Economic Growth Doesn't Cause Inflation (The Fed Does)


On Wednesday Wall Street eagerly awaited the latest pronouncement from the nation’s central planners of the monetary and banking system. And although the official Fed statement itself was more nuanced, the press coverage of it repeated one of the crudest inheritances from the Keynesian revolution: the fallacy that economic growth causes price inflation.

The crazy idea is encapsulated in the subtitle of the article I’ve hyperlinked above: "Despite slowdown in economic growth, risks of inflation remain." Then the first paragraph informs us:

The Federal Reserve left a key interest rate unchanged on Wednesday as the economy signaled that it was on track for a soft landing in which growth slows enough to restrain inflation.


As with most faulty economic doctrines, the claim that economic growth causes price inflation isn’t just wrong, it’s exactly backwards. Let’s go back to basics. The price of something (quoted in dollars) is just the exchange ratio between dollar bills and the good in question.

Now what happens when the quantity for sale of a particular good or service increases? For example, why are American laborers worried about Mexican immigrants coming into the country? Why, they’re worried that with a larger supply of labor, the wage rate (measured in dollars) will go down. Nobody in his right mind would say, "Because of huge increases in the pool of laborers, economists are worried that wages might spike out of control, making it difficult for employers to maintain their profit margins."

It’s the same thing when it comes to other goods and services. If the economy cranks out five percent more stuff this year than last year, those items will be more affordable to consumers, not less! If you’re haggling with a merchant at a fruit stand over some bananas, and then another merchant pulls his banana cart up next to the first guy, is that going to help you or hurt you in your negotiations?

Now granted, there are all sorts of caveats. The dollar price of a good isn’t due to a simple mechanical formula, whereby one divides the "total amount of output" (whatever the heck that phrase even means) by the total quantity of money to come up with the "price level" (again, whatever the heck that phrase even means). Even if the amount of money and amount of production remain constant, if all of a sudden people decide they detest holding pictures of U.S. presidents, then dollar prices will rise as people try to unload their dollars in exchange for other goods. So I don’t want my above musings to detract from the subtleties of the analysis; supply and demand matter, even when it comes to the "price" of money.

Even so, the point remains: Other things equal, the larger the growth in real output, the lower dollar prices will be. Economic growth reduces inflation. The financial press has it exactly backwards.


What then does cause price inflation? Is it Arab tycoons, stock speculators, or perhaps thuggish labor unions?

Nope. Private individuals can influence the prices of particular goods and services, but they can’t raise prices in general. If OPEC succeeds in driving up the price of oil (and hence gasoline), Americans will spend more at the pump. But that means Americans will have less money to spend at the movie theater and fancy restaurant, so prices in general won’t rise.

The one institution that does have the power to generate price inflation is the central bank. When the Federal Reserve decides the time is ripe for an "open market operation," it buys U.S. bonds from member banks and credits their accounts with the Fed itself.

Now where does this "credit" come from? Is there an account of "Fed money" (backed up by the gold at Fort Knox perhaps) that gets debited by $10 million, and then member bank XYZ’s account is credited by $10 million?

No, that’s not it. The Fed simply adds numbers to bank XYZ’s balance. Poof! New base money created out of thin air. And then, due to the magic of the fractional reserve banking system, those new reserves get pyramided into an even larger addition to the overall quantity of money in the economy.

Other things equal, when you add to the stock of money, its price in terms of other goods and services will fall. When the "price" of money falls, that means dollar prices of goods and services go up, because the money is worth less than it was before.

In other words, if the Fed really wants to control price inflation, all it needs to do is stop inflating the money supply.