Inflation is …
Inflation is one of the most misunderstood concepts in finance, perhaps because the term is often used imprecisely. I will use the word precisely in this essay, not in the sense that I will use it in the only “correct” way, but in the sense that when I use it here, it will mean the very specific thing I intend it to mean.
Irving Fisher’s Equation of Exchange connects money and economic activity:
MV=PQ
For purposes of this essay, “inflation” means a positive change in P, and “deflation” means a negative change in P. Thus, as used here, inflation means a general rise in nominal prices, the kind of thing that allows us to say that $X in 1927 is the equivalent of $Y in 2020, not a change in real prices for individual goods or services (transistors or tummy-tucks) or in the price of assets, which I consider a reduction in the price of risk. Fisher’s equation may hold for a segment of the economy, but in this essay I am concerned with a particular economy: the one that uses the US dollar as its medium of exchange. That economy is bigger than the US alone, which is why Q cannot by measured as the goods and services comprising GDP.
Inflation is a tax.
Let’s get this bugbear out of the way early. Yes, inflation is a tax. Before there was inflation, governments actually imposed an overt tax on cash. Money could not be used as legal tender unless it bore a current stamp, and the stamp could only be obtained by paying a tax. The purpose of the tax was to discourage hoarding of cash in a barter economy. If you sold something, you were expected to buy something. To be clear, the point was not to discourage saving. The “demurrage” tax applied to cash, not other assets. Capital spending is spending, too. Money could be saved so long as it was invested. A policy that promotes spending does not necessarily promote consumption.
Too much is made of the fact that inflation is a tax. Taxes are a necessary feature of economic life. We tax property, income, and behavior (like using gasoline or tobacco). Of these, perhaps the most easily defended are the excise taxes, the ones that create disincentives to behaviors that have bad effects on the general public (externalities)…
