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Economic calculation problem

2013-12-06T09:21:32Z

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{{Wikipedia text|Economic_calculation_problem|390005384}}
The '''economic calculation problem''' is a criticism of central [[economic planning]]. It was first proposed by [[Ludwig von Mises]] in 1920 and later expounded by [[Friedrich Hayek]].<ref name="Mises">{{cite book
|title= Economic calculation in the Socialist Commonwealth
|accessdate=2008-09-08
|last= Von Mises
|first= Ludwig
|authorlink= Ludwig von Mises
|year= 1990
|format= pdf
|publisher= [[Ludwig von Mises Institute]]
|url= http://mises.org/pdf/econcalc.pdf
}}</ref><ref>F. A. Hayek, (1935), "The Nature and History of the Problem" and "The Present State of the Debate," om in F. A. Hayek, ed. ''Collectivist Economic Planning'', pp. 1-40, 201-43.</ref>

==Summary==
The problem referred to is that of how to distribute resources [[Rational choice theory|rationally]] in an economy. The [[free market]] solution is the [[price mechanism]], wherein people individually have the ability to decide how a good or service should be distributed based on their willingness to give money for it. The price conveys embedded information about the [[Supply and demand|abundance of resources as well as their desirability]] which in turn allows, on the basis of individual consensual decisions, corrections that prevent [[Economic shortage|shortages]] and [[Economic surplus|surpluses]]; Mises and Hayek argued that this is the only possible solution, and without the information provided by market prices socialism lacks a method to rationally allocate resources. Those who agree with this criticism argue it is a refutation of [[socialism]] and that it shows that a [[socialist]] [[planned economy]] could never work. The debate raged in the 1920s and 1930s, and that specific period of the debate has come to be known by [[economic historian]]s as ''The Socialist Calculation Debate.''

[[Ludwig von Mises]] argued in a famous 1920 article "Economic Calculation in the Socialist Commonwealth" that the pricing systems in socialist economies were necessarily deficient because if government owned or controlled the [[means of production]], then no rational prices could be obtained for [[capital goods]] as they were merely internal transfers of goods in a socialist system and not "objects of exchange," unlike final goods. Therefore, they were unpriced and hence the system would be necessarily inefficient since the central planners would not know how to allocate the available resources efficiently.<ref name="Mises" /> This led him to declare "...that rational economic activity is impossible in a socialist [[commonwealth]]."<ref name="Mises" /> Mises developed his critique of socialism more completely in his 1922 book ''Socialism, an Economic and Sociological Analysis''.
[http://www.grosir-kosmetik.com/62-glutera.html Glutera], [http://www.grosir-kosmetik.com/63-been-pink-beauty-series.html Been pink]

==Argument in detail==
The seeds of the '''calculation debate''' had been planted by a host of economists before [[Ludwig von Mises]] posed the central question "in such a form as to make it impossible that it should ever again disappear." Mises' article, adapted from a lecture of a year earlier, appeared in the spring of 1920 entitled "Economic Calculation in the Socialist Commonwealth" ([http://mises.org/pdf/econcalc.pdf pdf]). The famous challenge of Mises was uncompromising and to the point: "Where there is no free market, there is no pricing mechanism: without a pricing mechanism, there is no economic calculation." Two years later the argument was enlarged in a wide-ranging critique of socialism, entitled ''Die Gemeinwirtschaft'' ("Socialism", [http://mises.org/books/socialism/contents.aspx html], [http://www.mises.org/books/socialism.pdf pdf]).

The main effect of Mises' arguments has been best summed up by the renowned socialist economist [[Wikipedia:Oskar R. Lange|Oskar Lange]]: "It was [Mises'] powerful challenge that forced the socialists to recognize the importance of an adequate system of economic accounting in a socialist economy. Even more, it was chiefly due to Professor Mises' challenge that many socialists became aware of the very existence of such a problem." But the real effect, was to force the socialists to retreat from a pure advocacy of Marxian socialism to a compromise watered down with "competitive" infusions-market socialism.<ref name="Bradley_socialism">Robert Bradley, Jr. [http://mises.org/journals/jls/5_1/5_1_3.pdf "Market Socialism: A Subjectivist Evaluation"] (pdf), The Journal of Libertarian Studies, Vol. V, No. 1 (Winter 1981). Referenced 2010-07-06.</ref>

Even if the socialists have been able to create a mighty army of citizens all eager to do the bidding of their masters, what exactly would the socialist planners tell this army to do? How would they know what products to order their eager slaves to produce, at what stage of production, how much of the product at each stage, what techniques or raw materials to use in that production and how much of each, and where specifically to locate all this production? How would they know their costs, or what process of production is or is not efficient?

In any economy more complex than the Crusoe or primitive family level, the socialist planning board would simply not know what to do, or how to answer any of these vital questions. Developing the momentous concept of calculation, Mises pointed out that the planning board could not answer these questions because socialism would lack the indispensable tool that private entrepreneurs use to appraise and calculate: the existence of a market in the means of production, a market that brings about money prices based on genuine profit-seeking exchanges by private owners of these means of production. Since the very essence of socialism is collective ownership of the means of production, the planning board would not be able to plan, or to make any sort of rational economic decisions. Its decisions would necessarily be completely arbitrary and chaotic, and therefore the existence of a socialist planned economy is literally "impossible" (to use a term long ridiculed by Mises's critics).

