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Why Do Prices Rise Over Time?

Since 1950, prices in the United States have risen roughly tenfold. Given this history, it would be easy for one to believe that inflation is just a natural part of economic life. But there have been many extended periods in human history where prices were either stable or even declined.

For example, prices in the United States fell at a rate of 1 per cent a year from 1879 to 1897 and then rose at a rate of little more than 2 per cent a year from 1897 to 1914 (Friedman & Schwartz, “A Monetary History of the United States”, page 91).

This begs some obvious questions. Why do prices rise over some extended periods of time and not others? More specifically, why did prices remain relatively stable while the United States adhered to a strict gold standard pre-WWI? In contrast, why did prices rise dramatically in the later half of the 20^th century as the United States abandoned the gold standard?

Milton Friedman famously remarked, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

The long-term economic data clearly supports Friedman’s contention. But, Friedman never adequately explained why this is the case. Why should growth in the monetary base that is in excess of growth in real output lead to rising prices over extended periods of time?

The view of The Money Enigma is that the primary reason that prices rise over time is because growth in the monetary base that is greater than growth in real output acts to reduce the value of money.

The value of money acts as the denominator of the price level: as the value of money falls, prices as measured in money terms rise. If the value of money is relatively stable over time, as it generally was under a strict gold standard, then the price level is relatively stable. However, if the value of money declines significantly over time, as it has tended to do under fiat regimes, then the price will rise significantly.

Why does fiat money tend to lose value over extended periods of time? The simple answer to this question is that maintaining the value of fiat money relies on restricting the growth in the fiat monetary base and, under fiat regimes, the temptation to expand the monetary base is simply too great.

In more technical terms, fiat money is a long-duration, special-form equity instrument and represents a proportional claim on the future output of society. Measured over long periods of time, growth in the monetary base that is in excess of growth in real output will reduce the value of a proportional claim on future output, i.e. it will lead to a decline in the value of money. It is this sustained decline in the value of money that is the primary driver of inflation over long periods of time.

Every Price is a Relative Measurement of Market Value

In most of our daily life, we measure things using “standard units” of measurement. For example, we measure height in inches and weight in pounds. Inches and pounds are useful tools for measurement because they are invariable in the property that they are trying to measure. One inch is exactly the same length as it was yesterday and as it will be one year from now.

In this sense, most of the measurements that we make in our daily can be considered to be “absolute” measurements: they are made using a standard unit of measurement that is invariable in the property being measured.

However, in our economic interactions, the way we measure things is quite different.

The price of a good in money terms is a measure of the market value of that good. For example, if we know that an apple costs one dollar, then that tells us something about the value of apples.

However, while the price of a good is a measure of the market value of that good, it is not an absolute measure of the market value of that good. Why? Price is not an absolute measure of market value because our unit of measurement, “money”, is not invariable in the property that is being measured.

Unlike inches and pounds, which are both invariable in the property they are measuring, money is not invariable in the property of market value.

Therefore, the price of a good is always a relative, as opposed to an absolute, measure of market value.

What does this mean in practice?

If the price of apples in money terms is a relative measure of market value, then this means that the price of apples can rise for one of two reasons. Either (a) the market value of apples rises (each apple becomes “more valuable”), or (b) the market value of money falls (each dollar becomes “less valuable”).

The way that economics is taught today creates the temptation to ignore the second element outlined above. Traditional supply and demand theory focuses on how changes in the supply and demand for a good impact the market value of that good and, therefore, the price of that good.

What is often overlooked in this analysis is that the price of a good in money terms depends just as much on the market value of money as it does on the market value of the good itself. While it may be useful for classroom demonstrations to assume that the value of money is constant, this is not the way the world actually works.

This is particularly the case when we consider what drives prices over extended periods of time. For example, in 1950 apples in Florida cost roughly 20 cents per pound. Today, apples sell for approximately $1.50-2 per pound.

Why did apple prices increase roughly tenfold over the last sixty years? Was there “too much demand” for apples or “too little supply?” Or did something else happen? Maybe the market value of apples, as measured in absolute terms, hasn’t changed that much over that period of time. Maybe, the price of apples has risen tenfold because the value of money (the value of one US Dollar) has fallen by roughly 90% over that same period!

Arguably, the price of apples in money terms has risen tenfold over the past sixty years not because of any significant change in the value of apples per se, but because a dramatic fall in the value of our unit of measurement, i.e. a dramatic fall in the value of money.

