12¢ Hamburgers and $600 Cars

Consumer Price Index numbers have recently been reported and the federal government assures us that they have inflation under control. Nothing to worry about, go about your business.

In a recent article I explained how government officials can report a low inflation rate by including only particular prices in their price level estimates. Price inflation is due to monetary expansion and the reported level of inflation can be manipulated by omitting the most inflationary prices from the calculations.

The total effect of monetary policy on the price level is also concealed by estimating price inflation in a manner that excludes part of these effects. Government agencies report price inflation. If they reported monetary inflation, the inflation estimates would be much higher. The Federal Reserve expands the money supply, driving prices up. However, by reporting price inflation as they do, the ruling elite lay claim to much lower inflation rates.

The purpose of price indices is to provide an estimate of the increase in a price level over and above some constant price level. However, price indices do not provide us with a measure of the actual increase in prices that is caused by our government’s monetary policies. Government officials have an incentive to conceal how much their monetary policies affect the prices of the goods we purchase. One way to do this is to ignore, as price indices do, part of the price level effects of monetary policies.

First of all, there are reasons to dismiss any measure of a price level. Ludwig von Mises observedthat the “pretentious solemnity which statisticians and statistical bureaus display in computing indexes of purchasing power and cost of living is out of place. These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred.” And in “practical life nobody lets himself be fooled by index numbers.” Price indices do not provide us with accurate indications of the level of inflation. It is possible, however, to roughly estimate the price levels of various situations. For instance, it is possible to get some idea of the total price level effect of monetary policy.

Expansionary monetary policies drive prices up. However, if the money supply was fixed, prices would tend to fall. Any potential decrease in the price level is ignored by the CPI and by price indices in general. To estimate the total price effect of expansionary monetary policies, we must also consider the potential decrease in the price level that would have occurred in the absence of such monetary policies.

The value of money and therefore the price level is determined by the supply and demand for money. As the economy grows, the demand for money tends to increase, driving the value of money up and the price level down. Historically, when economic growth is accompanied by increases in the money supply, the inflationary effects on prices due to the monetary expansion have generally outweighed the economic growth’s negative effects on prices.

The price level increases, but economic growth reduces the amount of the rise of the price level. If there was no real economic growth, then monetary policies would result in even higher prices. The total effect on the price level due to monetary policies includes the increase in the price level due to an expanding money supply and the potential decrease in the price level that would have occurred in the absence of expansionary monetary policies.

In order to get an estimate of the potential decrease in the price level, I will assume that any change in the money supply has a proportional effect on the price level. For example, if the money supply increased from $100 in period one to $200 in period two, then the price level in the second period would be twice as high as it would have been in the absence of the expansionary monetary policy. Admittedly, the increased money supply may not have this proportional effect on the price level. However, all price indices are arbitrary and imprecise calculations that are often presented to the public as precise numbers. The following calculations are simply estimates of the price level effects of government policies.

One can calculate a potential price level that would have occurred with a fixed money supply by recognizing that if the money supply and the price level change proportionately, then the ratio of a fixed money supply to the actual money supply would equal the ratio of the price level given a fixed money supply and the actual price level for a given year. I will assume that the money supply was fixed starting in 1959. If that is the case, then

M1959/Mn = Pfms/Pn

where M1959 is the 1959 level of M3 ($299.7 billion), Mn is the level of M3 in year n, Pfms is the potential price level that would have occurred if there had been a fixed money supply, and Pn is the estimated price level (CPI) in year n. This formula gives us a way, using M3 and CPI data, to estimate Pfms for any particular year. The table below provides us with the estimates of M3, the Consumer Price Index, and the price index that would have occurred if there had been a fixed money supply for various years since 1959.

According to the CPI, the 2005 price level was 6.7 times higher than it was in 1959. However, in the absence of an expanding money supply, the price level would have been one–fifth as high as it was in 1959. Due to economic growth, the price level in this period would have fallen by 80 percent. Therefore, the expanding money supply over the last 46 years has resulted in a current price level over 34 times higher than it otherwise would have been.

Let’s put this in everyday terms. Suppose these estimates represent the changes in the prices of goods such as hamburgers, cars, and housing. According to these numbers, a hamburger that cost 60¢ in 1959 would have cost $4 in 2005. If the money supply had been fixed, however, that hamburger would only cost 12¢ today. Similarly, a $20,000 car in 2005 would have cost slightly less than $3,000 in 1959. Again, without the monetary effect on prices, that car would only cost $600 today. The price of a $45,000 house in 1959 would have increased to $300,000 in 2005. With a fixed money supply, that house would cost $9,000 today.

Currently, price inflation is thought of as an increase in the price level above some previous level. However, if we think of price inflation as the increase in the price level over and above what the price level would have been in the absence of the expansionary monetary policies, then this gives us a more accurate picture of the effects of government policies. The estimations provided here show that the price level effects due to government manipulation of the money supply are much larger than indicated by standard price indices.

Mark Brandly is an Associate Professor of Economics at Ferris State University. Send him mail. See his archive. Comment on the blog.