6. General Price Level and Inflation

That all of the terms in fact are measured in some form or another is not the issue; the question is which of them can be meaningfully measured.

The Quantity Theorists – and Fisher, in particular – are dogmatic in connecting inflation to changes in the stock of money. As we have seen, excess aggregate demand is at root caused by excess monetization, so that there is truth in the dogma. In my view, however, it is better to see the problem in process terms, as the creation of a tide of purchasing power that floods onto the goods side of the pool of fluid capital and drives up market-clearing prices.

A major problem with quantity theorists, with the exception of Wicksell, is that they neither specify a reason why excess monetization occurs, nor do they spell out a mechanism whereby the excess purchasing power that is created eventually leads to inflation. The standard litany of quantity theorists is: “Suppose the quantity of money is doubled.” Clearly, the most fanciful deus ex machina for bringing this about is Milton Friedman’s helicopter that flies about spreading money to one and all.

I am abstracting, for the moment, from the fact (discussed in Chap.​ 4) that the expectations which drive the current supply of goods and the expectations which drive the current flow of income are in general separated by one-half of an average production period.

I put aggregate supply in quotation marks in this sentence in order to distinguish aggregate supply as it is being conceived here from the aggregate supply that was defined in Chap.​ 3. Aggregate supply defined there refers to the flow of output that is currently emerging from production, whereas the aggregate supply defined here refers to the entire stock of goods embodied in the pool of fluid capital. The latter differs from the former by the addition of held-over inventories of finished goods from past production.

I put to the side for now the question of how an excess of purchasing power could come to exist in the first place.

The situation is actually better described as too much purchasing power chasing too few goods.

As discussed by von Mises in The Theory of Money and Credit – and in great detail by Schumpeter in The Theory of Economic Development – demand-pull inflation necessarily results in “forced savings.” This is because the “extra” purchasing power allows goods to be bid away (through higher prices) from those with lower willingnesses-to-pay. Indeed, Schumpeter saw this process as the essence of development, because it is the (new) purchasing power in the hands of entrepreneurs which allows resources to be transferred from old uses into new uses. Forced saving will be discussed below.

Since some production decisions take place at each point in time, the two pools defining aggregate demand and aggregate supply change continuously. Conceptually, therefore, changes in the general price level are also best viewed as occurring continuously, in response to the ebb and flow of the pool of purchasing power against the stock of goods embodied in the pool of fluid capital. However, as data are necessarily collected over intervals of time, rather than continuously, defining a price index that changes continuously is obviously a practical impossibility. Of existing conventional aggregate price indices, the one which comes closest to the continuously chained index which emerges from this discussion is the implicit deflator for GDP. This is because the implicit GDP deflator is, in principle, a current quantity-weighted index.

So long as the money that is created by an excessive collateralization of assets remains in the asset markets, goods prices will not be affected. But there is the obvious danger that this will not remain the case, so that there could be inflation in the goods market as well.

Another way of stating this is that, in equilibrium, asset prices are tied to goods prices, and that causation in fact runs from goods prices to asset prices, rather than vice versa. The deflation of asset prices that occurred in Japan in the early 1990s is a case in point, as is also the bursting of housing bubbles in the U.S and other countries in 2006–07.

The demands in question are those which arise from the funding of current production, investment in newly produced means of production, and consumption in excess of current income. Current consumption demands are not included because these demands are funded out of current income, which is paid in money.

This follows from portfolio adjustment in which yields on different assets, including money, are equalized.

This might accordingly seem to imply a horizontal equilibrium yield curve, but this is not necessarily the case. The conventional view at present (at least in elementary money and banking textbooks) seems to be that long-term interest rates are determined as geometric means of expected short-term rates. [cf., for example, Burton and Lombra (2000).] The normally positive slope of the yield curve is then seen as a consequence of the greater uncertainty which attaches to expectations the further they lie in the future. Another factor to be taken into account is the option loss associated with a long-term security as opposed to a short-term one. Since the future is unknown, an “investor” unexpectedly needing money might have to sell a long-term security at a loss before its maturity. To compensate for this possibility, long-term rates will need to be higher than short-term rates. An additional liquidity premium will accordingly attach to short-term rates. For an analysis of this option effect, see Hlusek (1999).