Inflation & Deflation
November 11, 2008 · Posted in Monetary Economics
Inflation and deflation are market phenomena whose occurrence only becomes important under a fiat money system. Under a voluntary money system in which individuals are given the immediate choice to choose what they in fact prefer as the best money, goods that are limited in supply will naturally prevail and inflation will be modest and negligible. It is a historical fact that over time the precious metals gold and silver outstripped all other goods as media of exchange for their limited supply, durability, uniformity, divisibility, and aesthetic appeal. In the Untied States it was of course the compulsory intervention by a cash strapped government that outlawed the non-acceptance of the paper dollar, a fiat money, and on top of that outlawed any private ownership of gold.
Inflation is defined as an increase in the money supply, the nominal amount of money units held by all individuals within a certain territory.
Inflation occurs in a fiat money system when the central bank or fractional reserve banks produce additional money to be used in a certain territory and use it to buy goods or to perform credit transactions with other individuals on the market.
Since the marginal value preference assigned by individuals to each additional unit of money will be lower the more money they hold, the price of goods expressed in terms of money will be more likely to rise over time, if the money growth exceeds the growth of other goods.
The fundamental issue with inflation is not that prices go up. If the newly created money was distributed evenly across society, all incomes would rise in lockstep with prices. The entire operation would be a zero sum game. The fundamental issue is that inflation in a fiat money system occurs through creation of new money that certain individuals receive earlier than others. Wealth is thus shifted from those who receive the money later (after prices have already gone up) to those who receive it earlier (before prices have gone up). Typically this means a shift of wealth from workers to the government and to owners of fractional reserve banks and the central bank. It lowers the general standard of living insofar as it becomes less desirable to perform work that fulfills voluntary value preferences and more desirable to perform work based on bureaucratic government decisions that involve theft and compulsory action.
Deflation is defined as a drop in the money supply. It occurs when the central bank or fractional reserve banks reduce the money supply by reversing their inflation by selling goods other than money, thus withdrawing money out of circulation, or when individuals make more re-payments as part of credit transactions (which they entered into with the central banks or fractional reserve bank) than additional money is produced.
As the money supply declines, the price of other goods in terms of money is more likely to drop over time.
Deflation is in essence a correction of the previous misallocations created by inflation.
Addendum: What I was referring to above is monetary inflation. Please see more details in Inflation & Deflation Revisited.