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
of silver
of silver
2)100 ounce $100 paper bills
IOU of Silver
lent to Jeremy Lin
3)0 $100 paper bills
spent wastefully
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.