Monetary and Price Inflation: Understanding the Difference.

When a central bank such as the Federal Reserve creates and distributes money, monetary inflation results. Our most current example of this type of economic intervention is known as QE3. The Fed is buying mortgage backed securities with new currency, which increases the total supply of money in the economy.

Price inflation is an increase in prices for any reason. Price inflation occurs when more dollars compete for the same amount of goods. 

The value of a dollar in 1913, the year the Fed was created, is now equal in buying power to about three cents. The argument is not over whether price inflation has occurred, but whether the reason is corollary or causative. You would be hard pressed to find another cause that would be consistently present throughout the same time span.

The primary method that the Fed uses to grow the money supply is by purchasing debt instruments from its selected traders; that elite group of privileged financial corporations that the Fed exclusively trades with. The Fed purchases a debt security from one of its traders and then credits their Federal Reserve bank account with the purchase amount. New money has been created.

This action in itself is not price inflation. The Fed has replaced a debt instrument with new money. The security’s price {and those similar to it in the economy} has been inflated due to the Fed’s buying power, but widespread price inflation throughout the economy has yet to occur.

Through this process, one of the Fed’s selected traders removes an asset from their balance sheet and the Fed credits the value to the trader’s Federal Reserve account. The security is stored in the Fed’s vaults. Monetary inflation occurs, as the money supply is larger by the sale amount of the security.

Since we can assume that the Fed’s client was meeting the Fed’s reserve requirements previous to the sale, they now have excess reserves in the same amount as the sale price of the security. Price inflation is possible if those excess reserves are used to leverage loans or investments. Traders can leverage the extra reserve gained by the sale or they can loan it to other big banks, who may also use it for leverage.

If the leveraged reserves enable bank credit that is utilized for a venture and that venture turns out to actually be productive, then we have essentially substituted a product for the new money. Keynesians would argue this action would not lead to price inflation. Since product value now represents the new money, the increased money supply is chasing an equal value in increased product.

This venture could also be non productive or only partially productive. Any material or resource which is purchased with the new currency and does not result in a product with value equal to the new money causes an increase in material prices. Labor will also be utilized that cannot be utilized elsewhere at the same time, contributing upward pressure on wages. This is due to supply and demand.

This can also be true of any money that is spent, regardless of where the money originated from. Mal investment always creates unwarranted demand on material and labor and can apply upward pressure on prices, regardless of whether it is drawn from the existing money supply or newly issued.

Investments and loans often result in purchases of existing goods rather than production of new goods. If an existing security or good is purchased with the new money, then we have more money chasing existing goods, which results in price inflation.

The Keynesians would argue that purchases of existing products and goods increase the demand for new production, equalizing the equation, but again, the continued devaluation of our currency is a good indicator that new goods are not always produced under these conditions.

What is often forgotten is that price inflation has occurred in the same period of economic history in which phenomenal advances have been made in the production process. We are now able to produce goods with minimal amounts of labor and material input; to an extent that would have been unimaginable just decades ago.

More efficient production increases the quantity of goods in relation to both labor input and the existing money supply, which applies downward pressure to prices and/or upward pressure on wages. Neither has occurred to any great extent relative to overall price inflation, which suggests two possibilities: the rate of price inflation is much greater than the devaluation of the currency would let on and/or the surplus that has been generated by labor and material efficiency has been diverted to a privileged group{s}. 

While it may seem obvious that monetary inflation caused by money production leads and results in price inflation, it really isn’t even a necessary component in assessing the legitimacy of institutional money creation. The real question to is whether any individual, institution or group has the right to control the money supply and subsequently control the lives of people in this country and all over the world.