True Inflation

True inflation happens when a further increase in effective demand produces no increase in output.

• Instead, the demand raises the cost-unit proportional to the increase in effective demand.

Up to this point, the effect of monetary expansion is entirely a question of degree, and there is no previous point at which we can draw a definite line and declare that conditions of inflation have set in.

Every previous increase in the quantity of money is likely, in so far as it increases effective demand, to spend itself partly in increasing the cost-unit and partly in increasing output.

Thus, we have an asymmetry on the two sides of the critical level above which true inflation sets in. For a contraction of effective demand below the critical level will reduce its amount measured in cost-units; whereas an expansion of effective demand beyond this level will not, in general, have the effect of increasing its amount in terms of cost-units.

This result follows from the assumption that the factors of production, and in particular the workers, are disposed to resist a reduction in their money-rewards, and that there is no corresponding motive to resist an increase.

This assumption is, however, obviously well founded in the facts, due to the circumstance that a change, which is not an all-round change, is beneficial to the special factors affected when it is upward and harmful when it is downward.

If, on the contrary, money-wages were to fall without limit whenever there was a tendency for less than full employment, the asymmetry would, indeed, disappear. But in that case there would be no resting-place below full employment until either the rate of interest was incapable of falling further or wages were zero. In fact we must have some factor, the value of which in terms of money is, if not fixed, at least sticky, to give us any stability of values in a monetary system.

The view that any increase in the quantity of money is inflationary (unless we mean by inflationary merely that prices are rising) is bound up with the underlying assumption of the classical theory that we are always in a condition where a reduction in the real rewards of the factors of production will lead to a curtailment in their supply.

With the aid of the notation introduced in Chapter 20 we can, if we wish, express the substance of the above in symbolic form.

Assuming MV = D

• M is the quantity of money
• V is its income-velocity (this definition differing in the minor respects indicated above from the usual definition)
• D the effective demand

If, then, V is constant, prices will change in the same proportion as the quantity of money provided that ep ( = Ddp/pdD), is unity. This condition is satisfied (see Chapter 20 §I above) if eo = 0 or if ew = 1.

The condition ew = 1 means that the wage-unit in terms of money rises in the same proportion as the effective demand, since ew = DdW/WdD and the condition eo = 0 means that output no longer shows any response to a further increase in effective demand, since eo = DdO/OdD. Output in either case will be unaltered.

Next, we can deal with the case where income-velocity is not constant, by introducing yet a further elasticity, namely the elasticity, of effective demand in response to changes in the quantity of money,

ed = MdD/DdM

This gives us:

Mdp/pdM = ep.ed where ep = 1 - ee.eo (1 - ew)

so that:

e = ed - (1 - ew)ed . ee.eo

= ed (1 - ee. eo + ee.eo.ew)

where e without suffix ( = Mdp/pdM) stands for the apex of this pyramid and measures the response of money-prices to changes in the quantity of money.

Since this last expression gives us the proportionate change in prices in response to a change in the quantity of money, it can be regarded as a generalised statement of the Quantity Theory of Money. I do not myself attach much value to manipulations of this kind

I warn again that they involve just as much tacit assumption as to what variables are taken as independent (partial differentials being ignored throughout) as does ordinary discourse, whilst I doubt if they carry us any further than ordinary discourse can. Perhaps the best purpose served by writing them down is to exhibit the extreme complexity of the relationship between prices and the quantity of money, when we attempt to express it in a formal manner.

Of the four terms ed, ew, ee and eo upon which the effect on prices of changes in the quantity of money depends,

ed is the liquidity factors which determine the demand for money in each situation ew is the labour factors (or, more strictly, the factors entering into prime-cost) which determine the extent to which money-wages are raised as employment increases ee and eo are the physical factors which determine the rate of decreasing returns as more employment is applied to the existing equipment.

If the public hold a constant proportion of their income in money, ed = 1; if money-wages are fixed, ew = 0; if there are constant returns throughout so that marginal return equals average return, eeeo = 1; and if there is full employment either of labour or of equipment, eeeo = 0.

Now e = 1, if ed = 1 and ew = 1; or if ed = 1, ew = 0 and ee.eo = 1; or if ed = 1 and eo = 0.

There is a variety of other special cases in which e = 1. But in general e is not unity; and it is, perhaps, safe to make the generalisation that on plausible assumptions relating to the real world, and excluding the case of a “flight from the currency” in which ed and ew become large, e is, as a rule, less than unity.

Section 7

In the long run is there not some simpler relationship?

If there is some tendency to a measure of long-run uniformity in the state of liquidity-preference, there may well be some sort of rough relationship between the national income and the quantity of money required to satisfy liquidity-preference, taken as a mean over periods of pessimism and optimism together.

