12/10/2012 10:47 BST | Updated 11/12/2012 05:12 GMT

Is The Way Central Banks View Inflation Simply Wrong? - Why QE Will Create Inflation.

There has been an assumption by mainstream macroeconomists over the last thirty years, since the inception of monetarism, that inflation is purely a monetary phenomenon. This assumption has led to the concept that money supply and prices are effectively directly correlated. For example if money supply increased the expected outcome would be for prices to rise and conversely if money supply decreased the expected outcome would be for prices to fall.

This has led to the definition of inflation and deflation becoming distorted from the original terminology. For example when economists discuss the current economic crisis the term deflation is used to describe a reduction in the money supply. This is technically incorrect the correct definition for deflation is a decrease in the price of a basket of goods from one period of time to another. Simply because the money supply has decreased does not necessarily mean prices have fallen. Conversely if the money supply increases it does not necessarily mean prices have risen.

The introduction of Monetarism has led to a new definition of inflation and deflation, which does not always ring true. Although there is a strong link to money supply and the price of goods, it is not an absolute rule. Alterations in money supply might be one cause of inflation but it is not inflation in itself. It is like saying a ship sinking is a hole in the hull, when in actual fact the ship sinking is when it becomes submerged in water. There may be many factors that led to the ship sinking a hole in the hull is merely one possible cause.

There are many causes of inflation and money supply might be one of them. However it is not the only factor that will impact on the price of a basket of goods from one period of time to another. The biggest problem I have with the, 'Inflation is purely a monetary phenomenon' theory is that the emphasis is put solely on domestic money supply, which to me seems naive. The domestic economy of one nation will never be able to compete with global economic output.

Regardless of the impact monetary policy has on one nations economic output it will have little if any consequence on entire global economic output. The ability to purchase goods on international markets will be the main factor that determines prices. The domestic tool which will impact the ability to purchase goods from foreign sources and ultimately prices is currency value, which will fluctuate according to supply and demand. The ability to control the money supply will alter the price of the currency and in turn the price of goods.

Domestic money supply does not have an impact on prices purely as a result of the relationship with domestic output, but as a result of the impact it has on purchasing foreign goods. Therefore it is possible to state that the observed relationship of prices (inflation and deflation), which has been linked to the correlation between domestic output and domestic money supply, may in fact be more closely linked to currency value and the international market for goods. If this analysis is correct it poses a worrying prospect to the Quantitative Easing programme.

The current method of controlling inflation and deflation is to alter the interest rate to change the money supply. The higher the interest rate, the less money in the economy because the price of lending has increased. The lower the interest rate, the more money in the economy because the price of lending has fallen. The relationship with money supply and inflation and deflation, which is argued by the 'Inflation is purely a monetary phenomenon' supporters, believes this is justification to prove their theory.

They therefore believe that domestic money supply must be at a certain level to set the price they want to hit their inflation target. However I think that the reality of what they are observing is the relationship between domestic money supply and the ability to purchase foreign goods. If the domestic money supply decreases, which it would through an interest rate rise, the price of the currency on the international markets will rise enabling the nation to buy more goods at a lower relative price, reducing domestic inflation.

The converse is also true if domestic money supply increases, which it would through an interest rate reduction, the price of the currency on the international markets will fall reducing the ability of the nation to buy as many goods for the same price they could before the reduction in the interest rate, increasing domestic inflation. If this is true then it means the currently accepted view of inflation and the reaction alterations in the domestic money supply will have on controlling inflation is wrong.

For example the current assumption is that if there is a reduction in money supply, for whatever reason, it must be replaced by central bank intervention to maintain money supply targets. The usual method of intervention would be a reduction in the interest rate however the interest rate is nearly at zero, which makes it difficult to use any further. Therefore the central banks have been using Quantitative Easing to increase the money supply, which is currency debasement. There is an assumption that any form of money supply alteration will have the same effect on prices due to the observed relationship between interest rates and prices.

This is the worrying prospect, the assumption that inflation is related to domestic money supply and domestic output presumes the outcome of Quantitative Easing would be to push the money supply up to the level needed to hit inflationary targets. When in fact, if the true impact domestic money supply alterations have is the effect on currency value and the ability to purchase foreign goods, all that Quantitative Easing will do is depreciate the purchasing power of the currency creating inflation.

Perhaps another way to look at the situation is the view of deflation. The assumption is it is a result of a lack of money supply in the domestic economy, which may be true to a certain extent. However if the money is pumped into the economy through Quantitative Easing the ability to purchase foreign goods will diminish as a result of currency devaluation, this will in turn likely create inflation.

Therefore it is possible to state that the current view of inflation and its causes has really been an observation of another macroeconomic relationship, which has created confusion about the nature of domestic money supply and how it should be applied in certain situations. It does not necessarily hold true that alterations in money supply will have the same impact on prices if another tool is used to influence it.