Monetary inflation is a sustained increase in the money supply of a country. It usually results in price inflation, which is a rise in the general level of prices of goods and services. Originally the term "inflation" was used to refer only to monetary inflation, whereas in present usage it usually refers to price inflation.
There is general agreement among economists that there is a causal relationship between the supply and demand of money, and prices of goods and services measured in monetary terms, but there is no overall agreement about the exact mechanism and relationship between price inflation and monetary inflation. The system is complex and there is a great deal of argument on the issues involved, such as how to measure the monetary base, or how much factors like the velocity of money affect the relationship, and what the best monetary policy is. However, there is a general consensus on the importance and responsibility of central banks and monetary authorities in affecting inflation. Keynesian economists favor monetary policies that attempt to even out the ups and downs of the business cycle. Currently, most central banks follow such a rule, adjusting monetary policy in response to unemployment and inflation (see Taylor rule). Followers of the monetarist school advocate either inflation targeting or a constant growth rate of money supply, while some followers of Austrian School economics advocate either the return to free markets in money, called free banking, or a 100 percent gold standard and the abolition of central banks.
The monetarist explanation of inflation operates through the Quantity Theory of Money, where M is Money Supply, V is Velocity of Circulation, P is Price level and T is Transactions or Output. As monetarists assume that V and T are determined, in the long run, by real variables, such as the productive capacity of the economy, there is a direct relationship between the growth of the money supply and inflation.
The mechanisms by which excess money might be translated into inflation are examined below. Individuals can also spend their excess money balances directly on goods and services. This has a direct impact on inflation by raising aggregate demand. Also, the increase in the demand for labour resulting from higher demands for goods and services will cause a rise in money wages and unit labour costs. The more inelastic is aggregate supply in the economy, the greater the impact on inflation.
The increase in demand for goods and services may cause a rise in imports. Although this leakage from the domestic economy reduces the money supply, it also increases the supply of money on the foreign exchange market thus applying downward pressure on the exchange rate. This may cause imported inflation.
The Austrian School maintains that inflation is any increase of the money supply (i.e. units of currency or means of exchange) that is not matched by an increase in demand for money, or as Ludwig von Mises put it:
In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur.
Given that all major economies currently have a central bank supporting the private banking system, money can be supplied into these economies by means of bank credit (or debt). Austrian economists believe that credit growth propagates business cycles (see Austrian Business Cycle Theory.) However, the Austrian theory of the business cycle varies significantly from mainstream theories, and economists such as Gordon Tullock, Bryan Caplan, and Nobel laureates Milton Friedman and Paul Krugman have said that they regard the theory as incorrect.
- Michael F. Bryan, On the Origin and Evolution of the Word "Inflation", clevelandfed.org
- Ludwig von Mises Institute, The Gold Standard
- Ron Paul, The Case for Gold, mises.org
- The Theory of Money and Credit, Mises (1912, , p. 272)
- The Economics of Legal Tender Laws, Jörg Guido Hülsmann (includes detailed commentary on central banking, inflation and FRB)
- Gordon Tullock (1988). "Why the Austrians are wrong about depressions" (PDF). The Review of Austrian Economics 2 (1): 73–78. doi:10.1007/BF01539299. Retrieved 2009-06-24.
- Caplan, Bryan (2008-01-02). "What's Wrong With Austrian Business Cycle Theory". Library of Economics and Liberty. Retrieved 2008-07-28.
- Friedman, Milton. "The Monetary Studies of the National Bureau, 44th Annual Report". The Optimal Quantity of Money and Other Essays. Chicago: Aldine. pp. 261–284.
- Friedman, Milton. "The 'Plucking Model' of Business Fluctuations Revisited". Economic Inquiry: 171–177.
- Krugman, Paul (1998-12-04). "The Hangover Theory". Slate. Retrieved 2008-06-20.