There may be, for example, some fairly stable proportion of the national income more than which People will not readily keep in the shape of idle balances or long periods together, provided the rate of interest exceeds a certain psychological minimum; so that if the quantity of money beyond what is required in the active circulation is in excess of this proportion of the national income, there will be a tendency sooner or later for the rate of interest to fall to the neighbourhood of this minimum.

The falling rate of interest will then, cet. par., increase effective demand, and the increasing effective demand will reach one or more of the semi-critical points at which the wage-unit will tend to show a discontinuous rise, with a corresponding effect on prices. The opposite tendencies will set in if the quantity of surplus money is an abnormally low proportion of the national income. Thus the net effect of fluctuations over a period of time will be to establish a mean figure in conformity with the stable proportion between the national income and the quantity of money to which the psychology of the public tends sooner or later to revert.

These tendencies will probably work with less friction in the upward than in the downward direction. But if the quantity of money remains very deficient for a long time, the escape will be normally found in changing the monetary standard or the monetary system so as to raise the quantity of money, rather than in forcing down the wage-unit and thereby increasing the burden of debt. Thus the very long-run course of prices has almost always been upward. For when money is relatively abundant, the wage-unit rises; and when money is relatively scarce, some means is found to increase the effective quantity of money.

During the nineteenth century, the growth of population and of invention, the opening-up of new lands, the state of confidence and the frequency of war over the average of (say) each decade seem to have been sufficient, taken in conjunction with the propensity to consume, to establish a schedule of the marginal efficiency of capital which allowed a reasonably satisfactory average level of employment to be compatible with a rate of interest high enough to be psychologically acceptable to wealth-owners.

There is evidence that for a period of almost one hundred and fifty years the long-run typical rate of interest in the leading financial centres was about 5 pet cent., and the gilt-edged rate between 3 and 3.5% and that these rates of interest were modest enough to encourage a rate of investment consistent with an average of employment which was not intolerably low.

Sometimes the wage-unit, but more often the monetary standard or the monetary system (in particular through the development of bank-money), would be adjusted so as to ensure that the quantity of money in terms of wage-units was sufficient to satisfy normal liquidity-preference at rates of interest which were seldom much below the standard rates indicated above.

The tendency of the wage-unit was, as usual, steadily upwards on the whole, but the efficiency of labour was also increasing. Thus the balance of forces was such as to allow a fair measure of stability of prices; — the highest quinquennial average for Sauerbeck’s index number between 1820 and 1914 was only 50 per cent. above the lowest. This was not accidental.

It is rightly described as due to a balance of forces in an age when individual groups of employers were strong enough to prevent the wage-unit from rising much faster than the efficiency of production, and when monetary systems were at the same time sufficiently fluid and sufficiently conservative to provide an average supply of money in terms of wage-units which allowed to prevail the lowest average rate of interest readily acceptable by wealth-owners under the influence of their liquidity-preferences. The average level of employment was, of course, substantially below full employment, but not so intolerably below it as to provoke revolutionary changes.

To-day and presumably for the future the schedule of the marginal efficiency of capital is, for a variety of reasons, much lower than it was in the nineteenth century. The acuteness and the peculiarity of our contemporary problem arises, therefore, out of the possibility that the average rate of interest which will allow a reasonable average level of employment is one so unacceptable to wealth-owners that it cannot be readily established merely by manipulating the quantity of money. So long as a tolerable level of employment could be attained on the average of one or two or three decades merely by assuring an adequate supply of money in terms of wage-units, even the nineteenth century could find a way. If this was our only problem now — if a sufficient degree of devaluation is all we need — we, to-day, would certainly find a way.

But the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners.[2] If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money. From the percentage gain, which the schedule of marginal efficiency of capital allows the borrower to expect to earn, there has to be deducted

1. The cost of bringing borrowers and lenders together,

2. Income and surtaxes and (3) the allowance which the lender requires to cover his risk and uncertainty, before we arrive at the net yield available to tempt the wealth-owner to sacrifice his liquidity. If, in conditions of tolerable average employment, this net yield turns out to be infinitesimal, time-honoured methods may prove unavailing.

To return to our immediate subject, the long-run relationship between the national income and the quantity of money will depend on liquidity-preferences. And the long-run stability or instability of prices will depend on the strength of the upward trend or the wage-unit (or, more precisely, of the cost-unit) compared with the rate of increase in the efficiency of the productive system.

Author’s Footnotes

1. Cf. Chapter 17 above.

2. Cf. the nineteenth-century saying, quoted by Bagehot, that “John Bull can stand many things, but he cannot stand 2 per cent.”