In the course of intense discussion throughout the 1920s and 1930s, the socialist economists were honest enough to take Mises's criticism seriously, and to throw in the towel on most traditional socialist programs: in particular, the original communist vision that workers, not needing such institutions as bourgeois money fetishism, would simply produce and place their products on some vast socialist heap, with everyone simply taking from that heap "according to his needs."

The socialist economists also abandoned the Marxian variant that everyone should be paid according to the labor time embodied into his product. In contrast, what came to be known as the Lange-Lerner solution, acclaimed by virtually all economists, asserted that the socialist planning board could easily resolve the calculation problem by ordering its various managers to fix accounting prices. Then, according to the contribution of Professor [[Wikipedia:Fred M. Taylor|Fred M. Taylor]], the central planning board could find the proper prices in much the same way as the capitalist market: trial and error. Thus, given a stock of consumer goods, if the accounting prices are set too low, there will be a shortage, and the planners will raise prices until the shortage disappears and the market is cleared. If, on the other hand, prices are set too high, there will be a surplus on the shelves, and the planners will lower the price, until the markets are cleared. The solution is simplicity itself!

Set aside the obvious absurdity of trusting a coercive governmental [[monopoly]] to act somehow as if it were in "[[perfect competition]]" with parts of itself. Another grievous flaw in the Lange model is thinking that general equilibrium, a world of certainty where there is no room for the driving force of entrepreneurship, can somehow be used to depict the real world. The actual world is one not of changeless "givens" but of incessant change and systemic uncertainty. Because of this uncertainty, the capitalist [[entrepreneur]], who stakes assets and resources in attempting to achieve profits and avoid losses, becomes the crucial actor in the economic system, an actor who can in no way be portrayed by a world of general equilibrium. Furthermore, it is ludicrous, as [[Friedrich Hayek|Hayek]] pointed out, to think of general equilibrium as the only legitimate "theory," with all other areas or problems dismissed as mere matters of practicality and degree. No economic theory worth its salt can be worthwhile if it omits the role of the entrepreneur in an uncertain world. The "equations" are not simply excellent theory that faces problems in practice; for in order to be "good," a theory must be useful in explaining real life.

Moreover, in his later rebuttal to the champions of the Pareto-Barone equations, Mises points out that the crucial problem is not simply that the economy is not and can never be in the general equilibrium state described by these differential equations. In addition to other grave problems with the equilibrium model (e.g.: that the socialist planners do not now know their value scales in future equilibrium; that money and monetary exchange cannot fit into the model; that units of productive factors are neither perfectly divisible nor infinitesimal-and that marginal utilities, of different people cannot be equated-on the market or anywhere else), the equations "do not provide any information about the human actions by means of which the hypothetical state of equilibrium" has been or can be reached. In short, the equations offer no information whatever on how to get from the existing disequilibrium state to the general equilibrium goal.

Another grave flaw in the Lange-Taylor trial-and-error approach is that it concentrates on consumer goods pricing. It is true that retailers, given the stock of a certain type of good, can clear the market by adjusting the prices of that good upward or downward. But, as Mises pointed out in his original 1920 article, consumers goods are not the real problem. Consumers, these "market socialists" are postulating, are free to express their values by using money they had earned on a range of consumers' goods. Even the labor market — at least in principle — can be treated as a market with self-owning suppliers who are free to accept or reject bids for their labor and to move to different occupations. The real problem, as Mises has insisted from the beginning, is in all the intermediate markets for land and capital goods. Producers have to use land and capital resources to decide what the stocks of the various consumer goods should be. Here there are a huge number of markets where the State monopoly can only be both buyer and seller for each transaction, and these intra-monopoly, intra-state transactions permeate the most vital markets of an advanced economy — the complex lattice-work of the capital markets. And here is precisely where calculational chaos necessarily reigns, and there is no way for rationality to intrude on the immense number of decisions on the allocation of prices and factors of production in the structure of capital goods.

Mises discussed in [[Human Action]] the "trial-and-error" method, and pointed out that this process only works in the capitalist market. There the entrepreneurs are strongly motivated to make greater profits and to avoid losses, and further, such a criterion does not apply to the capital goods or land market under socialism where all resources are controlled by one entity, the government.

This was a critique, not only of socialism, but of the entire Walrasian [[Wikipedia:General equilibrium theory|general equilibrium model]]. The major [[fallacy]] of the "market socialists," Mises pointed out, is that they look at the economic problem from the point of view of the manager of the individual firm, who seeks to make profits or avoid losses within a rigid framework of a given, external allocation of capital to each of the various branches of industry and indeed to the firm itself. In other words, the "market socialist" manager is akin, not to the real driving force of the capitalist market, the capitalist entrepreneur, but rather to the relatively economically insignificant manager of the corporate firm under capitalism.

They consider the structure of industrial production and the allocation of capital to the various branches and production aggregates as rigid, and do not take into account the necessity of altering this structure in order to adjust it to changes in conditions. They fail to realize that the operations of the corporate officers consist merely in the loyal execution of the tasks entrusted to them by their bosses, the shareholders. The operations of the managers, their buying and selling, are only a small segment of the totality of market operations. The market of the capitalist society also performs those operations which allocate the capital goods to the various branches of industry. The entrepreneurs and capitalists establish corporations and other firms, enlarge or reduce their size, dissolve them or merge them with other enterprises; they buy and sell the shares and bonds of already existing and of new corporations; they grant, withdraw, and recover credits; in short they perform all those acts the totality of which is called the capital and money market. It is these financial transactions of promoters and speculators that direct production into those channels in which it satisfies the most urgent wants of the consumers in the best possible way.

