Inflation for Beginners—II

September 10, 1951

It is often argued that to attribute inflation solely to an increase in the volume of money is “oversimplification.” This is true. Many qualifications have to be kept in mind.

For example, the “money supply” must be thought of as including not only the supply of hand-to-hand currency, but the supply of bank credit—especially in the U.S., where most payments are made by check. And it is an oversimplification to say that the value of an individual dollar depends simply on the present supply of dollars outstanding. It depends also on the expected future supply of dollars. If most people fear, for example, that the supply of dollars is going to be even greater a year from now than at present, then the present value of the dollar (as measured by its purchasing power) will be lower than the present quantity of dollars would otherwise warrant.

Again, the value of any monetary unit such as the dollar, depends not merely on the quantity of dollars but on their quality. When a country goes off the gold standard, for example, it means in effect that gold, or the right to get gold, has suddenly turned into mere paper. The value of the monetary unit therefore usually falls immediately, even if there has not yet been any increase in the quantity of money. This is because the people have more faith in gold than they have in the promises or judgment of the government’s monetary managers. There is hardly a case on record, in fact, in which departure from the gold standard has not soon been followed by a further increase in bank credit and in printing-press money.

In short, the value of money varies for basically the same reasons as the value of any commodity. Just as the value of a bushel of wheat depends not only on the total present supply of wheat but on the expected future supply and on the quality of the wheat so the value of a dollar depends on a similar variety of considerations. The value of money, like the value of goods, is not determined by merely mechanical or physical relationships, but primarily by psychological factors, which may often be quite complicated.

In dealing with the causes and cure of inflation, it is one thing to keep in mind real complications; it is quite another to be confused or misled by needless or nonexistent complications. For example, it is frequently said that the value of the dollar depends not merely on the quantity of dollars but on their “velocity of circulation.” Increased “velocity of circulation,” however, is not a cause of a further fall in the value of the dollar; it is itself one of the consequences of the fear that the value of the dollar is going to fall. (Or, to put it the other way round, of the belief that the price of goods is going to rise.) It is this belief that makes people more eager to exchange dollars for goods. The emphasis by some writers on “velocity of circulation” is just another example of the error of substituting dubious mechanical for real psychological reasons.

Another blind alley: in answer to those who point out that inflation is primarily caused by an increase in money and credit, it is contended that the increase in commodity prices often occurs before the increase in the money supply. This is true. This is what happened immediately after the outbreak of war in Korea. Strategic raw materials began to go up in price on the fear that they were going to be scarce. Speculators and manufacturers began to buy them to hold for profit or protective inventories. But to do this they had to borrow more money from the banks. The rise in prices was accompanied by an equally marked rise in bank loans and deposits. From May 31, 1950, to May 30, 1951, the loans of the country’s banks increased by $12,000,000,000. If these increased loans had not been made, and new money (some $6,000,000,000 by the end of January 1951) had not been issued against the loans, the rise in prices could not have been sustained. The price rise was made possible, in short, only by an increased supply of money.