Ratio Theory: The Price Level is a Relative Measure of Market Value

So far, we have focused only on the price of one good, the price of apples. The price of apples in money terms measures the market value of apples in terms of the market value of money. Therefore, the price of apples can rise either because (a) apples become more valuable, or (b) money becomes less valuable.

In this sense, the market value of money acts as the denominator of the price of apples. All else remaining equal, if the market value of money falls, the price of apples, as measured in money terms, will rise.

If this observation is true for the price of apples, then it is also true the price of every other good in the economy, i.e. the market value of money is the denominator of every money price in the economy.

The price of apples, the price of bananas, the price of milk… all of these prices, as expressed in money terms, are determined by both the market value of the good itself (apples/bananas/milk) and the market value of money. All else remaining equal, if the market value of money falls, then the price of all these goods, as measured in money terms, will rise.

Now, let’s think about what determines the price of a typical basket of goods, or what is often known as “the price level”.

Clearly, if the value of money is the denominator of the every money price in the economy, then the value of money is also the denominator of the price level. All else remaining equal, as the value of money falls, the price of the basket of goods will rise.

The price level is a relative measure of market value. The price level measures the market value of the basket of goods in terms of the market value of money. In this sense, we can think of the price level as a ratio of two values. The price level is determined by the ratio of the market value of the basket of goods (the numerator) divided by the market value of money (the denominator).

The key to “Ratio Theory”, as illustrated in the slide above, is isolating the market value of goods from the market value of money by measuring both in terms of a “standard unit” for the measurement of market value. Just as we measure height and weight in terms of a standard unit, so we can, at least theoretically, measure the property of market value in terms of standard unit, i.e. a unit that is invariable in the property of market value. For more on this topic please read “The Measurement of Market Value: Absolute, Relative and Real”.

In simple terms, the Ratio Theory of the Price Level implies that the price level can rise for one of two basic reasons. Either (a) the basket of good and services becomes more valuable, or (b) money becomes less valuable.

Now let’s return to original question. Why do prices rise over some periods of time and not others? More specifically, why were prices relatively stable under a gold standard and why did prices rise dramatically once the gold standard was abandoned?

The Gold Standard and Price Stability

Speaking in general terms, history indicates that prices tend to more stable, when measured over long periods of time, under a gold standard than they are under fiat monetary regimes. This is not to say that prices don’t fluctuate under a gold standard nor that there is no inflation under a gold standard, but it is true, as a general rule, that inflation has been systematically lower under true gold standard regimes than it has been under fiat money regimes.

So, why do prices tend be stable over long periods of time under a gold standard?

The view of The Money Enigma is that the main difference between a fiat money regime and a gold standard system is that, under the gold standard, the value of money is relatively constant as its value is tied to gold. Therefore, the denominator in our price level equation tends to be stable over long periods of time and the price level itself is relatively stable.

In contrast, under a fiat money system, the value of money tends to decline over time for reasons that we shall discuss shortly. As the denominator in our price level equation declines, sometimes precipitously, the price level rises.

The key principle of a gold standard is that each dollar is exchangeable for some fixed amount of gold. Under a gold standard, paper money has value because the issuing authority has made an explicit promise that paper notes are convertible into a fixed amount of gold on request.

Therefore, the value of each note is tied directly to the value of the gold. As the value of gold rises, the value of money rises. As the value of gold falls, the value of money falls.

Measured over long periods of time, the value of gold tends to be relatively stable. There are good reasons for this, as discussed in a recent post titled “What Determines the Price of Gold?”

In simple terms, gold acts a constant in sea of economic variables. More specifically, the stock of gold is relatively constant over time and, perhaps more importantly, its growth is very predictable. While the value of gold does fluctuate, gold is still the closest thing that we can find to an economic constant, especially when considered over long periods of time.

The value of gold is susceptible to sudden increases in supply, i.e. new discoveries. For example, when the New World was discovered, a large influx of gold and silver into Europe led to the “Price Revolution”. The new supply of gold and silver led to a gradual fall in the value of gold and prices, as measured in gold terms, rose roughly six-fold over a 150 year period. Nevertheless, that rate of inflation only amounted to 1-1.5% per year!

The point is that prices tend to be stable under a gold standard because the value of gold tends to be stable and, therefore, the value of money tends to be stable. If the value of money, the denominator in our price level equation, is relatively stable over time, then the price level itself is relatively stable. Economic cycles of excess demand and excess supply may lead to variations in the value of the basket of goods, the numerator in our equation, but it is the value of money, the denominator in our equation, that is the key determinant of inflation when measured over long periods of time.