But no "market socialist" has ever suggested preserving or carrying over, much less understood the importance of, the specifically entrepreneurial functions of capitalism:

<blockquote>Nobody has ever suggested that the socialist commonwealth could invite the promoters and speculators to continue their speculations and then deliver their profits to the common chest. Those suggesting a quasi-market for the socialist system have never wanted to preserve the stock and commodity exchanges, the trading in futures, and the bankers and money-lenders as quasi-institutions. One cannot play speculation and investment. The speculators and investors expose their own wealth, their own destiny. This fact makes them responsible to the consumers, the ultimate bosses of the capitalist economy. If one relieves them of this responsibility, one deprives them of their very character. They are no longer businessmen, but just a group of men to whom the director has handed over his main task, the supreme direction of the conduct of affairs. Then they--and not the nominal director--become the true directors and have to face the same problem the nominal director could not solve: the problem of calculation.<ref name="Mises_market_socialism">Ludwig von Mises. [http://mises.org/humanaction/chap26sec5.asp "XXVI. The Impossibility of Economic Calculation under Socialism: Quasi-market"], online version of [[Human Action]], referenced 2010-07-07.</ref></blockquote>

For Mises, in short, the key to the capitalist market economy and its successful functioning is the entrepreneurial forecasting and decision-making of private owners and investors. The key is emphatically not the more minor decisions made by corporate managers within a framework already set by entrepreneurs and the capital markets.

For [[Friedrich Hayek|Hayek]], the major problem for the socialist planning board is its lack of knowledge. Without a market, the socialist planning board has no means of knowing the value-scales of the consumers, or the supply of resources or available technologies. The capitalist economy is, for Hayek, a valuable means of disseminating knowledge from one individual to another through the pricing "signals" of the free market. A static, general equilibrium economy would be able to overcome the Hayekian problem of dispersed knowledge, since eventually all data would come to be known by all, but the ever-changing, uncertain data of the real world prevents the socialist planning board from acquiring such knowledge. The knowledge which is yielded by market-pricing cannot be collected by a central authority or programmed into a mechanical device, not just because it is too complex, but rather because it is knowledge given only in use. Unhampered markets transmit this knowledge, which is otherwise irretrievable, dispersed in millions of people.<ref name="Gordon_Anatomy">David Gordon. [http://mises.org/daily/3652/Grays-Anatomy-Selected-Writings "Gray's Anatomy: Selected Writings"], ''Mises Daily'', September 10, 2009. Referenced 2011-03-06.</ref>

Hence, as is usual for Hayek, the argument for the free economy and against statism rests on an argument from ignorance. But to Mises the central problem is not "knowledge." He explicitly points out that even if the socialist planners knew perfectly, and eagerly wished to satisfy, the value priorities of the consumers, and even if they enjoyed a perfect knowledge of all resources and all technologies, they still would not be able to calculate, for lack of a price system of the means of production.

In a critique of socialism by Professor Georg Halm:

<blockquote>Because capital is no longer owned by many private persons, but by the community, which itself disposes of it directly, a rate of interest can no longer be determined. A pricing process is always possible only when demand and supply meet in a market…. In the socialist economy … there can be no demand and no supply when the capital from the outset is in the possession of its intending user, in this case the socialistic central authority. Now it might perhaps be suggested that, since the rate of interest cannot be determined automatically, it should be fixed by the central authority. But this likewise would be quite impossible. It is true that the central authority would know quite well how many capital goods of a given kind it possessed or could procure…; it would know the capacity of the existing plant in the various branches of production; but it would not know how scarce capital was. For the scarcity of means of production must always be related to the demand for them, whose fluctuations give rise to variations in the value of the good in question… If it should be objected that a price for consumption-goods would be established, and that in consequence the intensity of the demand and so the value of the means of production would be determinate, this would be a further serious mistake…. The demand for means of production, labor and capital goods, is only indirect.</blockquote>
Halm then adds that the central authority, contrary to his above concession, would not even be able to find out how much capital it is employing. For capital goods are heterogeneous, and therefore how "can the total plant of one factory be compared with that of another? How can a comparison be made between the values of even only two capital-goods?" In short, while under capitalism such comparisons can be made by means of money prices set on the market for every good, in the socialist economy the absence of genuine money prices arising out of a market precludes any such value comparisons. Hence, there is also no way for a socialist system to rationally estimate the costs (which are dependent on prices in factor markets) of any process of production.

But the decisive rebuttal has been leveled by Mises in Human Action: the [[Soviet Union]] and Eastern European economies were not fully socialist because they were, after all, islands in a world capitalist market. The communist planners were therefore able, albeit clumsily and imperfectly, to use prices set by world markets as indispensable guidelines for the pricing and allocation of capital resources.

