Wednesday, February 19, 2014

What Causes Inflation?

When the Bank of Canada talks about inflation, what they really mean is price inflation. That is, the general rise in prices of goods and services. Indeed, justification for the central bank is in its perceived ability “to contribute to solid economic performance and rising living standards for Canadians by keeping inflation low, stable, and predictable.” This implies that inflation is a naturally occurring aspect of a market economy. Whether you define inflation as rising prices or adding to the money supply, this phenomenon is not intrinsic to market forces. It is a result of the mixed-market economy, where government bureaucrats and select businessmen decide how they’d like to interfere with the voluntary actions of individuals.

So what causes inflation? It’s not the free market. The price of a good in money is just the exchange ratio between the money and the good in question. When the quantity of the good increases, it price falls. If new immigrants arrive in the country to work, wage rates go down. But Bank of Canada economists would say that because of the increase in labour, wages will rise too quickly, making it difficult for employers to maintain optimal performance. I’m not sure if the Bank follows its error this far, but it does ignore the fact that if you’re at a farmers market haggling with a seller over the price of apricots, and then another seller enters with a fresh box of apricots, your bargaining power has increased. The larger the output, the lower the price will be. Of course one cannot divide total output by total quantity of money and come up with a “price level.” Supply and demand matter. Regardless, the reasoning holds and the free market does not create inflation intrinsically.

So what causes price inflation? Not corporations. They can influence the price of goods and services, but they can’t raise prices in general. If Wal-Mart succeeds at shutting down every small business across North America, then decides to raise their prices to exorbitant levels, all this means is that Canadians will have less to spend on other goods (and that Wal-Mart must have some good lobbyists). But prices in general will not rise. Unless of course, Wal-Mart’s market share encompasses the entire market order, at which point the price system will be subverted into some kind of “Wal-Mart Communist Planning Board”…

But what about the Bank of Canada? It engages in something called “open market operations,” where it buys Canadian bonds from the Big Five Banks and then credits their accounts with BoC money. Now where did the central bank get its money? It based on gold? Nope. Does the Bank of Canada get debited when the Big Five accounts are credited? Nope. The BoC simply adds numbers to the balance sheet of whatever bank it is crediting. This is how they control interest rates. To add insult to injury, the Big Five Banks engage in fractional reserve banking with these new reserves, pyramiding it into an even larger stockpile of money.

Other things being equal, when you increase the money supply, its price in terms of other goods will fall. So when the price of money falls, the prices for goods and services increase. In other words, money loses its purchasing power. It is worth less than it was before. Let’s look again at the Bank of Canada’s intended goal: “to contribute to solid economic performance and rising living standards for Canadians by keeping inflation low, stable, and predictable.” They create inflation! If the market economy were allowed to prosper with a market-based money (like gold, silver, cowries or bitcoin) and a free banking system (no more Chartered cronyism) there would be no inflation! Just the criminal act of counterfeiting money.

Also available at Mises Canada

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