Fiat Money Regimes and Inflation

If prices are relatively stable under a gold standard, then why do prices tend to rise under fiat money regimes?

Almost universally, fiat money regimes have experienced levels of inflation that are far above long-term historical averages. For example, prices in the United States pre-WWI were relatively stable, but then exploded higher in the second half of the 20^th century.

But why is this the case?

Once again, I would encourage readers to look at the price level equation below and think about what is likely to be the key difference between a gold standard system and a fiat money system.

Does seem reasonable to believe that the key difference between periods of low inflation and high inflation is the numerator in our equation? Was the value of the basket of goods relatively stable pre-WWI, but then, for some reason, broke with history and exploded higher in the second half of the 20^th century?

Or is it more plausible to believe that the difference between the two periods was the denominator in our equation, the value of money?

The view of The Money Enigma is that it is the denominator, not the numerator, which is the key driver of the price level as measured over long periods of time. More specifically, it was the collapse in the value of fiat money in the second half of the 20^th century that led to inflation well above historical averages.

Under a strict gold standard, the value of money is tied to the value of a gold and, consequently, its value tends to be relatively stable. In contrast, the value of fiat money is not pegged to the value of any real asset. Indeed, fiat money is, at least superficially, just a piece of paper.

So why does fiat money have any value and why does that value tend to decline over time?

The first part of that question is an issue that we have addressed in detail on several occasions. I would encourage people who are genuinely interested in this topic to read two recent posts, “Why Does Money Exist? Why Does Money Have Value?” and “The Evolution of Money: Why Does Fiat Money Have Value?”

In simple terms, under a gold standard, paper money represented an explicit contract that promised that it could be exchanged for gold. When the gold standard was abandoned, the explicit contract that governed paper money was rendered null and void.

So, why did paper money retain any value? It retained value because the explicit contract was replaced by an implied-in-fact contract, or “social contract”, between the holders of money and the issuer of money.

What is the nature of the implied contract that governs fiat money?

Again, this is a lengthy subject that is discussed in the “Theory of Money” section of this website. But, in simple terms, fiat money is a financial instrument: it has value as an asset to one party because it represents a liability to another party. More specifically, fiat money is a liability of society and a proportional claim on the future output of society.

This is a complicated idea, but there is a simple analogy that we can use to help us think about what determines the value of fiat money.

In many ways, fiat money is like shares of common stock. A share of common stock represents a proportional claim on the future residual cash flows of a company. In contrast, one of fiat money represents a proportional claim on the future output of society.

Over an extended period of time, if a company grows its earnings faster than it grows shares outstanding, then the value of the stock will rise. Conversely, if over a lengthy period, a company grows it shares outstanding faster than it grows its earnings, then the value of its shares will fall. Why? Each share is a claim on earnings and, ultimately, the value of each share depends on the earnings per share.

Similarly, if over an extended period of time, a society grows its real output faster than it grows its monetary base, then the value of each unit of the monetary base will rise, i.e. the value of money will rise and, all else equal, the price level will fall.

This doesn’t happen very often, especially under fiat money regimes. Rather, most of us are more familiar with the alternative scenario.

If over a long period of time, a society grows its monetary base faster than real output, then the value of money will fall. Why? The value of money falls because money, the monetary base, derives its value from an implied-in-fact contract. More specifically, money represents a proportional claim on future output. In general terms, as real output per unit of money falls, the value of money falls and, all else remaining equal, the price level rises.

In summary, the primary reason that prices tend to rise under fiat money regimes is that, over long periods of time, fiat money regimes tend to grow the monetary base at a rate that is faster than the growth in real output. Fiat money is a financial instrument and represents a proportional claim on future output. All else remaining equal, as the “real output/base money” ratio declines over time, the value of fiat money declines.

The key difference between a gold standard regime and a fiat money system is the behavior of the value of money over long periods of time.

Under a gold standard, the value of money is relatively stable because it is tied to the value of gold. In a fiat money system, the value of money is heavily influenced by political process and the “needs/wants” of our society. Inevitably, as central bankers acquiesce to the needs of the people, the monetary base grows at much faster rates than real output, leading to a decline in the value of money and a rise in the general price level.

Author: Gervaise Heddle

What Causes Inflation?

Inflation remains one of the great enigmas of modern economics. In this week’s post, we will examine a simple theory of the price level, “Ratio Theory of the Price Level”, and a basic model that can be used for thinking about short-term movements in the price level “The Goods-Money Framework”. We will then use these ideas to examine some of the traditional explanations for inflation.

Despite extensive academic studies and seemingly endless debate, a quick keyword search on “what causes inflation?” will reveal a jungle of different ideas and opinions regarding the true drivers of inflation.

The traditional view, taught at high schools and colleges, is that inflation can be driven by “demand pull” or “cost push” factors. In essence, this is a macroeconomic extension of the basic microeconomic tenet that the price of a good can rise either because there is more demand for that good (“demand pull”) or because there is reduced supply for that good (“cost push”).

The “demand pull/cost push” model represents an “old Keynesian” view of how the world works: if aggregate demand increases, then real output should increase and the price level will rise, particularly if the economy is operating near full capacity.

Mainstream economists recognize that this simple aggregate supply and demand view of the world often fails to predict episodes of high inflation. Therefore, this basic Keynesian model has been fudged by the addition of something called “inflation expectations”. This “New Keynesian” model states that inflation is caused by either (1) too much demand, or (2) expectations of future inflation. The problem with the “inflation expectations” term in the New Keynesian models is that no one seems to have a good sense of what determines “inflation expectations”.

The issue is made more complicated by the fact that most economists recognize that, over the long term, the monetary base plays an important role in the determination of the price level. Even senior central bankers tie themselves in knots trying to explain how to reconcile the New Keynesian model of the world with the simple, empirical fact that money matters. Mervyn King, former Governor of the Bank of England, discusses this problem in his article “No money, no inflation – the role of money in the economy” (2002) in which he concludes that “the absence of money in the standard models which economists use will cause problems in the future”. Frankly, I couldn’t agree more.

If even central bankers can’t reconcile the competing views of what drives inflation, then this suggests that something is wrong with the underlying models. The view of The Money Enigma is that both Keynesian and Monetarist models fail to provide satisfactory models for the determination of the price level because they both start from the wrong fundamentals.

In order to build useful models of the price level, we need to go back and challenge the basics of current microeconomic theory. In particular, we need to develop a more comprehensive answer to the question “how is a price determined?”

It is the view of The Enigma Series that the current presentation of microeconomic price determination, namely the traditional supply and demand chart with price on the y-axis, presents a one-sided and very limited view of the price determination process.

The view of The Enigma Series is that every price is a function of two sets of supply and demand. More specifically, the price of one good (the primary good) in terms of another good (the measurement good) is a function of both supply and demand for the primary good and supply and demand for the measurement good.

A few weeks ago, we discussed how prices are determined in a genuine barter economy (an economy in which there is no commonly accepted medium of exchange). We asked the question “what determines the price of apples in banana terms? Is it supply and demand for apples? Or is it supply and demand for bananas?” The answer is both.

Every price is a relative expression of two market values. The market value of apples is determined by supply and demand for apples. The market value of bananas is determined by supply and demand for bananas. The price of apples, in banana terms, is a relative expression (a ratio) of these two market values. Therefore, the price of apples, in banana terms, is a function of two sets of supply and demand (see diagram below).

This principle can be extended to the determination of “money prices”. The price of a good, in money terms, is a relative expression of the market value of the good and the market value of money. For example, if the market value of one apple is three times the market value of one US Dollar, then the price of an apple, in US Dollar terms, is three dollars.

In general terms, the dollar price of an apple can rise for one of two reasons: either the market value of an apple rises (for example, there is a supply shortage), or the market value of the dollar falls.

The diagram below illustrates how the price of apples, in money terms, is determined by two sets of supply and demand: supply and demand for apples, and supply and demand for money. The key in this diagram is the y-axis unit of measurement: a “standard unit” of market value. Instead of using price, a relative measure of market value, on the y-axis, the diagrams above and below use an absolute measure of market value of the y-axis. The standard unit of market value is a theoretical and invariable measure of the property of market value, just as “inches” are an invariable measure of the property of length.

The key point that readers should take away from the above diagram is that every “money price” in our economy is a ratio. More specifically, the price of a good in money terms is a ratio of the market value of the good (the numerator) divided by the market value of money (the denominator).

The Inflation Enigma, the second paper in The Enigma Series, extends this simple microeconomic concept (every price is a relative expression of two market values) to a macroeconomic level. If the market value of money is the denominator of every money price in the economy, then the price level can be stated as a ratio of two market values: the “general value level”, a hypothetical measure of the absolute market value of the basket of goods/services, and the market value of money. This is called the Ratio Theory of the Price Level.