Mises's insight was confirmed as early as the mid-1950s, when the British economist Peter Wiles visited Poland, where Oskar Lange was helping to plan Polish socialism. Wiles asked the Polish economists how they planned the economic system. As reported, "What actually happens is that "world prices", i.e. capitalist world prices, are used in all intra-[Soviet] bloc trade. They are translated into rubles ... entered into bilateral clearing accounts."<ref name="Rothbard_calculation_debate">Murray N. Rothbard. [http://mises.org/daily/2401 "The End of Socialism and the Calculation Debate Revisited"], Mises Daily, reposted from ''The Review of Austrian Economics'' in 1991. Referenced 2010-07-07.</ref>

==References==
<div style="font-size:85%">
<references/>
</div>

==Bibliography==
* {{Cite journal
|last=Hayek|first=F. A.|authorlink=Friedrich Hayek
|title=The Use of Knowledge in Society
|journal=[[Wikipedia:The American Economic Review|The American Economic Review]]
|volume=35|issue=4
|year=1945
|pages=519-530
|url=http://www.jstor.org/stable/1809376
}}
* {{Cite journal
|last=Hoppe|first=Hans-Hermann|authorlink=Hans-Hermann Hoppe
|title=Socialism: A Property or Knowledge Problem?
|journal=The Review of Austrian Economics
|volume=9|issue=1
|year=1996
|pages=143-149
|doi=10.1007/BF01101888
|url=http://mises.org/journals/rae/pdf/rae9_1_13.pdf
}}
* {{Cite book
|last=Mises|first=Ludwig von|authorlink=Ludwig von Mises
|title=Economic Calculation in the Socialist Commonwealth
|publisher=[[Mises Institute|Ludwig von Mises Institute]]
|place=Auburn, Alabama
|year=2012
|url=http://mises.org/document/448/Economic-Calculation-in-the-Socialist-Commonwealth
|isbn=978-1-61016-550-1
}}
* {{Cite journal
|last=Rothbard|first=Murray N.|authorlink=Murray Rothbard
|title=The End of Socialism and the Calculation Debate Revisited
|journal=The Review of Austrian Economics
|volume=5|issue=2
|year=1991
|pages=51-76
|doi=10.1007/BF02426928
|url=https://mises.org/journals/rae/pdf/rae5_2_3.pdf
}}

==Links==
*[http://mises.org/humanaction/chap26sec1.asp The Impossibility of Economic Calculation Under Socialism] by [[Ludwig von Mises]]
*[http://mises.org/daily/2401 The End of Socialism and the Calculation Debate Revisited] by [[Murray N. Rothbard]]
*[http://mises.org/journals/scholar/mackenzie10.pdf Oskar Lange and the Impossibility of Economic Calculation] by [[D.W. MacKenzie]]
*[http://mises.org/journals/scholar/Boettke.pdf Socialism: Still Impossible After All These Years] by [[Peter J. Boettke]] and Peter T. Leeson
*[http://mises.org/misesreview_detail.asp?control=267 Must Economies Be Rational?] by [[David Gordon]]
*[http://mises.org/media/5220 Calculation and Socialism] by [[Joseph T. Salerno]], Recorded July 27, 2010 in Auburn, Alabama. Includes an introduction by Mark Thornton (1:00:38).

{{DEFAULTSORT:Economic Calculation Problem}}
[[Category:Austrian School of Economics]]
[[Category:Economic concepts]]

Inflation

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{{For|historical examples of inflation|Inflations}}

'''Inflation''' is a general increase in the [[money supply]].<ref name="Hazlitt_inflation">Henry Hazlitt. [http://mises.org/story/2914 "What You Should Know About Inflation"], ''[[Mises Institute]]'', referenced 2009-06-07.</ref><ref name="Shostak_inflation">Frank Shostak. [http://mises.org/story/908 "Defining Inflation"], ''[[Mises Institute]]'', posted on 2002-06-03, referenced 2009-05-26.</ref>

One of the effects, that may accompany inflation (and is sometimes confused for it) is a rise in [[price]]s. A similar, but opposite effect in kind is [[deflation]].

==Definitions==
There are several ways to define inflation, with varying usefulness and ability to explain the phenomenon.

===Increase in money supply===
[[Price]]s do not stay constant, they are always rising and declining. An increase in the [[money supply]] - inflation, properly defined - has a tendency to raise them in general.<ref name="Rothbard_inflation">Murray N. Rothbard. [http://mises.org/rothbard/mes/chap12f.asp "11. Binary Intervention: Inflation and Business Cycles"], Chapter 12—The Economics of Violent Intervention in the Market, ''[[Man, Economy and State]]'', online version, referenced 2009-05-26.</ref>

<blockquote>When the supply of money is increased, people have more money to offer for goods. If the supply of goods does not increase — or does not increase as much as the supply of money — then the prices of goods will go up. Each individual dollar becomes less valuable because there are more dollars. Therefore more of them will be offered against, say, a pair of shoes or a hundred bushels of wheat than before. A "price" is an exchange ratio between a dollar and a unit of goods. When people have more dollars, they value each dollar less. Goods then rise in price, not because goods are scarcer than before, but because dollars are more abundant.<ref name="Hazlitt_inflation" /></blockquote>

An increased stock of [[commodity]] money will raise the standard of living by further satisfying nonmonetary demands for the commodity. New paper money does not demonstrably benefit some without injuring others.<ref name="Rothbard_inflation" />

