Part 5.1: The inflationary process and the economic effects of inflation

Price changes of goods and services may arise due to variations in their supply and demand or due to changes in the purchasing power of money. The former case was to be called by Mises ¹ “good-induced-changes” and the latter case “cash-induced-changes”.

If, indeed, the harvest of apples is particularly abundant, the price of apples ,and related products such as apple juice or apple pies, in grocery stores will be lower than the previous season and consumers will be better off. On the contrary, if the extraction of copper is lower than expected, the price of copper and of all copper-related goods will increase. In any case, only a specific number of goods is affected. However, a general rise (or fall) in the prices almost all goods and services in the economy must have  a monetary origin (cash-induced-changes).  Remember that a decrease in the purchasing power (or price) of money is caused by an increase in its quantity/supply while the demand for money remains constant or goes up to an amount that does not cover the extra supply of money. This implies that any additional monetary income above what people want to hold in cash balances will be spent. 

Imagine for example that one day the cash balances of all the people on earth are doubled. As their demand for money has not changed  or has increased not much in general, people will be willing to get rid of so much cash. Will society be wealthier? No. Remember that only the availability of real goods matters for prosperity and in this case the amount of consumer and producer goods remains the same. The relative wealth of individuals won’t be affected, as when they suddenly rush to spend the new money (there are not more things to buy), “the only impact would be an approximate doubling of all prices, and the purchasing power of the dollar or franc would be cut in half, with no social benefit being conferred.”. ²  Economic calculation would just be adapted to the new situation changing the figures. Of course, in real life equi-proportionate expansions of everyone’s money holdings at the same time don’t happen. The newly created money starts always in the hands of some specific groups. 

Rothbard uses an example of counterfeiting in order to explain the inflationary process. An increase in the money supply will be equal to the amount of money counterfeited by the criminals and this money will be in their hands first, ready to be spent. “Counterfeiting, in short, involves a twofold process: (1) increasing the total supply of money, thereby driving up the prices of goods and services and driving down the purchasing power of the monetary unit; and (2) changing the distribution of income and wealth, by putting disproportionately more money into the hands of the counterfeiters. ³ So, we have said that the first receivers of the fresh new money are obviously the counterfeiters, who buy goods and services. The second receivers of the money are actually those to which the counterfeiters are purchasing these goods. The additional income of these retailers is spent on new purchases, which benefit other groups that keep on spending.  The new money works step by step throughout the economic system. The counterfeiters can buy at first all they want without any rise in the prices of these purchases. The retailers who benefit from the additional demand can increase their prices and they can still buy at the old prices, as no other prices have changed yet. The first receivers of this chain start to bid up goods and services, increasing their demand and rising thus their prices. But during the process, some groups see how the prices of the goods they buy are going up while the prices of what they sell (their income) remains unchanged. ‘In short, the early receivers of the new money in this market chain of events gain at the expense of those who receive the money toward the end of the chain, and still worse losers are the people (e.g., those on fixed incomes such as annuities, interest, or pensions) who never receive the new money at all’. ⁴ 

At the beginning of WWI, the belligerent countries went off the gold-standard and started printing unbacked paper money. Unwilling to raise too many taxes, governments found  a more subtle way to finance the war, namely, the printing press. Following the logic of the above example, the government was the privileged receiver of the new money, which was spent in the armament industry. The businessmen, workers and stockholders of those industries benefited most, as they saw their incomes soar while the prices of the rest of the economy remained unchanged. One of the first receivers of the chain were also the extractive industries, such as the iron or copper ore mining companies, which increased their prices due to the growing demand that they faced from the armament industry. However, other sectors relying on iron and copper, such as companies manufacturing cutlery, water pipes or houses, saw the prices of their main inputs soar while their own selling prices were the same  as before. The new money worked step by step throughout the economic system in successive waves, because governments pumped money into the system many times. The war effort required a large part of the productive capacity of these economies, consequently, the flow of consumer goods to the market was reduced and their prices rose dramatically. In order to control the situation and to protect vulnerable collectives from hunger, such as the fixed-income groups, governments enforced strict rationing.

 

As we have seen, an increase in the quantity of money leads to rising prices, but this is a gradual process. Imagine that the counterfeiters or the government don’t increase the money supply again: After some time, once the effects of the new money have worked themselves out, prices have risen, but not uniformly. Some have increased more, while others not so much,  some have remained constant or even have gone down. The average is positive without any doubt, but this is not the whole story. Due to the fact that the first receivers gain at the expense of the latest receivers, there is a transfer of income and wealth form the latter group to the former. This is a redistribution effect of income and wealth that can be called a sum 0 game, as all what is gained by the counterfeiters and the first receivers is lost by the latest receivers and, especially, by the fixed-income groups. 

The process has distorted the situation prior to the increase in the quantity of money in many ways. The new equilibrium reflects a permanent change in the distribution of income and wealth, as said before. Hence, the patterns of demand have also changed, because the winners of the inflationary process spend the money in different ways than the losers were doing before. Thereby, the structure of relative prices changes due to the new demand (remember that some prices go up a lot, some not so much and others not at all or even go down), which in turn affects the quantity, the quality and the goods and services to be produced. In other words, firms adapt their production to the new relative prices and spending patterns of consumers. Note that in no case will an increase in the amount of goods and services available for the society as a whole stem from such a process, that is, an increase in the quantity of money does not make the people wealthier, but the opposite is true. 

Quotations, references and comments

¹ Ludwig von Mises, La Acción Humana,Tratado de Economía, page 504. Published by Unión Editorial, 7^th edition (2004). Any reference to this book will be based on the Spanish edition. Title of the original English edition (1949), Human Action, A Treatise on Economics.

² Murray N. Rothbard, The Case Against the Fed, page 23. Published by Ludwig von Mises Institue (2007).

³ Ibid. page 22

⁴ Ibid. page 24