In a previous article, I claim that central banks cause inflation by adding new money to the money supply. A critic of my position may challenge this point: Aren’t there other explanations for inflation? Yes, it is true, there are other causes. Let’s explore one of the alternative explanations, often referred to as “ripple theory.” It is a true account, but I will argue that it only refers to limited instances of inflation, not to the broad and persistent inflation that we have experienced in the last hundred years.
To understand the ripple theory, we must first distinguish two uses of the term inflation:
1) Inflation: addition to the money supply. The word inflation means increases in the monetary base, and our own monetary authority uses the term in this sense. The Fed refers to its own participation in the market as inflation. One of the central missions of the Fed is to inflate the currency specifically to lower long-term interest rates and increase employment. This is not a secret or a debate; simply go to the Fed website and they will tell you what they do: “The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation.”
2) But inflation also refers to the rising of prices. A critic of my position may question the relationship between monetary inflation – increases in the money supply – and price inflation – increases in the price of goods. Since these usages refer to different phenomena, a critic of my position will assert that they are not causally connected. He will claim that monetary inflation is not the cause, or at least not the only cause, of price inflation.
This is true: monetary inflation is not the only cause of price inflation. Prices can rise for many reasons. Scarcity, increased demand, decreased production, corporate greed, etc, can all raise prices. But there is a limit to this kind of price inflation. It is dishonest to attribute broad and persistent price inflation across the whole of the economy to factors such as these without mentioning monetary inflation.
A person who argues as above is arguing for the ripple theory of inflation. According to the ripple theory, when the price of a central commodity, such as gasoline, rises, it causes a ripple of price increases through the rest of the economy. This is true: if the price of a central commodity raises for whatever reason, we will often experience some associated price inflation. Since gasoline costs more, transportation companies must charge more to offset their higher costs, businesses must charge more to offset the higher price of transportation, and customers must pay more to meet the higher price of business. Thus, a ripple theorist might argue, inflation spreads without any increase in the monetary supply.
All of this is true. But this theory cannot account for broad and persistent price inflation. All of the prices in society cannot rise together in the ripple theory of inflation as they do in the monetary theory of inflation.
Consider the following: If people spend more on gasoline, they have less to spend in other areas of the economy. The higher price of gasoline gives people two options: buy less gasoline or buy less of another commodity. Everyone has felt this pinch and acted accordingly. When gasoline prices rise, customers lose purchasing power for all other businesses. All other businesses must lower prices to continue to make sales. A rise in the price of a central commodity will create price inflation in one place, but price deflation in other areas. In this way, the ripple theory can only explain temporary and limited forms of price inflation.
The only way all prices can rise together across the whole of the economy is if more money enters the market. What we have seen in America in the last one hundred years is broad and persistent price inflation across the entire economy. The dollar has lost fully 95 percent of its value since our government abandoned the gold standard and gave itself the power to print money out of thin air. This type of inflation – the most pernicious kind – the kind that has kept the lower classes behind the rising cost of living – is caused by and increasing money supply, not by rippling price increases.