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About that “Inflation” Defintion

There’s been a lot of commentary in recent weeks about the definition of inflation.  Specifically, Noah Smith and Paul Krugman have been critical of the way Austrian economists use the definition to mean a rise in the monetary base (as opposed to the more common use as a rise in the price level of a certain basket of goods).  I think definitions are important for constructing a coherent and logical framework for understanding the world.  That’s why you’ll notice that my book reads a lot like a textbook (it’s way sexier though, trust me).  I was very careful to define terms very precisely to establish an understanding that can be built from.

Anyhow, the above argument is mostly about whether Austrians changed the definition at some point to suit their own needs.  It’s clearly impossible to know this and there’s clear evidence of both uses as shown here throughout history.  But who cares what the traditional use of the term is?  The fact is, almost every single economist alive today uses the term to mean a rise in the price level.  That is the agreed upon understanding and it’s the most coherent and logical one.

More importantly though, what does anyone gain from defining inflation the way Austrians do?  In my view, this is just a sign of the antiquated underlying ideas that define Austrian economics.  As we all know by now, the monetary base is a terrible way to construct any understanding of what’s happening to the monetary system, prices, GDP, etc.  The Fed has expanded the Monetary Base by FOUR TRILLION dollars in the last 5 years and yet this morning’s CPI report came in at a ho-hum 2.1% and GDP is still muddling along.  A record expansion in the balance sheet did not create high inflation, an economic boom or really much of anything.  All it seems to have done (and this is still hotly debated) is increase asset prices some by reducing the supply of others.  The effects of this huge MB expansion appears to have been on the fringes of the economy at best.

The bottom line is, I don’t know what the obsession with the monetary base is.  Economists like to obsess over the central bank and the government because they view these entities as creating the real “money” in our economy.  But this model almost always relies on a defunct money multiplier concept, misunderstandings of modern banking and ignores the fact that credit (bank created money) is indeed money.  In fact, bank money isn’t just money, it’s the most important form of money that exists in our economy.  Starting with the government and working out to the banking system is constructing a model of understanding that is entirely backwards.  So starting with the Monetary Base as a foundation for understanding “inflation” is not just wrong in the common usage of the word, but almost certain to mislead you about the effects of this “money” creation.  In essence, the Austrian definition of “inflation” is practically useless to anyone who wants to understand our monetary system as it actually exists.

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