Why did overestimated coins led to inflation and well-estimated coins to deflation?

Question

It is said in Debt, the first 5,000 years by David Graeber (chapter 4, note 2) that when the value of metal coins represented exactly their weight, the result was deflation. The author says that when Locke's reforms were enacted, the results were catastrophic. How exactly did it pan out ?

Then, it is said that when the coins are too much altered, the result is inflation. The author says that the political power maintained the value of its money by taxes. How could it lose its value ? Some say that the fall of the Roman Empire is related to its money being too much altered, is it true ?

Answer 1

First imagine a world without any coinage, where all purchases and sales must be achieved through barter. Further imagine that there are well accepted equivalencies, between all goods so that an average ox is understood to be worth 10 average sheep, 8 average goats, etc. Three of those goods will of course be copper, silver and gold, so that there will be well understood equivalencies between not only those three precious metals, but also between each of those and every other good. For instance, an average sheep might be worth 0.5 oz of silver.

To this world we now add well-estimated coinage, with each dime being 0.5 oz of silver and each penny being 0.5 oz of copper, with 1 dime = 12 pennies. In this economy a sheep costs 1 dime, or 12 pennies. Now the economy runs with much less friction not only because coins are much easier to carry, but also because sales transactions can be made without requiring an exact match of need and supply between seller and buyer.

Now imagine that a cash-strapped monarch decides to debase the coinage by minting a debased dime containing only 0.25 oz of silver. Since a sheep is still worth 0.5 oz of silver, a sheep farmer will only sell a sheep for 2 of these debased dimes, or for one of the original good dimes. (In effect this debased dime is a nickel, but it is still nominally denominated as a dime.) Now the price of every non-specie good has suddenly doubled when denominated in the new debased dimes. That is inflation.

The reason David Graber states that when the value of metal coins represented exactly their weight, the result was deflation is that historically, the quantity of silver and copper mined each year less that withdrawn from circulation for jewellery and other consumer goods was insufficient to match the growth of the economy. (Gold is largely irrelevant, as only states and very wealth individuals traded in gold, but the same statement holds true.) With the precious metals from which coins were minted becoming scarcer (relative to the size of the economy) each year, the demand for these metals and their respective coins increased, meaning that other goods traded for a lesser quantity of the same coin each year. That is deflation.

There were exceptions to the above, the most notable being as a result of the huge quantity of silver brought to Europe in the 16th and 17th centuries by the Spanish. There was a substantial inflation during this period. There was also a dramatic increase in economic activity due to the historically very unusual adequacy of circulating currency.

Answer 2

Let's look at inflation first.

"when the coins are too much altered, the result is inflation."

When coins are altered, they are almost always debased - other metals are mixed with silver to allow the government to mint more coins with the same amount of specie. So if I have enough silver to produce 1000 coins, and I mix in 50% tin, I can now produce 2000 coins. That is the definition of inflation. although the face value of the coin hasn't changed, the price of goods and services will double because adding more coins to the economy doesn't add more goods or services.

To address OP's subsequent question, let's do a thought experiment. Imagine that today you earn $100/week and you spend $50/week for rent and $50/week for food. Tomorrow the government announces that it will add a zero to all currency. The government controls currency, but it doesn't control the availability or price of goods & services. Your landlord will immediately raise your rent to $500/week, and the grocer will raise the price of food to $500/week. Your employer however is much less motivated to raise your wage; they may raise it partially, or slowly. This is a flawed experiment because it sounds like the employer is evil, and because it is a simple change; inflation is not a velocity, it is an acceleration.

Now let's imagine that the government has decided that every week it will add a zero to the currency. So this week a $50 becomes a $500, and next week it will be a $5000, and so on. You're holding two $50 bills - do you trade them in for the $500 bill? Yes, absolutely because the $50 will buy much less goods and services next week. If you hold onto the $50, it will only pay 10% of your rent next month. Matter of fact, if you're clever, you'll go to the bank and offer to pay $75 for a $50 bill - because tomorrow you can trade that $50 for a $500 and pay the bank back $75, and still make a profit of 425. In times of inflation, you want to borrow as much money as you can, because you'll pay back the loan with less valuable currency. You do not want to save, because the money will be less valuable (have less buying power). you do not want to lend money because the debtor will pay you back with less valuable money. If you do lend, you're going to want to impose a huge interest penalty.

I was wrong in my original post - you don't take a 50% pay cut, but you do lose money. In times of inflation you want to borrow heavily and spend quickly because money in your hand is losing value. There are rumors that in pre-war Germany, it made sense to sell firewood and heat your house with the cash you got in return.

Deflation

Imagine that there are exactly 1 coin for every person in the world, and that salaries, and prices are adjusted to that standard.

Next year the population has increased by N%, and technology has increased the productivity of every worker by X% - the total amount of goods and services have now increased by some factor related to X & N. The relationship between the total value of goods and services and the amount of money has changed.

Let's repeat the thought experiment from above; today you have two $50 bills and the government has resolved to remove a zero from the currency every weeek; next week they will be $5 bills, and the week after that they'll be $0.50 bills. Do you trade your $50's? No, only a fool will trade. Hold on to your money as long as you can - eat less, pay your rent late, etc. Every week you can hold on to one of those $50 bills it buys more and more.

Modern day Japan is experiencing deflation. You can reliably expect the price of goods and services to drop from year to year. That means that you want to put off purchases as long as possible, because the price will continue to drop. That means that producers are going to go out of business because demand is dropping (people deferring purchases), and they'll have to lay off workers. Less workers means less consumption, which means that more companies will go out of business. Deflation is bad.

Is it true that the Roman Empire fell because of inflation ("money being too much altered")? Wallace's first law of Roman history is "For any given cause of the fall of the Roman Empire, you'll be able to find someone who says that is true, and someone who says it is false.

The logical corollary to the first law of Roman History is, "Whenever anyone advances an argument about why the Roman Empire fell, leave the room before the screaming starts."

If I have time later, I'll go back and add sources.

Answer 3

Deflation is when a given coin buys more and more goods over time. Inflation is the reverse: more and more coins are needed to buy the same thing.

If an economy grows, but the money supply (the total amount of gold and silver available) stays the same, then the money will get more valuable over time (deflation). For example, if the country has 1000 pounds of gold coin in it, but over the course of several years the country doubles its production of wheat, timber and other goods, then, other things being equal, the gold will buy more stuff than it did previously.

Also, if gold leaves the country, then what remains will buy more, even if production stays the same.

Conversely, if the supply of gold increases relative to the goods available, then inflation occurs: a quantity of gold will buy less than it did formerly.

Sometimes, gold (or a monetary equivalent) is made into fixed denominations. For example, a Roman aureus was originally about 8 grams of gold. If the standard is changed or if dross metal is added to the coin (called debasement), then inflation may occur instantly. For example, the Roman emperor, Marcus Aurelius, decreased the gold content of the aureus to 6.5 grams of gold. This caused inflation instantly: each aureus bought less stuff.

If a country uses scrip, meaning unbacked paper money as a substitute for gold, then the value of the scrip will go up or down depending in part on how much of it there is in comparison to the goods available for purchase. If the country prints a large amount of scrip, then inflation can result.