Inflation and economic growth

Dr Frank Shostak
BrookesNews.Com
Monday 10 October 2005

Mainstream economics sees inflation as general rises in commonly accepted price indices. It is held that the rate of growth in economic activity is a key factor in determining the rate of increases in price indices. Thus a strengthening in activity leads to higher prices and hence higher inflation while weaker activity causes lower inflation.

This way of presenting the issue of inflation raises some questions. For instance why must strong economic activity lead to general price rises? If the increase in economic activity arises as a result of increases in real wealth, i.e. increases in goods and services that are on the highest priority list of consumers, why should this lead to higher prices?

On the contrary, more real wealth for a given stock of money will increase the rate of exchange of money versus real goods and services. In other words the purchasing power of money will increase i.e. prices of goods and services will fall. This in turn means that economic activity, which stems from real wealth expansion, will not result in a general rise in prices as the mainstream view argues.

So what type of economic activity will produce general rise in prices? Careful assessment of this question would show that once activity rises as a result of an increase in consumption of goods and services without the corresponding increase in the supply, this will lead to general rise in prices. How can it happen that consumption could increase without an increase in the supply of real wealth i.e. goods and services?

After all in a market economy money must be earned. To earn money means that an individual must produce something that can be exchanged for money. Once money is earned it then can be exchanged for goods and services. In other words earning money precludes the possibility of consuming without producing first. It is however, not the case whenever money is created out of “thin air” i.e., by the central bank and through the fractional reserve banking.

For once money is created out of “thin air” it means that nobody earned this money i.e. nothing was exchanged for it. Now the central bank and commercial banks that create money out of “thin air” are in a position to exchange it for goods and services. In other words money out of “thin air” gives rise to an exchange of nothing for something or to consumption without preceding production.

From this we can infer that what causes general rise in prices is increases in the money stock. Inflation is seen by most individuals as bad news. For, it is seen as undermining people’s living standards through the erosion of real incomes. Is it valid to regard general rise in prices as inflation?

For if inflation is a general rise in prices then we must conclude that a rise in prices undermines people’s living standards. Careful analysis of this issue will show that a rise in prices doesn’t as such undermine people’s living standards. Prices are the manifestation of people’s valuation of goods in terms of money. The act of valuing, however, cannot alter these goods. (People’s views about the facts of reality cannot alter these facts). Consequently, a rise in prices cannot erode people's living standards and therefore cannot be regarded as inflation.

What then is inflation? It is simply increases in the money stock which causes consumption without production and thus a general rise in prices. Inflation therefore, is increases in the money stock which as a rule tends to manifest by a general rise in prices. Once increases in money are regarded as inflation then the damage that inflation inflicts becomes apparent.

For increases in money sets in motion an exchange of nothing for something, i.e. leads to an unearned consumption, which results in overtime in general economic deterioration. Against this background of what inflation is various pronouncement, by economists and policymakers can be put into a different perspective.

Does it make sense to plead with the central bank to lower interest rates and pump more money because the rates of increases in the consumer price index are moderate? Once we realise that what alters the fact of reality is not changes in prices as such but rather monetary injections, then obviously there cannot be any logical justification to ask the central bank to ease its monetary stance.

Mainstream economists however, by resorting to various econometric studies, cling to the view that up to a certain percentage increase in the consumer price index, loose monetary policies of the central bank can grow the economy. Above this percentage it is argued, loose monetary policies are likely to weaken the economy.

This conclusion however, cannot withstand the test of logic. For it implies that up to a certain rate of growth in the consumer price index, the monetary pumping leads to consumption that is preceded by production. Above this figure the monetary pumping causes consumption without production. In other words the nature of money somehow mutates.

Now, if the monetary pumping could cause consumption that is preceded by production then it implies that through the monetary printer one can create real wealth. If this could have been done then the world-wide poverty could have been eradicated a long time ago.

Dr Shostak is a former professor of economics who now works in the private sector

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