The Mystery of Banking

68
The Mystery of Banking
Chapter Five.qxp 8/4/2008 11:38 AM Page 68

---

F
IGURE
5.3 — P
HASE
I 
OF
I
NFLATION
increase the money supply to a fare-thee-well, finance their
deficits and subsidize favored political groups with cheap credit,
and prices will rise only by a little bit! 
It is human nature that when you see something work well,
you do more of it. If, in its ceaseless quest for revenue, govern-
ment sees a seemingly harmless method of raising funds without
causing much inflation, it will grab on to it. It will continue to
pump new money into the system, and, given a high or increasing
demand for money, prices, at first, might rise by only a little. 
But let the process continue for a length of time, and the pub-
lic’s response will gradually, but inevitably, change. In Germany,
after the war was over, prices still kept rising; and then the post-
war years went by, and inflation continued in force. Slowly, but
surely, the public began to realize: “We have been waiting for a
return to the good old days and a fall of prices back to 1914. But
prices have been steadily 
increasing
. So it looks as if there will be
no return to the good old days. Prices will not fall; in fact, they
will probably keep going up.” As this psychology takes hold, the
public’s thinking in Phase I changes into that of Phase II: “Prices
The Demand for Money
69
Chapter Five.qxp 8/4/2008 11:38 AM Page 69

---

will keep going up, instead of going down. Therefore, I know in
my heart that prices will be 
higher
next year.” The public’s 
de
fla-
tionary expectations have been superseded by 
in
flationary ones.
Rather than hold on to its money to wait for price declines, the
public will spend its money faster, will draw down cash balances
to make purchases ahead of price increases. In Phase II of infla-
tion, instead of a rising demand for money moderating price
increases, a falling demand for money will 
intensify
the inflation
(Figure 5.4). 
70
The Mystery of Banking
F
IGURE
5.4 — P
HASE
II 
OF
I
NFLATION
Here, in Phase II of the inflation, the money supply increases
again, from M
′
to M
′′
. But now the psychology of the public
changes, from deflationary to inflationary expectations. And so,
instead of prices rising (PPM falling) from 0B to 0D, the falling
demand for money, from D
′
to D
′′
, raises prices from 0D to 0E.
Expectations, having caught up with the inflationary reality, now
accelerate the inflation instead of moderating it. 
Both these phases of a typical inflation can be combined as
shown in Figure 5.5. 
Chapter Five.qxp 8/4/2008 11:38 AM Page 70

---

F
IGURE
5.5 — C
OMBINED
I
NFLATION
: P
HASES
I 
AND
II 
There is no scientific way to predict at what point in any infla-
tion expectations will reverse from deflationary to inflationary.
The answer will differ from one country to another, and from one
epoch to another, and will depend on many subtle cultural fac-
tors, such as trust in government, speed of communication, and
many others. In Germany, this transition took four wartime years
and one or two postwar years. In the United States, after World
War II, it took about two decades for the message to slowly seep
in that inflation was going to be a permanent fact of the Ameri-
can way of life. 
When expectations tip decisively over from deflationary, or
steady, to inflationary, the economy enters a danger zone. The
crucial question is how the government and its monetary author-
ities are going to react to the new situation. When prices are
going up faster than the money supply, the people begin to expe-
rience a severe