Wednesday, 24 August 2022

INFLATION: A Critique of the 'Inflation-Psychology' Doctrine

"As used by its supporters, the term 'inflation psychology' is supposed to refer to an uncaused primary. That is, people allegedly have an inflation psychology ... they simply have it, and because they have it, they spend more rapidly. Of course, there is such a thing as inflation psychology, but it is not a primary. It is based on the fact of inflation. It comes into existence only after many years of inflation.
    "Properly understood, what the term 'inflation psychology' really refers to is the various ways in which a rapidly expanding quantity of money reduces the desire of people to hold money... [having] an effect on prices only by way of raising aggregate monetary demand.* 
    "Inflation psychology also has an influence on prices from the side of supply, because it influences the expectations of sellers. ... These [expectations] cause a rise in prices beyond the levels appropriate to the current size of monetary demand—they make the rise in prices outrun the rise in demand by gearing this year’s prices, in effect, to the expected demand of next year and beyond. These price increases operate as a kind of 'cost push,' but, of course, one that is entirely induced by the expansion in the quantity of money and consequent rise in aggregate monetary demand...
    "Now sometimes, when the government makes an effort to cut back on inflation, and really does reduce the rate at which it expands the money supply for a while, some observers, who are familiar with the quantity theory of money, are surprised to see that prices continue to rise at a substantial rate.... In order [however] to convince people that it is serious in its determination to end inflation, the government must restrict its increase in the quantity of money for a protracted period. In the meanwhile, however, because people have had no reason to believe that the government will continue to limit itself, they will probably have placed themselves in even more overextended positions.... In this context, stopping the inflation or significantly restricting it must precipitate a crisis. And then the government must either allow the crisis to occur or, to avoid it, give in and fulfil people’s expectation that inflation will resume....
    "This type of situation illustrates an inherent flaw of paper money. The fact that paper money can be inflated, and over time is inflated, causes expectations about future inflation. The existence of these expectations then makes it impossible to stop inflating without a crisis, while the threat of the crisis induces the government to resume and accelerate the inflation. Inflation psychology is an inevitable consequence of paper money and is a critical step in its ultimate downfall."
~ George Reisman, from pages 916-17 of his book Capitalism: A Treatise on Economics. Read it online here, or buy it here (currently at half-price!)

* The essential explanation for general and persistent across-the-board rising prices is an expanding quantity of money allowing these prices to be paid. See formula here from pages 505 and 897 of Reisman's book:

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