Thinking about money, inflation and American experience

When the money supply goes up faster than the total production of goods and services, the result is inflation of prices. When the money supply goes up slower than the GDP, the result is that prices go down. How am I to understand this?

I have lived through a lot of inflation. When I first started to work in 1950 I was paid 50 cents an hour. That was pretty good money for a kid. Today the minimum wage in Maryland is $7.25 per hour. The difference is primarily one of inflation. I lived for several years in Chile when the annual inflation was more than 20 percent, giving me a visceral feeling that the value of money was ephemeral.

Gold and silver came to be money by cultural evolution over a long historical period rather than be planning. They are stable materials, suitable for coining, that are difficult and costly to find, mine, refine and manufacture into coins. They serve as a marker for value due to those properties. There have been, however, many other forms of money.

It is only recently in historical terms that governments have come to understand money as symbol, to recognize the role of the money supply in affecting prices. and to have the basis in economic theory to seek to define monetary policy to plan and manage the supply of money.

It costs the tax payer about three cents to produce piece of paper money, whether that bill is worth $1, $5, $10. $20, $50, $100 or more. What makes the bill worth its face value is the legislation that declares it to be "legal tender". The law requires that people in the United States accept legal tender in payment for debts and purchases (while checks and other forms of payment need not be accepted under law).

The U.S. Constitution granted the federal government the right to coin money. In the 19th century the United States minted both silver and gold coins, raising the problem of the ratio of the actual market value of the two metals. When the silver in coins was worth more than the face value of the coins (which could be obtained with gold coins), people melted down the silver coins leading to money shortages.

During the Civil War, the Union started printing "greenbacks" using paper currency to finance the war. In the post Civil War years the nature of money was in considerable debate. In 1870 the Supreme Court found that it was unconstitutional for the government to issue paper money, a decision that was reversed in subsequent decisions in the following decade. Congress in the 1970s addressed the issue of backing payment of the U.S. debt with gold or silver, vacillating as to whether to allow silver to be used.

Production is based on people, natural resources, investment, and technology. In the latter part of the 19th century, with very high levels of immigration, expanding rapidly into the west and discovering new natural resources, drawing investment from all over the world as well as sustaining high levels of domestic savings, and experiencing rapid technological innovation and dissemination, the rate of growth of the U.S. GDP was very high. The growth of the gold supply could not keep pace, and for much of the time silver was not freely minted into coins. As a result, money grew scarce and there was deflation. The prices of goods and services went down. However, debts incurred when the value of money was high had to be paid with money that was now worth more. Farmers especially were hit, since there was a global deflation in agricultural prices as well as a domestic one, and their income went down while their debts did not.

As Hofstadter points out in The Age of Reform, this situation was a key causation of the unrest in the farm states that led to the Populist movement. The silver miners in the mountain states joined in the movement realizing that increasing the role of silver in the money supply would create more income for them. This led to William Jennings Bryan's Cross of Gold speech at the 1896 Democratic National Convention calling for the free coinage of silver. This has been called the greatest political speech in American history and propelled the young Congressman Bryan to the presidential nomination of his party and to national prominence that lasted for decades.

Today life is more complicated. We pay our bills with checks and credit cards. Banks and other financial institutions essentially create money. lending and re-lending money as the currency circulates in the economy. Fortunately, countries have created central banking establishments and systems of economic accounts that help the government keep track of the money supply; when the governmental institutions do a good job, the money supply grows in step with the GDP, meeting targets for inflation. It is only on relatively rare occasions, such as the end of the last decade, in which unexpected financial crisis hits and the money supply contracts in unforeseen ways.