INFLATION: The Elimination of "Less Supply" as the Cause of an Inflationary Rise in Prices

"More [monetary] demand or less supply are the necessary, indispensable connection between higher prices and any alleged other cause of higher prices. If they are absent, there simply is no connection between that alleged cause and higher prices. The quantity theory of money connects the increase in the quantity of money to the rise in prices by way of establishing a connection to more demand. As previously explained, a growing quantity of money raises the [monetary] demand for consumers’ goods through the new and additional money being spent and re-spent....
    "Decreases in supply must be eliminated from consideration as the cause of a rising price level  ... There are seven reasons for eliminating reductions in supply [including the following]:

"i. The Actual Influence of Supply [Historically] Has Been to Reduce Prices
    "In almost every year [from] World War II [to the early 90s], which is the period [previously] complained of as marked by inflation, prices [had] indeed risen in the United States, Western Europe, and Japan. Yet, over the same period of time, supply ... increased rather than decreased in these places, and it [did] so in practically every year. Supply ... increased enormously, as the result of a larger population, and, consequently, more people working; and, even more, as the result of technological progress and capital accumulation, which ... raised the productivity of labour and thus enabled each worker on average to produce a greater output. 

"Our formula for the general consumer price level, of course [see below], shows that the effect of increases in supply must be to reduce prices in inverse proportion. The fact that the price level [rose over this period], therefore, despite vast increases in supply, can be ascribed only to the influence of even more substantial increases in [monetary] demand. The problem of rising prices in the United States and every other leading country over [those] fifty years or more [was] clearly one of rising demand, not falling supply.

"ii. Where Falling Supply Contributed to Rising Prices, Its Role Has Been Relatively Minor
    "Of course, there are some countries in which supply has fallen, and fallen quite substantially ... [yet even at their worst] the cumulative decreases never exceeded a figure of 50 percent. If, for the sake of argument, we take this figure of 50 percent, we could account for a doubling of the price level in these countries on the basis of supply reductions. (I say a doubling, because our formula for the general price level [see below] shows that a halving of supply coupled with an unchanged demand must produce a doubled price level.) However, as is well-known, the price levels in countries like Chile and Uruguay [had] ... increased probably by a factor of fifty or more... Therefore, even where supply ... decreased, the overwhelmingly greater part of the rise in prices cannot be accounted for on the basis of reductions in supply, but must be ascribed to increases in [monetary] demand....

"v. Falling Supply Cannot Explain the Range of Price Increases that Exists Under Inflation
    "Even such supply reductions as are not themselves caused by rising [monetary] demand, and which, therefore, may legitimately be said to be an independent cause of higher prices—for example, poor crops due to bad weather—should not be described as a cause of inflation, despite the fact that they raise the general consumer price level. This is because they do not produce the range of price increases that people associate with inflation.
    "When people complain of 'inflation,' they have in mind more than a mere rise in the weighted average of consumer prices that is depicted in the consumer price-level formula. They have in mind a condition in which almost every individual price rises and hardly any individual prices fall. It is highly doubtful that they would complain of inflation if a large number of individual prices actually fell, even if, at the same time, the consumer price level, in the sense of the weighted average of consumer prices, rose. Yet precisely this phenomenon of widespread price declines would be the effect of reductions in supply that were not accompanied by increases in demand. If supply fell without being accompanied by an increase in [monetary] demand, the effect would be that a whole host of prices would actually fall, even though the weighted average of prices rose.
    "A large number of prices would fall, because the effect of a reduction in supply would be to make people poorer. As they became poorer, they would concentrate a larger and larger proportion of their limited demand on necessities and a smaller and smaller proportion on luxuries. The prices of all luxury and semi-luxury items would therefore tend to fall....
    "The principle here is that a drop in the supply of any good that comparatively speaking is a necessity causes spending to shift to it from goods that comparatively speaking are luxuries.... For example, a drop in the supply of gasoline causes a sharp jump in the price of gasoline and, at the same time, acts to reduce the demand for automobiles, motel rooms, and so on. The prices of such things, therefore, tend to fall, and actually would fall if the quantity of money and demand in the aggregate did not rise and thus hold up or even increase the demand for them at the same time that people concentrated their expenditures more heavily on the goods in reduced supply. 

    "The phenomenon of large numbers of prices actually falling as the result of declining supplies would be a continuing one as supply fell and the weighted average of prices rose from year to year.... From year to year the rise in prices would outweigh the fall in prices, because of the overall reduction in supply. At the same time, however, numerous cases would always exist in which prices fell. On the basis of this discussion, it should be clear that if not accompanied by an increasing aggregate [monetary] demand, a reduction in supply would be accompanied by widespread declines in individual prices, even while the weighted average of prices rose. It would therefore not qualify as a cause of what most people have in mind when they complain of inflation. In order for practically every price to rise, there must be rising aggregate [monetary] demand. That is the only way that the demand for some goods can increase without reducing the demand for other goods....
    

    "This means that we have narrowed the problem of inflation down exclusively to one of rising aggregate demand, which our formula for the general consumer price level [see below] shows to be the only conceivable remaining explanation."

~ George Reisman, from pages 897-907 of his book Capitalism: A Treatise on Economics. Read it online here, or buy it here (currently at half-price!) 

NOTE: Formula for the general consumer price level: