Inflation Issues in Jewish Law
Rabbi Dr. Aaron Levine

Proceeding clearly from the above understanding of the dispute between Rav and Samuel is a rejection of the notion that the debtor's responsibility consists of an obligation to restore to the lender the purchasing power he gave up at the time of the loan. What the obligation consists of is merely to return what was loaned out. When a stipulation is made to make payment with currency, Rab and Samuel dispute the obligation of the debtor. Talmudic decisors follow Samuel's view. ⁶ Accordingly, payment is made with the original medium of exchange, even if it was declared defunct at the time of repayment, provided, of course, that it continues to circulate somewhere, e.g. in Mishan.

With the debtor's obligation essentially consisting of a duty to return what was lent to him, discharging the debt with the original monetary unit satisfies the stipulation as long as it minimally retains its identity as a medium of exchange. Minimal identity retention obtains when the medium of exchange retains its purchasing power in respect to one or more of the entire set of commodities previously available, albeit now available only in a foreign country. Since the original medium of exchange still circulates in Mishan, it may reasonably be assumed that it retains its purchasing power in respect to at least one or more of the entire set of commodities previously available.

Rav, in our view, may very well also subscribe to the principle that minimum identity retention allows the original medium of exchange to be used to discharge a debt. Retaining its purchasing power in respect to one or more commodities available only in a foreign country does not, however, suffice. Minimum identity retention obtains only if the monetary unit retains its purchasing power in respect to one or more of the entire set of commodities available domestically. With the government declaring the original monetary unit defunct, payment must be made with the new monetary unit.

Proceeding clearly from the above is a rationale of why inflation induced by a commodity shortage, other things equal, does not call for an upward payment adjustment for the debtor. Since the money supply is assumed to remain constant, the monetary unit can well be expected to retain its original exchange value in respect to one or more of the entire set of commodities available domestically. Given that the medium of exhcange retains its identity, a nomalistic approach is adopted for the payment obligation of the debtor, despite the loss in real terms this approach causes the lender.

In sharp contrast, when the inflation is caused by an increase in the money supply, other things equal, the absolute price level will rise. With the medium of exchange losing its identity, a nomalistic approach is rejected in favor of a payment obligation that would effectively restore for the lender the purchasing power he gave up at the time of the loan.

When both commodity shortage and money supply growth are simultaneously operational, the monetary unit could very well maintain its purchasing power in respect to one or more of the entire set of commodities, despite the rise in the absolute price level occasioned by the monetary growth. Should the medium of exchange maintain its identity despite the monetary growth, the nomalistic approach recommends itself.

Within the framework of a modern economy, monetary expansion invariably impacts on the relative price structure as well as the absolute price level. What brings this about is the workings of the fractional reserve system.

A fractional reserve system requires a bank to hold as idle cash only a fraction of a deposit it receives. To illustrate, a legal reserve requirement of 20% would require a bank to hold as idle cash only $200 of a $1000 deposit received.

Within the framework of a fractional reserve rule, monetary expansion is accomplished when holders of cash assets decide to exchange these cash assets for demand deposits or bank credit. Creating for a cash asset holder a demand deposit does not in itself expand the money supply as the increase in the money supply occasioned by the creation of the demand deposit is exactly counterbalanced by an equal reduction of currency in circulation. While the initial deposit changes only the composition but not the size of the money supply, the stage is set for monetary expansion. Meeting the 20% reserve requirement allows bank A to lend out $800 of the $1,000 deposit. This process of monetary expansion continues as the loan is spent and its proceeds are redeposited in another bank. Successive rounds of expansion eventually come to a halt when the entire original cash deposit of $1,000 is held as idle cash by the banking system as a whole.

Monetary expansion occurs also in consequence of expansionary federal reserve credit policy. Financing a deficit by selling bonds to the federal reserve illustrates such an expansionary policy. Let us suppose, for instance, that for the purpose of financing a $20 billion deficit, the treasury sells $20 billion of bonds to the federal reserve. The federal reserve pays for the bonds by increasing the treasury's account with it by $20 billion. Given its newly created demand deposit, the treasury can now write $20 billion of additional checks against its account at the federal reserve.

What the above description of commercial bank and federal reserve credit expansion indicates is that monetary expansion profoundly impacts on the relative price structure. Farmers, consumers and businessmen compete for the available credit. Each of these groups is by no means homogeneous. The spending pattern of the recipients of the bank credit impact upon the relative price structure. Similarily affecting the relative price structure is the spending pattern of recipients of federal spending, financed by means of monetary expansion.

Inflation in a modern economy is rooted in causes other than an increase in the monetary unit and a reduction in the supply of commodities. Phenomena exerting an inflationary impact on the economy include: a general loosening of credit conditions; increased government deficits; a breakdown of the competitive structure of the economy and an increase in the population. Besides exerting an upward pressure on the price level, these phenomena effect the relative price structure as well. The set of goods and services in a modern economy is indeed enormous, including commodity prices, consumer goods, the fees of professional services, financial assets and the country's foreign exchange rates. While inflation generally exerts an upward pressure on prices, some prices, such as bond prices and foreign exchange rates, actually decline. Moreover, within the framework of normal economic progress, industries rendered obsolete by technological advance experience price declines. Since the medium of exchange in a modern inflationary economy can be expected to maintain its exchange value in respect to one or more of the entire set of available goods and services, the nomalistic approach recommends itself in the treatment of loan transactions.