Do Banks Cause Inflation? What are other possible causes?

Question

Some people believe that inflation is caused by an increase in the money supply when the banks print more notes engage in fractional reserve lending. Is this correct?

As I understand it, when there is more available money in the market, the price of goods will increase. But will a normal merchant acknowledge the increase of money supply and raise prices immediately? I posit that, in the short run, merchants won't increase prices in response to increased money supply.

So, why does increased money supply lead to price inflation?

Specifically, after the banks print more notes, where will the money be distributed first? Who will be the first one to have a need to rise their price? Does the enterprise borrow more money and spend more money in the market, and then the merchant increase their price when there are a lots of order?

Answer 1

No, it isn't generally believed that inflation is caused by individual banks printing money. Governments manage money supply through Central Banks (which may, or may not, be independent of the state).

There are a number of theories about money supply and inflation (from Monetarist, to Keynesian, and so on). The Quantity Theory of Inflation says that long-term inflation is the result of money-supply but short-term inflation is related to events/local conditions.

Short-term inflation is a symptom of economic change. It's like a cough for a doctor. It simply indicates an underlying event.

When prices go up it encourages new producers to enter the market, create new supply which will then act to lower prices. In this way inflation is managed by ensuring that information travels throughout the economy. If prices go up for specific goods, then - all things being equal - supply should go up since the increase implies increasing demand. If prices go down then this implies demand has gone down and so producers will reduce supply.

Obviously this isn't a perfect relationship. There is "stickiness" which can be caused by a whole bunch of market conditions (from banning of short-selling, to inelasticity of demand/supply).

Your question isn't about quantitative easing (which is a state-led way of increasing money-supply and which could increase inflation but is hoped to increase expenditure and investment) so I won't cover that here.

The important take-away is that inflation is an essential price signal to investors and business people so that they can assess market cycles. Without it we would end up with vast over- or under-supply and much greater economic disruption.

Answer 2

Some people believe that inflation is caused by an increase in the money supply when the banks engage in fractional reserve lending. Is this correct?

You are referring to the Austrian school of thought. The Austrians define inflation in terms of money supply. In other words, inflation is defined as an increase in the aggregate money supply, even if prices stay the same of fall.

This is not the only definition of inflation. The mainstream defines inflation as a general increase in the prices of consumer goods.

Based on the first definition, then your supposition is correct by definition. Based on the second definition, you can make a case that money supply affects prices. But keep in mind, it's just one factor affecting prices. Furthermore, economics is resistant to experimentation, so it is difficult to establish causality.

Austrian economists tend to approach the problem of "proof" using a 2-pronged tactic: establish plausibility by explaining the mechanism, then look for historical evidence to back up that explanation.

As I understand it, when there is more available money in the market, the price of goods will increase. But will a normal merchant acknowledge the increase of money supply and raise prices immediately? I posit that, in the short run, merchants won't increase prices in response to increased money supply.

So, why does increased money supply lead to price inflation?

The simple answer, in the Austrian school of thought, is that you have more money chasing the same amount of goods. In other words, printing money doesn't actually increase the number of widgets made.

I believe the Austrian school is consistent with your supposition that prices don't increase in the short run. In other words, producers don't increase prices immediately after observing an increase in the money supply.

Specifically, after the banks print more notes, where will the money be distributed first?

The Austrian story goes as follows:

Imagine that the first borrower is a home constructor, and he is borrowing freshly "printed" money to build new homes. This constructor will need to buy materials and hire labor to build homes, and in doing so he will bid against other home constructors. The increased demand for lumber, nails, tools, carpentry, etc. will ever so slightly increase the market prices for these goods and services.

So the money goes first to the borrower, but then flows also to the people selling to the borrower, and the people selling to the sellers, etc. It has a ripple effect.

Who will be the first one to have a need to rise their price?

These producers won't need to increase their price, but they will choose to do so if the believe that demand outstrips supply. In other words if you have more orders than you can fill, then you may post higher prices because you think consumers will tolerate the higher price.

You might object that competition deters any one producer from unilaterally raising prices, but in fact if all producers are failing to keep up with demand, then you can unilaterally raise prices because other producers don't have any excess inventory to undercut you with.

Answer 3

There are several causes of inflation. One is called cost push — that is, if the price of e.g. oil goes up sharply (as it did in the 1970s), it creates inflation by making everything cost more. Another is called demand pull: if labor unions bargain for higher wages (as they did in the 1960s), their wage costs push up prices, especially after they start buying.

The kind of inflation that the banks cause is monetary inflation. That is, for every dollar of deposits, they can make $5 or $10 of loans. So even though they don't "print" money (the Fed does) it's as if they did. The result could be the kind of inflation called "too much money chasing too few goods."

Answer 4

Sure banking interest causes inflation, due to the fractional reserve system. Money is created from debt. With a $1,000 deposit and a reserve ratio of 10%, $100 is kept on reserve and $900 loaned. The $900 may become another deposit, and so on until theoretically $9,000 is created. That's OK because it represents new production. Things balance, and besides, the $9.000 is cancelled when the loan is returned. Nonetheless, that was new money on which interest has to be paid. You pay if from your salary, but for the aggregate system more aggregate money has to be returned than aggregate production was realized. That extra money has to be created somewhere in the system more than production. That is the definition of inflation.