[This article is part of the Understanding Money Mechanics series, by Robert P. Murphy. The series will be published as a book in 2021.]
This chapter explains the connection between the quantity of money and the height of prices quoted in that money. The chapter therefore deals with the phenomenon of “inflation,” but as we shall see, the very meaning of this word changed during the twentieth century. (For clarity, we will distinguish the two concepts by using the more specific terms “monetary inflation” and “price inflation.”) We will summarize some of the famous episodes of hyperinflation throughout history, showing the disaster that results when governments run the printing press too aggressively.
Finally, we will highlight the Austrian criticism of the so-called equation of exchange, nowadays usually written as MV = PQ. Although the equation is a tautology, this framework encourages thinking of money and prices in a mechanistic fashion rather than using the tools of subjective value theory. Although it is important to recognize that massive price inflation is always the result of massive monetary inflation, there isn’t a stable relationship between the two; it’s not the case that, say, a 50 percent increase in the quantity of money necessarily leads to a 50 percent increase in prices.
Changing Definitions: Monetary Inflation vs. Price Inflation
Nowadays when the media or government officials discuss “inflation” they mean “the increase in consumer prices.” However, originally the term referred to an increase in the quantity of money (including bank credit). Here is how Ludwig von Mises, in a 1951 speech, discusses the semantic change and its implications:
There is nowadays a very reprehensible, even dangerous, semantic confusion that makes it extremely difficult for the non-expert to grasp the true state of affairs. Inflation, as this term was always used everywhere and especially in this country [the United States], means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term “inflation” to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. It follows that nobody cares about inflation in the traditional sense of the term. As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil.1
Precisely to avoid confusing modern readers while retaining the ability to diagnose cause and effect, in this chapter we use the more specific terms “monetary inflation” and “price inflation.”
Famous Historical Episodes of Hyperinflation
Milton Friedman is often quoted as saying, “Inflation is always and everywhere a monetary phenomenon.” To give more context, that quotation goes on to say “in the sense that [price inflation] is and can be produced only by a more rapid increase in the quantity of money than in output.”2 Although economists have debated the accuracy of Friedman’s famous assertion, the historical record shows that episodes of rapid price inflation (almost) always go hand in hand with rapid monetary inflation.3 In other words, if there is a genuine hyperinflation, then the government printing press is always involved. In this section we cover three famous historical examples.
The US Civil War
The United States’ Civil War (or War between the States, as some prefer to call it) saw large-scale inflation in both the Union (Northern) and Confederate (Southern) economies, but it was particularly pronounced in the Confederacy. According to one estimate, fully one-third of the Confederate government’s revenue came from the printing press, while only 11 percent came from tax receipts (with the rest covered by floating bonds). As a result, prices in the Confederate states increased rapidly: From early 1861 to early 1862, consumer prices doubled, and by the middle of 1863 they had risen by a factor of thirteen relative to the war’s start. With military defeats in 1864 and 1865 sapping confidence in the Confederate currency, its value eventually collapsed—with prices rising some 9,000 percent cumulatively from the war’s start—leading Southerners to use other monies or even barter. In the North, things were not nearly as bad, with consumer prices “only” rising about 75 percent from 1861 to 1865.4
The Weimar Republic
One of the more (in)famous examples of hyperinflation was the experience of Germany from 1921 to 1923. Because of its massive debts (including harsh reparations payments to the Allies, dictated by the Treaty of Versailles) following World War I, the German government resorted to the printing press to pay its bills. Yet because the war debts were denominated in “gold marks,” this resulted in a vicious spiral, with each round of monetary inflation causing the German paper mark to depreciate against gold (and foreign currencies) even further, leading the German officials to print paper marks with higher denominations on each note in the next round in a vain attempt to stay ahead of the depreciation.5 During the two-year hyperinflation, the total number of marks held by the public increased by a factor of more than 7 billion.6 According to Milton Friedman, money in the hands of the public increased at “the average rate of more than 300 percent a month for more than a year, and so did prices.”7
In the single worst month of the German hyperinflation, October 1923, consumer prices (according to one estimate) rose 29,500 percent, or almost 21 percent per day.8 The inflation was so severe that male workers would give their wages to their wives, who rushed to market, looking to exchange the rapidly depreciating paper for “real” goods that would better hold their market value. It was the Weimar Republic hyperinflation that gave us the iconic notion of workers being paid in wheelbarrows of cash, though that particular detail may be apocryphal. In any event, it is certainly true that everyday life changed, for example with restaurant patrons trying to pay their bill upfront rather than after eating because prices would rise during the course of the meal.9
chapter_9_weimar_wheelbarrow.jpg 
Zimbabwe
A more recent (and severe) hyperinflation occurred in Zimbabwe, from 2007 to 2009. In the worst month, November 2008, prices increased more than 79 billion percent, or 98 percent per day.10 As with other hyperinflations, in Zimbabwe too the connection between monetary and price inflation was evident:
chapter_9_zimbabwe_inflation_chart.jpg 
Source: Globalization and Monetary Policy Institute, “Hyperinflation in Zimbabwe,” in 2011 Annual Report ([Dallas, TX]: Federal Reserve Bank of Dallas, 2011), chart 8, https://www.dallasfed.org/~/media/documents/institute/annual/2011/annual11b.pdf.
