Only (Too Much) Money Causes Inflation

By: Don Mathews
January 3, 2024

To repeat: many economists seem to have forgotten what causes inflation.

The explanations of the post-pandemic inflation that economists have advanced most frequently are supply chain disruptions from the pandemic and the Russia-Ukraine war and rising wages driven by the tight labor market.

Supply chain disruptions and rising wages are simple, intuitive and thus appealing explanations of inflation. In fact, each is a specific case of what is commonly called “cost-push” inflation.

The notion of cost-push inflation has been thoroughly discredited numerous times over the past 250 years. Here’s why.

Prices of individual goods and the general level of prices are two significantly different things. The price of any individual good is a microeconomic phenomenon; it is determined a plethora of factors, including the cost of producing the good. Supply disruptions or rising wages that increase the cost of producing an individual good often lead to an increase in the price of the good.

The general level of prices is a macroeconomic phenomenon; it is determined by the supply of money in circulation relative to real GDP, the economy’s total output of final goods and services. Only a change in the money supply relative to real GDP can cause the general level of prices to change.

An increase in the price of an individual good is not inflation. It may be a symptom of inflation, but it’s not inflation. 

Inflation is the persistent increase in the general level of prices. The only way the general level of prices can increase persistently is if the growth rate of the money supply, which is determined by the Federal Reserve, persistently exceeds the growth rate of real GDP, which is pretty stable. 

In the post-pandemic inflation, the 12-month rate of inflation rose from 1.4% in January 2021 to 8.9% in June 2022. Only a high rate of money supply growth can cause that sort of inflation.

Supply chain disruptions cannot cause anything close to that sort of inflation. Supply chain disruptions have no effect on the money supply, never mind its rate of change. And when supply chain disruptions affect real GDP growth, the effects are small and temporary.

Supply chain disruptions generally affect a small percentage of goods and services produced. They do cause production costs to increase, but not persistently. 

When the price of a good increases, buyers reduce the amount they buy. Consequently, businesses that raise prices in response to a supply chain disruption reduce production as well. Less production means less demand for the other resources those businesses use, which reduces the prices of those resources to businesses not directly affected by the supply chain disruption.

It doesn’t happen overnight, but a supply chain disruption that causes higher production costs, higher prices and less production of certain goods inevitably causes lower production costs, lower prices and more production of other goods.

Rising wages driven by a tight labor market can be a symptom of inflation, but rising wages do not cause inflation, and not only for the same reasons that supply chain disruptions don’t cause inflation.

The primary driver of rising wages is rising worker productivity. The more productive workers are, the harder firms compete for them. Rising productivity pays for rising wages.

Cost-push inflation is thus a myth. Inflation has a single cause: excessive money supply growth.

From 2000 to 2019, the U.S. money supply increased at an average annual rate of 6.2%. It then increased by 25.7% in 2020, and another 11.4% in 2021. From February 2020 to February 2022, the U.S. money supply increased by 40.4%.

That’s what caused the post-pandemic inflation.  

Reg Murphy Center