Ratio Theory of the Price Level states that the price level is a function of the value of goods relative to the value of money. If the value of goods rises relative to the value of money, then the price level rises (inflation). If the value of goods falls relative to the value of money, the price level falls (deflation).

We can best illustrate Ratio Theory with a simple macroeconomic framework called “The Goods-Money Framework” (see diagram below). The Goods-Money Framework is broken into a left side and right side. On the left side, aggregate supply and demand for goods/services determines real output (x-axis) and the market value of goods (y-axis), as measured in absolute terms. On the right side, supply and demand for money (the monetary base) determines the market value of money (again, market value is measured in absolute terms).

The price level is a ratio of two macroeconomic equilibrium: the market value of goods, as determined on the left side of the model, divided by the market value of money, as determined on the right side of the model. Now, let’s get back to our original question.

What causes inflation?

The left side of the Goods-Money Framework provides some distinctly Keynesian answers to this question. All else equal, the price level will rise if the market value of goods (the “general value level”) rises. In a stylized sense, this can occur either because the aggregate demand curve shifts to the right (“demand pull”) or because the aggregate supply curve shifts to the left (“cost push”).

The right side of the Goods-Money Framework provides a somewhat more Monetarist perspective on the issue. All else equal, the price level will rise is the market value of money falls. In very simple terms, this can occur either because the supply of money (the monetary base) increases or because the demand for money falls.

In practice, both the left side and right side of the model are both moving at the same time. For example, deflationary forces that are acting on the left side of the model, (for example, “globalization” of the labor force), might be offset by inflationary forces on the right side (for example, aggressive monetary easing), leading to a net result where the price level changes little. [Note: if both the numerator and denominator fall by roughly the same percentage, then there is no change to the ratio itself].

While interpreting the left side of the framework is relatively straightforward, the right side of the framework is extremely complex. The main problem is that “supply and demand” is, in practice, a poor short-term model for the determination of the market value of money.

We know from recent experience that a large increase in the monetary base can have little short-term impact on the market value of money (and hence, little short-term impact on the price level). The reason for this is that money is a proportional claim on the future output of society. More importantly, money is a long-duration asset. The market value of money depends far more upon expectations of future levels of the monetary base than it does on the current levels of the monetary base.

The Velocity Enigma, the final paper in The Enigma Series, develops a valuation model for money that demonstrates that the current market value of money depends upon long-term expectations. More specifically, the current market value of money is highly dependent upon the expected long-term path of the “real output/base money” ratio.

As you can see, there is no simple answer to the question “what causes inflation?”

The traditional Keynesian view provides a very limited perspective on the issue. Importantly, the notion that inflation can only occur if the economy is overheating (the economy can only experience inflation if there is “too much demand”) is nonsense.

The price level depends upon a complex set of expectations. Most notably, the expected long-term path of the “real output/base money” ratio is the key determinant of the market value of money. In turn, the market value of money is the denominator of every “money price” in the economy.

This model provides a sensible explanation for how inflation can occur in a weak economic environment. If aggregate demand is weak, then this will place downward pressure on the market value of goods on the left side of our model. However, if confidence in the economic future of the country falters, then this can easily lead to a decline in the market value of money that overwhelms the fall in the market value of goods. In the context of Ratio Theory, as the denominator (the market value of money) falls more rapidly than the numerator (the market value of goods), the price level rises.

In summary, we can say that, in the short-term, the drivers of the price level are complex. Aggregate demand and supply matter, but expectations of the future path of the “real output/base money” ratio are critical.

While economists may disagree on the short-term drivers of the price level, there is at least a broader consensus on what drives the price level over the long-term: money. More specifically, the ratio of base money to real output is the key driver of the price level as measured from point to point over very long periods of time.

The Enigma Series provides a common sense explanation for this phenomenon.

Money is a special-form equity instrument of society that represents a proportional claim on the future output of society. The value of a proportional claim on the output of society will rise as real output rises and fall as the monetary base increases (i.e. as the number of claims against that output increases).

Therefore, if over a period of many years, the monetary base has grown at a much faster rate than real output (as it has in the United States over the past 80 years), we should expect the market value of money to have fallen significantly and, all else equal, the price level should have risen significantly.

Over long periods of time, it is this ratio of money/output that drives the price level. The question today is how long can the monetary base in the United States can remain at these extended levels without triggering a significant decline in the market value of money and reigniting inflation. Too many commentators who are worried about deflation are, at least implicitly, focused only on the left side of our model above. The key to inflation remains the right side of the model, the market value of money.

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