Almost everyone knows that inflation is defined as “Too much money chase too few goods”, butnot many people know what causes inflation. The majority of people believe that the process of printing money by the issuing authority such as the Federal Reserve is the culprit that causes inflation;however, it is not right. In this article, I will use a theory that has been thoroughly ignored among mainstream economists to explain why it is wrong and what is the true cause of inflation. This is known as “The Real Bill Doctrine” or “Backing Theory”.
In ages, the majority of macroeconomists have always emphasizes the positive relationship of “inflation” and “money supply” (the total amount of money available in the market at specific time). They believe an increase in money supply will proportionally increase the price level, which will lead to inflation. These economists are referred as “Quantity Theorists.”Their belief comes from the “Equation of Exchange”, which is MV=PY. “M is the quantity of money, P is the price level, and Y is aggregate output. V is velocity, which serves as the link between money and output. Velocity is the number of times in a year that a dollar is used to purchased goods and services.” (CH21, TheDemand for Money) As a result, this equation tells people that an increase in M will lead an increase in P.
Indeed, if we assume that all the Federal Reserve does is print money and sprinkle them by helicopters from the sky, then no doubt it will cause inflation regardless of any theory. However, that’s not the case in the real world because whenever the Federal Reserve issues new paper money, they can’tjust throw them into the market, but instead they have to use that money to purchase different assets that are equivalent to the value of the money they issued. The asset can be anything such as foreign government bonds, bank bonds, land, etc. This process of using issued money to purchase equivalent value of assets is called the “Backing Theory”.
The Microeconomics professor Michael Sproul, who is currently teaching in the University of Southern California, named the “Backing Theory”. This theory can be traced back to the “Real Bill Doctrine”, which can be found in the writing of John Law (1705), Simon Clement (1710), Adam Smith (1716), and many others. Unlike the Quantity Theory, the Backing Theory states that an increase or decrease in the money supply will normally have no effect on the price level as long as the money issuer has sufficient assets to cover redemption. To reconcile the Backing Theory with the equation of MV=PY, the Backing Theory says an increase M (money) will increase Y rather than P because Y is not the aggregate output of goods, but the quantity of goods bought with M.
The following is an example that I created to explain the cause of inflation in Backing Theory perspective.
1) 50 ounces $50 paper bills
2)100 ounce $100 paper bills
IOU of Silver lent to Jeremy Lin
3)0 $100 paper bills
In the calculation of line 3, we noticed that there is inflation in the market because each ounce of silver is now worth $1.67 paper dollar. Ifthe Federal Reserve still maintains the convertibility of 1 oz. = $1.00, then people will run to the bank and convert their money back into silvers. Unfortunately, there is only 150 ounces of silver to withdraw, so the last person who’s holding $100 paper will get nothing, and result in bankruptcy. If bank wants to avoid bankruptcy, the only way is to “suspend convertibility”, which means people cannot bring their paper bills to the bank teller to ask for an exchange anymore. The consequence of “suspend convertibility” is that the market will always maintain the inflation, $1.67/oz.
This example can apply to the real world too. Today, our Federal Reserve prints money in exchange of equal value bonds from the local banks, bonds from corporations (bailout), bonds from other countries, and other types of assets. We have inflation is not because of the action of “printing paper”, but because the depreciation of the asset that is backing the money. The depreciation can result from devaluation of foreign government bonds (if the foreign country is having a recession, their bond value will fall), default of banks and corporations etc.The U.S dollar we are using todayis called “fiat money”, which defined as “inconvertible currency”. This type of currency allows Federal Reserve to print money without worrying bankruptcy, but results in inflation.
After all, it is obvious that Backing Theory’s explanation towards the cause of inflation seems much more convincing than the Quantity Theory.