Defining “Inflation” Correctly
Inflation is typically defined as a general increase in the prices of goods and services—described by changes in the Consumer Price Index (CPI) or other price indexes.
If inflation is a general rise in measured prices, then why is it regarded as bad news? What kind of damage can it inflict? Mainstream economists maintain that inflation causes speculative buying, which generates waste. Inflation, it is maintained, also erodes the real incomes of pensioners and low-income earners and causes a misallocation of resources.
Despite all of these assertions regarding inflation’s side effects, mainstream economics doesn’t tell us how all of these bad effects are caused. Why should a general rise in prices hurt some groups of people and not others? Why should a general rise in prices weaken real economic growth? How does inflation lead to the misallocation of resources? Moreover, if inflation is just a rise in prices, surely these effects can be offset by adjusting everyone’s incomes in accordance with this general price increase.
The Problem with Price Indices
Despite its popularity, the whole idea of a consumer price index is flawed. It is based on the idea that it is possible to establish an average price of goods and services.
Suppose two transactions are conducted. In the first transaction, one loaf of bread is exchanged for $2. In the second transaction, one liter of milk is exchanged for $1. The price, or exchange rate, in the first transaction is $2/one loaf of bread. In the second transaction the price is $1/one liter of milk. In order to calculate the average price, we must add these two ratios and divide them by two; however, it is conceptually meaningless to add $2/one loaf of bread to $1/one liter of milk.
On this Rothbard wrote, “Thus, any concept of average price level involves adding or multiplying quantities of completely different units of goods, such as butter, hats, sugar, etc., and is therefore meaningless and illegitimate. Even pounds of sugar and pounds of butter cannot be added together, because they are two different goods and their valuation is completely different” (Man, Economy, and State, p. 734).
The Proper Definition of Inflation: It’s a Wealth Transfer
The reality of inflation is its association with the diversion of real wealth from one individual to another by means of an expansion in the money supply.
Historically, inflation occurred when a country’s ruler, such as a king, would force his citizens to give him all of their gold coins under the pretext that a new gold coin was going to replace the old one. In the process, the king would falsify the content of the gold coins by mixing it with some other metal and return impure gold coins to the citizens. On this Rothbard wrote,
More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks”, but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses.1
Because of the dilution of the gold coins, the ruler could now mint a greater amount of them and pocket the extra coins minted for his own use. What was now passing as a pure gold coin was in fact a gold alloy coin.
The increase in the number of coins brought about by this d
Article from Mises Wire