===Overly large increase in money supply===
This has been a popular definition in the past. A large increase in the money supply would have the accompanying effects - like price increases. However, it is not clear how large exactly an increase has to be, making it a judgment call.<ref name="Goods">Ludwig von Mises. [http://mises.org/humanaction/chap17sec6.asp "Inflation and Deflation; Inflationism and Deflationism"], ''Chapter XVII. Indirect exchange'', [[Wikipedia:Human Action|Human Action]] online edition, referenced 2009-04-27.</ref>

===Unbacked money===
According to [[Murray N. Rothbard|Rothbard]], '''inflation''' is the process of issuing [[money]] beyond any increase in the stock of specie. In other words, new money substitutes are issued without backing of their specie. The great gain comes from the issuer’s putting new money into circulation. The profit is practically costless, because, while all other people must either sell goods and services and buy or mine gold, the [http://www.grosir-kosmetik.com/63-been-pink-beauty-series.html Been pink] government or the [http://www.grosir-kosmetik.com/62-glutera.html Glutera] commercial banks are literally creating money out of thin air. They do not have to buy it. Any profit from the use of this magical money is clear gain to the issuers.<ref name="Rothbard_inflation" />

===Rising prices===
{{Main|Price inflation}}
In a popular definition, '''inflation''' is an ongoing rise in the general level of prices.<ref name="White_inflation">Lawrence H. White. [http://www.econlib.org/library/Enc/Inflation.html "Inflation"], ''[[Wikipedia:Concise Encyclopedia of Economics|The Concise Encyclopedia of Economics]]'', referenced 2009-05-26.</ref>

However, this fails to explain why inflation is dangerous or exactly how does it cause its effects. "Why should a general rise in prices weaken real [[economic growth]]? Or how does inflation lead to the misallocation of resources? Moreover, if inflation is just a rise in prices, surely it is possible to offset its effects by adjusting everybody's incomes in the economy in accordance with this general price increase."<ref name="Shostak_inflation">Frank Shostak. [http://mises.org/story/908 "Defining Inflation"], ''[[Mises Institute]]'', posted on 2002-06-03, referenced 2009-05-26.</ref>

It is sometimes claimed, that a specific price increase - e.g. of oil - can increase all prices on average. But if people must spend more on oil, will not prices drop for the goods that they can no longer afford to purchase?<ref name="Casey_rising_prices">Christopher P. Casey. [http://mises.org/story/3482 "Only Criminals Use Honest Money"], ''[[Mises Institute]]'', posted on 2009-06-03, referenced 2009-06-3.</ref> (It is also impossible to establish an average of prices of different goods and services.<ref name="Shostak_inflation" />)

It is contended that the increase in commodity prices often occurs ''before'' the increase in the [[money supply]]. Immediately after the outbreak of war in Korea, strategic raw materials began to go up in price on the fear that they were going to be scarce. Speculators and manufacturers began to buy them to hold for profit or protective inventories. But to do this they had to borrow more money from the banks. The rise in prices was accompanied by an equally marked rise in bank loans and deposits. If these increased loans had not been made, and new money had not been issued against the loans, the rise in prices could not have been sustained. The price rise was made possible, in short, only by an increased supply of money.<ref name="Hazlitt_inflation" />

===Historical development of the definition===
The term "inflation" as defined by the [[British Currency School]] was used strictly to denote an increase in the supply of money that consisted in the creation of currency and bank deposits unbacked by gold. It became accepted in the English-speaking world from the mid-nineteenth century.

However, because the writers of the British Currency School neglected to consider bank deposits as part of the money supply, their policies as adopted in Great Britain failed to prevent inflation and the [[business cycle]]. The School’s doctrines and policies fell into profound disrepute by the late nineteenth century, and its definition of inflation was replaced by that of the opposing [[British Banking School|Banking School]], which saw inflation as a state in which the money supply exceeds the needs of trade. From there it was a short step to the currently prevailing definition of inflation as an increase in the price level.<ref name="Salerno_inflation_history">Joseph T. Salerno. [http://www.thefreemanonline.org/featured/money-and-gold-in-the-1920s-and-1930s-an-austrian-view/ "Money and Gold in the 1920s and 1930s: An Austrian View"], ''The Freeman'', Volume: 49, Issue: 10, October 1999. Referenced 2010-08-11.</ref>

==The process of inflation==
Historically, governments have often inflated by debasing [[coin]]s, but they found it is cheaper and faster by creating paper [[money]] on a printing press.

In present times, the methods taken for inflation are usually more indirect. As an example from the US, the government will sell its bonds or other 'IOUs' to the [[bank]]s. In payment, the banks create "deposits" on their books against which the government can draw. A bank in turn may sell its government IOUs to the [[Federal Reserve Bank]], which pays for them either by creating a deposit credit or having more Federal Reserve notes printed and paying them out. This is how money is manufactured.<ref name="Hazlitt_inflation" />

The value of money varies for basically the same reasons as the value of any commodity. Just as the value of a bushel of wheat depends not only on the total present supply of wheat but on the expected future supply and on the quality of the wheat, so the value of a dollar depends on a similar variety of considerations. The value of money, like the value of goods, is not determined by merely mechanical or physical relationships, but primarily by psychological factors which may often be complicated.

