that the inflation will come to a stop, maintains the value of the notes.”

In other words, the very fate of fiat currency hinges on the ability of the central banks to convince their users that the cost of living is under control, hence the focus and constant rhetoric. However, at the same time, it is really the money supply growth that provides the main driving tool for economic policy changes.

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