As with the German episode, in Zimbabwe the authorities continued to increase the denomination of the currency notes. That is why economics professors around the world can (cheaply) obtain large Zimbabwean notes on eBay to show their classes the dangers of hyperinflation:
chapter_9_zimbabwe_note.jpg 
Source: ricketyus via Flickr.
The Equation of Exchange, MV = PQ
It is standard for economists to handle the relationship between money and prices using the equation of exchange, credited to Irving Fisher, which is nowadays11 often written as:
MV = PQ
where M is the quantity of money in the economy, V is the “velocity of circulation,” meaning the average number of times a unit of money “changes hands” during the time period in question,12 P is the “average price level,” and Q is the total quantity of real output produced during the period.
The left side of the equation captures the total amount of money (dollars, in the United States) that is spent during the period. For example, if M is $3 trillion and a dollar bill is used in a purchase on average four times per year, then there is a total of $12 trillion of total spending on output during a year. (Notice that weighting is important when calculating V: when a hundred-dollar bill is used in a transaction, it contributes to V one hundred times more than when a one-dollar bill is used.)
At the same time, the right-hand side of the equation equals the total number of dollars received during the year. For example, if the “average price” of goods and services (P) is $2/unit and the total real output (Q) during the year is 6 trillion units of goods and services, then the total amount received for the sale of goods and services is $12 trillion. Either way we calculate, we should come up with the same answer, because the total number of dollars spent during the year must equal the total number of dollars received. A common way of describing the equation is that nominal spending (the left-hand side) equals nominal income (the right-hand side), where nominal income is expressed as the “price level” (P) times “real GDP” (Q).
Strictly speaking, the equation of exchange is a tautology or an identity; given the definitions of the four variables, it is necessarily true. In practice, however, it is often used as a way of illustrating the so-called quantity theory of money, which—as the name suggests—is a theory that might be wrong. There are different formulations of the quantity theory of money, but one simple version says that changes in the quantity of money go hand in hand proportionally with changes in the level of prices. To illustrate this statement using the equation of exchange, we could say, “If M doubles while V and Q stay the same, then P must also double.”
What’s Wrong with MV = PQ?
Economists in the Austrian tradition have criticized the equation of exchange.13 In the first place, it seeks to explain economic phenomena in a mechanistic fashion, the way an engineer might write out an equation describing the flow of water through a pipe.
In contrast, the Austrians typically follow the approach of Mises by using the subjective preferences of an individual to explain his or her demand to hold a cash balance of a certain size. At any moment, there is no such thing as “money in circulation,” as the equation of exchange leads us to believe. Rather, every unit of money is always held in an individual or organization’s cash balance, and the Austrians typically use this perspective when tackling problems of monetary and price inflation. This “micro” method can then be scaled up to arrive at the market demand to hold money, which interacts with the total supply in order to explain the purchasing power of money. In this respect, the Austrian approach to explaining the “price” of money is the same subjective value theory used to explain the price of apples.
In light of the Austrian method, the variables of the equation of exchange are unhelpful or even nonsensical. No individual ever relies on the “average velocity of circulation” (V) of money when making decisions. The notion of a price level (or index), P, is also dubious, because it invites the false notion that changes in the quantity of money affect all prices uniformly. Yet in fact, when new money enters the economy in the real world, it isn’t “neutral,” but instead causes some prices to rise faster than others and in a sense transfers wealth from the rest of the community into the hands of the early recipients of the new money. The impact of this uneven process of price changes is called the Cantillon effect.14
Putting aside Cantillon effects, there is no reason for monetary inflation to necessarily have the same proportional impact on even the average index of prices. As Mises observed, once a hyperinflation is underway, injections of new money may lead to greater than proportional increases in “the price level” (if such a concept made sense), as the community seeks to rid itself of the cash as quickly as possible in exchange for other goods.15 For example, once a hyperinflation is underway, if the government doubles the quantity of money, then this action may result in more than a doubling of the typical price of a consumer good.
On the other hand, as the advanced economies experienced after the financial crisis of 2008, sometimes large injections of new base money do not correspond with comparable increases in consumer price indices. (We will cover this topic in greater detail in chapter 13.) Even if we restrict our attention to money in the hands of the public (using the aggregate M1 rather than the monetary base [M0]), it is still the case that there is no automatic connection between money and consumer prices:
chapter_9_m1_vs_cpi_in_usa.jpg 
To reiterate, no matter what happens, the outcome can always be reconciled with the equation of exchange, because it is an identity rather than a falsifiable theory. If M doubles while prices and real output stay relatively constant, the “explanation” is that V suddenly fell in half. In a scenario like this, the objection to the equation of exchange isn’t that it’s wrong, but rather that it may mislead observers into thinking there is a simple relationship between monetary and price inflation.