The value of a unit of money does not depend only on the present supply of money outstanding. It depends also on the expected future supply of dollars. If most people fear, for example, that the supply of dollars is going to be even greater a year from now than at present, then the present value of the dollar (as measured by its purchasing power) will be lower than the present quantity of dollars would otherwise warrant.<ref name="Hazlitt_inflation" />

===Limits===
If the government of a country is running a printing press, it may seem like a source of infinite wealth. But there are pragmatic limits on how much new money can be printed up each year. The more monetary inflation they sow, the greater the [[price]] inflation they will reap.

At some point, a government would actually make itself poorer in the long run by running the printing press too heavily in the present. For example, if the stock of money would be doubled in one year, the resulting price inflation could destabilize the economy and cause much needless [[capital]] consumption. The citizens would be less willing to invest in their businesses and retirement portfolios, knowing that their savings might be effectively confiscated again through massive creation of new money. Foreign investors would be also wary of exposing themselves to this country if its fiat currency is too volatile.

Because of these considerations, the government would no doubt print new money every year, but wouldn't overdo it. He would aim for a moderate level of constant price inflation, with the purchasing power of his fiat currency slowly falling over time in a predictable manner. Each year, the new influx of money into the economy would represent a transfer of wealth from all other currency holders into the government's possession. If the government wants to spend more money than it receives via its taxes and new money from the printing press (inflation), it can still resort to old-fashioned borrowing.<ref name="Murphy_Limits">Robert P. Murphy. [http://mises.org/daily/4029 "The Fed as Giant Counterfeiter"], Mises Daily, February 01 2010, referenced 2010-02-02.</ref>

Countries which sustained high inflation also often experience [[dollarization]] (the use of foreign currency). A government that has grossly abused its monopoly over the currency and payments system will often find this monopoly more difficult to enforce in the aftermath, and dollarization to be hard to get rid of.<ref name="Reinhart_dollarization">Carmen M. Reinhart and Kenneth S. Rogoff. [http://press.princeton.edu/titles/8973.html "This Time is Different"], ''Princeton University Press'', ISBN 978-0-691-14216-6, p. 191-196. Referenced 2011-07-14.</ref>

===Values===
The median inflation rates before [[World War I]] were well below those of the more recent period: 0.5 percent per annum for 1500-1799 and 0.71 percent for 1800-1913, in contrast with 5.0 percent for 1914-2006. In periods with much lower inflation rates and little expectation of high inflation, much lower inflation rates could be quite shocking and traumatic to an economy - and therefore considered crises.<ref name="Reinhart_Different">Carmen M. Reinhart and Kenneth S. Rogoff. [http://press.princeton.edu/titles/8973.html "This Time is Different"], ''Princeton University Press'', ISBN 978-0-691-14216-6, p.5. Referenced 2011-07-11.</ref>

==Effects of inflation==
{{See also|For and against paper money}}

===Profit of money creators===
Increases in the money supply initiate an exchange of something for nothing. They divert real funding away from those, that generate wealth towards the holders of the newly created money. The general increases in prices, which follow, are a symptom of the erosion of money's purchasing power.<ref name="Shostak_inflation" />

===Ways to increase prices===
The increase in the money supply will create a new level of [[price]]s, but it will not be the old level of prices, multiplied in all relations and quantities.

New money will change the spending habits of people. Also, some of them will make gains and losses and will alter their spending habits accordingly. Therefore, all prices will not increase uniformly. Some prices will rise more than others, therefore, some people will be permanent gainers, and some permanent losers, from the inflation.<ref name="Rothbard_inflation" />

Instead of raising prices, some companies prefer to reduce the quantity of the good sold.<ref name="Tucker_Shrinkage"> Jeffrey Tucker. [http://blog.mises.org/15410/prodcut-shrinkage/ "Product shrinkage"], ''Mises Blog'', January 24, 2011. Referenced 2011-01-25.</ref><ref name="Dickler_product">Jessica Dickler. [http://money.cnn.com/galleries/2011/pf/1101/gallery.downsized_consumer_products/index.html "Your favorite products - now 20% smaller"], ''CNNMoney.com'', January 06 2011. Referenced 2011-01-25.</ref><ref name="Basenese_Shrinkage">Lou Basenese. [http://www.istockanalyst.com/finance/story/5029395/the-shrinkage-factor-10-signs-that-food-inflation-is-alive-and-well The "Shrinkage" Factor: 10 Signs That Food Inflation Is Alive And Well], ''iStockAnalyst'', Apr 01, 2011. Referenced 2011-01-25.</ref><ref name="Clifford_Bags">Stephanie Clifford and Catherine Rampell. [http://www.nytimes.com/2011/03/29/business/29shrink.html?_r=2 "Food Inflation Kept Hidden in Tinier Bags"], ''New York Times'', March 28, 2011. Referenced 2011-01-25.</ref> Another possibility is to create blends of coffee out of cheaper ingredients<ref name="Smith_Bitter">Rich Smith. [http://www.dailyfinance.com/2012/06/19/noticed-that-your-coffee-tastes-funny-heres-why/?a_dgi=aolshare_twitter "The Bitter Truth About Why Your Coffee Isn't Tasting as Good Lately"], ''Daily Finance'', The Motley Fool, Posted 06/19/12. Referenced 2013-01-21.</ref> or watering beer down.<ref name="Dixon_Bitter">Hayley Dixon. [http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/9801908/Bitter-taste-for-drinkers-as-beer-is-watered-down-to-save-money.html "Bitter taste for drinkers as beer is watered down to save money"], ''The Telegraph'', 15 January 2013. Referenced 2013-01-21.</ref>

==Further misconceptions==

===Velocity of money===
It is frequently said that the value of money depends not merely on its quantity but on the "velocity of circulation." Increased "velocity of circulation," however, is not a cause of a further fall in the value of the dollar; it is itself one of the consequences of the fear that the value of the dollar is going to fall (or, to put it the other way round, of the belief that the price of goods is going to rise). It is this belief that makes people more eager to exchange dollars for goods. The emphasis by some writers on "velocity of circulation" is just another example of the error of substituting dubious mechanical for real psychological reasons.<ref name="Hazlitt_inflation" />

''See also [http://www.mises.org/story/918 Is Velocity Like Magic?] by Frank Shostak.''

===Shortage of goods===
A rise in prices can be caused either by an increase in the quantity of money (inflation) or by a shortage of goods — or partly by both. Wheat, for example, may rise in price either because there is an increase in the supply of money or a failure of the wheat crop. But we seldom find, even in conditions of total war, a general rise of prices caused by a general shortage of goods. Even in the [[Wikipedia:Inflation in the Weimar Republic|Germany of 1923]], after prices had soared hundreds of billions of times, high officials and millions of Germans were blaming the whole thing on a general "shortage of goods" — at the very moment when foreigners were coming in and buying German goods with gold or their own currencies at prices lower than those of equivalent goods at home. Similarly, the rise of prices in the United States since 1939 was attributed to a "shortage of goods", while official statistics have shown a rising industrial production.

Nor is a better explanation to say that the rise in prices in wartime is caused by a shortage in civilian goods. Even to the extent that civilian goods were really short in time of war, the shortage would not cause any substantial rise in prices if taxes took away as large a percentage of civilian income as rearmament took away of civilian goods.<ref name="Hazlitt_inflation" />

===Rising commodity prices===
According to some economists<ref name="Bernanke_commodities">Chairman Ben S. Bernanke. [http://www.federalreserve.gov/newsevents/speech/bernanke20080609a.htm "Outstanding Issues in the Analysis of Inflation"], quote: "Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities". Speech, At the Federal Reserve Bank of Boston’s 53rd Annual Economic Conference, Chatham, Massachusetts, June 9, 2008. Referenced 2010-06-22.</ref>, increases in commodity prices such as oil can be behind strong increases in the [[price]]s of goods and services.

If the price of oil goes up, and if people continue to use the same amount of oil as before, people will be forced to allocate more money to oil. If people's money stock remains unchanged, less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come down. (The term "average" is used here in conceptual form. We are well aware that such an average cannot be computed.)

Note that the overall money spent on goods doesn't change; only the composition of spending has altered, with more on oil and less on other goods. Hence the average price of goods or money per unit of good remains unchanged.

Likewise, the rate of increase in the prices of goods and services in general is going to be constrained by the rate of growth of money supply, all other things being equal, and not by the rate of growth of the price of oil.

It is not possible for increases in the price of oil to set in motion a general increase in the prices of goods and services without corresponding support from the money supply.<ref name="Shostak_commodities">Frank Shostak. [http://mises.org/daily/3018 "Commodity Prices and Inflation: What's the Connection?"], Mises Daily, July 2008, referenced 2010-06-22.</ref>

===Budget deficits===
A budget deficit is inflationary only to the extent that it causes an increase in the money supply. If it is fully financed by the sale of government bonds paid for out of real savings, it does not need to cause any inflation.

Inflation can occur even with a budget surplus if there is an increase in the money supply notwithstanding.<ref name="Hazlitt_inflation" />

===Wage price spiral===
Sometimes it is spoken of so-called "inflationary pressures" — particularly the so-called "wage price spiral."

If it were not preceded, accompanied, or quickly followed by an increase in the supply of money, an increase in wages above the "equilibrium level" would not cause inflation; it would merely cause unemployment. And an increase in prices without an increase of cash in people's pockets would merely cause a falling off in sales. Wage and price rises, in brief, are usually a consequence of inflation. They can cause it only to the extent that they force an increase in the money supply.<ref name="Hazlitt_inflation" />

==Inflation compared to counterfeiting==
Why is counterfeiting so bad if the government itself prints money? Suppose that Joe Doakes and his merry men have invented a perfect counterfeit. What would happen? In the first place, the aggregate money supply of the country would increase by the amount counterfeited; equally important, the new money will appear first in the hands of the counterfeiters themselves. Counterfeiting, in short, involves a twofold process: (1) increasing the total supply of money, thereby driving up the prices of goods and services and driving down the purchasing power of the money-unit; and (2) changing the distribution of income and wealth, by putting disproportionately more money into the hands of the counterfeiters.

[[David Hume]], in order to demonstrate the inflationary and non-productive effect of paper money, in effect postulated what Rothbard called the "Angel Gabriel" model, in which the Angel, after hearing pleas for more money, magically doubled each person's stock of money overnight. (In this case, the Angel Gabriel would be the "counterfeiter," albeit for benevolent motives.) While everyone would be happy from their seeming doubling of monetary wealth, society would in no way be better off: there would be no increase in capital or productivity or supply of goods. As people rushed out and spent the new money, the only impact would be an approximate doubling of all prices, and the purchasing power of the money would be cut in half, with no social benefit being conferred. An increase of money can only dilute the effectiveness of each unit of money.