Conclusion
Although the term “inflation” nowadays refers to rising consumer prices, historically it referred to increases in the quantity of money. There is a tight connection between monetary inflation and price inflation. Specifically, all examples of hyperinflation in prices involved comparable increases in the money stock. However, there are examples of large increases in the quantity of money that have not (thus far) resulted in comparable consumer price hikes. The equation of exchange, MV = PQ, is an identity and therefore must be true. Yet it invites a mechanistic view of the economy, rather than explaining prices on the basis of individual decisions to hold cash balances of a particular size.
- 1. Ludwig von Mises, Economic Freedom and Interventionism: An Anthology of Articles and Essays, ed. Bettina Bien Greaves (Irvington-on-Hudson, NY: Foundation for Economic Education, 1990), chap. 20, available at https://mises.org/library/economic-freedom-and-interventionism/html/p/123.
- 2. Milton Friedman, Counter-Revolution in Monetary Theory, Wincott Memorial Lecture, Institute of Economic Affairs, Occasional paper 33, 1970, quoted in John C. Williams, “Monetary Policy, Money, and Inflation” (presentation to the Western Economic Association International, San Francisco, CA, July 2, 2012), https://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2012/july/williams-monetary-policy-money-inflation/.
- 3. Depending on our definitions, we could possibly find historical examples where a natural disaster or wartime measure caused such a widespread restriction of production coupled with an increased demand to hold money that consumer prices skyrocketed, even in the absence of aggressive money printing. Yet even here, the effect would be nothing compared to examples of money-induced currency collapses.
- 4. Most Civil War statistics obtained from EH.net Encyclopedia of Economic and Business History, s.v. “The Economics of the Civil War,” by Roger L. Ransom, Aug. 24, 2001, https://eh.net/encyclopedia/the-economics-of-the-civil-war/. The 9,000 percent Confederate inflation figure comes from: “Inflation in the Confederacy,” Dictionary of American History, Encyclopedia.com, last modified Jan. 13, 2021, https://www.encyclopedia.com/history/dictionaries-thesauruses-pictures-and-press-releases/inflation-confederacy.
- 5. For the MMT (modern monetary theory) perspective, which argues that rising prices caused the monetary inflation in Weimar Germany rather than vice versa, see Phil Armstrong and Warren Mosler, “Weimar Republic Hyperinflation through a Modern Monetary Theory Lens,” Gower Initiative for Modern Monetary Studies, Nov. 11, 2020, https://gimms.org.uk/wp-content/uploads/2020/11/Weimar-Republic-Hyperinflation-through-a-Modern-Monetary-Theory-Lens.pdf.
- 6. Michael K. Salemi, “Hyperinflation,” Library of Economics and Liberty, accessed Jan. 28, 2021, https://www.econlib.org/library/Enc/Hyperinflation.html.
- 7. Milton Friedman, Money Mischief (New York: Harcourt Brace, 1994), p. 194, italics in original.
- 8. See Steve Hanke, “R.I.P. Zimbabwe Dollar,” Cato Institute, [Feb. 5, 2009], https://www.cato.org/zimbabwe. Note that the monthly and daily inflation rates are drawn from Hanke, who (in his table, which includes several countries) appears to be using thirty days per month for his calculations, even when (in the case of October 1923) the month in question had thirty-one days.
- 9. For an account of one researcher’s attempt to verify the wheelbarrow story, see Keri Peardon, “Wheelbarrows of Money,” Vampires, Ladies, and Potpourri (blog), June 1, 2013, https://keripeardon.wordpress.com/2013/06/01/wheelbarrows-of-money-and-the-weimar-republic/.
- 10. See Hanke, “R.I.P. Zimbabwe Dollar.”
- 11. Originally, the equation of exchange was written as MV = PT, where T stood for the total number of transactions occurring during the time period.
- 12. Strictly speaking, for the equation to be correct, the V must refer to the velocity of money only in the applicable transactions. For example, if Q refers to real output, then V refers to the velocity of turnover of money in exchanges involving newly produced goods and services. In contrast, when someone spends $1,000 on shares of corporate stock, this “turnover” of money would not go into the calculation of V.
- 13. See for example Ludwig von Mises, The Theory of Money and Credit, trans. J. E. Batson (Auburn, AL: Ludwig von Mises Institute, 2009), pp. 131–36; Mises, Human Action: A Treatise on Economics, scholar’s ed. (Auburn, AL: Ludwig von Mises Institute, 1998), pp. 395–97; and Murray Rothbard, Man, Economy, and State with Power and Market, 2d scholar’s ed. (Auburn, AL: Ludwig von Mises Institute, 2009), pp. 831–42.
- 14. For a discussion, see Mark Thornton, review of Money, Inflation, and Business Cycles: The Cantillon Effect and the Economy, by Arkadiusz Sieroń, Quarterly Journal of Austrian Economics 22, no. 3 (Fall 2019): 503–05, https://mises.org/library/money-inflation-and-business-cycles-cantillon-effect-and-economy.
- 15. Keep in mind that at any given moment all money must be held in the cash balances of various individuals or organizations. The community as a whole can’t “get rid of” newly created money, but rather the desire to do so (at existing prices) causes the purchasing power of money to fall—meaning prices rise—until equilibrium is restored.
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