In real life, the very point of counterfeiting is to constitute a process of transmitting new money from one pocket to another. Whether counterfeiting is in the form of making brass or plastic coins that simulate gold, or of printing paper money to look like that of the government, counterfeiting is always a process in which the counterfeiter gets the new money first.

In short, the early receivers of the new money in this market chain of events gain at the expense of those who receive the money toward the end of the chain, and still worse losers are the people (e.g., those on fixed incomes such as annuities, interest, or pensions) who never receive the new money at all. Monetary inflation, then, acts as a hidden "tax" by which the early receivers expropriate (gain at the expense of) the late receivers. As the earliest receiver of the new money is the counterfeiter's gain is the greatest. This [[tax]] is particularly insidious because it is hidden, few people understand the processes of money and banking, and because it is all too easy to blame the rising prices, or "price inflation/' caused by the monetary inflation on greedy capitalists, speculators, wild-spending consumers, or whatever social group is the easiest to denigrate. Obviously, too, it is to the interest of the counterfeiters to distract attention from their own role by denouncing any and all other groups and institutions as responsible for the price inflation.<ref name="Rothbard_counterfeiting">[[Murray N. Rothbard]]. [http://mises.org/books/fed.pdf The Case Against the Fed] (pdf), The Genesis of Money, p.12-15, referenced 2010-03-18.</ref>

==References==
{{Reflist}}

==Bibliography==
* {{Cite book
|last=Hazlitt|first=Henry|authorlink=Henry Hazlitt
|title=What You Should Know About Inflation
|edition=2nd
|publisher=[[Mises Institute|Ludwig von Mises Institute]]
|place=Auburn, Alabama
|year=2007
|url=http://mises.org/document/3127/What-You-Should-Know-About-Inflation
|isbn=978-1-61016-055-1
}}
* {{Cite book
|last=Palyi|first=Melchior|authorlink=
|title=An Inflation Primer
|publisher=Henry Regnery Company
|place=Chicago
|year=1962
|url=http://mises.org/document/5224/An-Inflation-Primer
|oclc=327322
}}
* {{Cite journal
|last=Sennholz|first=Hans F.|authorlink=Hans Sennholz
|title=Inflation and Unemployment
|journal=[[The Freeman]]
|volume=36|issue=6
|year=1986
|pages=226-233
|url=http://www.fee.org/the_freeman/detail/inflation-and-unemployment
}}
* {{Cite book
|last=White|first=Andrew Dickson|authorlink=Wikipedia:Andrew Dickson White
|title=Fiat Money Inflation in France
|publisher=D. Appleton-Century Company
|place=New York
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|url=http://mises.org/document/3041/Fiat-Money-Inflation-in-France
|oclc=5174308
}}
* {{cite encyclopedia
|last=White|first=Lawrence H.|authorlink=Wikipedia:Lawrence H. White
|editor-last=Henderson|editor-first=David R.|editor-link=Wikipedia:David R. Henderson
|title=Inflation
|url=http://www.econlib.org/library/Enc/Inflation.html
|encyclopedia=[[Wikipedia:The Concise Encyclopedia of Economics|The Concise Encyclopedia of Economics]]
|year=2007
|publisher=[[Wikipedia:Liberty Fund|Liberty Fund]]
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}}

==Links==
* [http://www.econlib.org/library/Enc/Inflation.html Inflation] from The Concise Encyclopedia of Economics
* [http://bpp.mit.edu/ The Billion Prices Project], [[Wikipedia:Massachusetts Institute of Technology|MIT]], a series of experimental inflation indexes
* [http://www.mises.org/story/2340 The Revolutionary War and the Destruction of the Continental] by [[Thomas E. Woods, Jr.]]
* [http://libertarianpapers.org/articles/2009/lp-1-43.pdf The Definition of Inflation According to Mises: Implications for the Debate on Free Banking] (pdf) by Nicolás Cachanosky
* {{mb|16955|Just What Is Inflation?|[[Douglas French]]|May 2011}}
* {{md|908|Defining Inflation|[[Frank Shostak]]|March 2002}}
* {{md|3909|The Non-Mystery of Inflation|Mark Spangler|1978}}
* {{mb|4212|Inflation and Supply-Side Economics|[[Stefan Karlsson]]|October 2005}}
* [http://mises.org/daily/4431 "Deficit Financing" and Inflation] by Ludwig von Mises and Bettina Bien Greaves
* [http://mises.org/daily/3729 Gold vs Paper] by [[Ludwig von Mises]], orig. published in July 1953
* [http://mises.org/daily/4654 How the Stock Market and Economy Really Work] by [[Kel Kelly]], September 2010
* [http://mises.org/MediaPlayer.aspx?Id=6022&silverlight=0 Currency Failures from Argentina to Zimbabwe: A Brief History of Inflation] (video) by Timothy D. Terrell, November 2010
* [http://www.cato.org/research/troubled-currencies-project?tab=introduction The Troubled Currencies Project] (maps the official and unofficial exchange rates and effective inflation rates of some currencies, where official data is unreliable or unavailable)

* {{wplink}}

[[Category:Money]]