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What Is Inflation?

Inflation is the general rise in the price level of goods and services in an economy over a specific period of time. This decreases the purchasing power of the local currency. Each country has its own method for measuring the level of inflation, which usually occurs monthly. For example, the United States uses the Consumer Price Index (CPI) as a measuring stick for inflation. All G20 nations use CPI to calculate the rate of inflation.

Shortly, professional economists and financial experts agree that inflation is harmful to the overall health of each country’s local economy. However, the major disagreement between economists is the cause of inflation. For the past several decades, the financial community has engaged in an ongoing debate concerning the root cause of inflation. There are two schools of thought regarding inflation. Let’s review the details.

Keynesian View

Arguably, John Maynard Keynes is regarded as the most influential economist of the modern financial era. Throughout his illustrious career, Keynes introduced several economic theories and econometric models which governments and businesses used to forecast future economic growth. In terms of inflation, Keynes developed two different theories on why the price level of goods and services would increase over time.

Demand-Pull Inflation – Keynes believed that inflation occurs when the total demand for goods and services in an economy exceeds the total supply of goods and services. Keynes argued that this phenomenon was caused by a rapid increase in a country’s level of employment. High employment will increase the number of wages within the economy. As wages increase, the demand for goods and services will also increase. Ultimately, the increased demand for goods and services will force prices to rise, thus creating inflation.

Cost-Push Inflation – Keynes developed an alternate theory of inflation. It was known as cost-push inflation. This type of inflation was caused by a substantial increase in the cost of an important good or service. Keynes defined an “important” good or service as one in which no suitable alternative is available. Under this scenario, the cost to produce other goods and services would increase due to a substantial decrease in the total supply of important goods or services.

Historical Overview

A perfect example of cost-push inflation occurred during the oil crisis of the early-1970s. Oil is considered an important good because it is frequently used in the production of other goods. As the price of oil increased, it forced the price of other goods and services to rise in unison with oil. The global economy experienced historic levels of inflation throughout the entire decade of the 1970s. Keynes’ theory of cost-push inflation became widely accepted as a legitimate basis for rising prices within the international community of economists and business leaders.

Monetarist View

Milton Friedman is one of the most vivid economists of the XX century. Friedman’s major contribution to the study of economics was a school of thought known as monetarism, which was first introduced in 1956. Monetarism gained national attention in a book, titled A Monetary History of the United States. This book quickly became regarded as one of the most important pieces of literature within the macroeconomic community.

Monetarism is an economic theory that focuses on central banking and the supply of money. Essentially, Friedman argues that excessive expansion of the money supply is inherently inflationary. Although he viewed central banks as a necessary component of a country’s monetary system, Friedman was often critical of their attempt to influence the growth rate of the economy by constantly adjusting the money supply. Friedman believed that central banks should play a very limited role in monetary policy. Friedman argued that central bank meddling usually produced a negative effect on economic growth.

Friedman claimed that monetary authorities should concentrate exclusively on maintaining price stability. So, he proposed that central banks create a fixed growth rate of the money supply. This became the core concept of monetarism. Those who agreed with Friedman’s idea of a fixed money supply became known as monetarists. The popularity of monetarism exploded within the professional economic community throughout the 1960s and 1970s. Many Keynesian economists abandoned their belief in John Maynard Keynes in favor of monetarism.

Historical Overview

The period from the 1960s to 1970s was excellent in terms of global price stability, low inflation, steady economic growth, low unemployment along very limited participation of central banks. Despite the oil crisis in the early 1970s, the global economy remained relatively stable for the better part of 20 years. This explains why many Keynesian economists switched their allegiance to monetarism.

In the late 1970s and early 1980s, monetarism lost some of its luster as several G20 nations experienced high levels of inflation. Monetarists believe that central banks should maintain a fixed growth rate of each country’s money supply. However, when this policy failed to produce the desired results, global monetary authorities unveiled an aggressive policy to sharply reduce the money supply. Central banks believed that shrinking the aggregate supply of money would force an increase in interest rates, reducing the demand for money at the consumer level. As the demand for money decreased, inflation rates would decline along with a reduction in the velocity of money.

During this period, Paul Volcker was the chairman of the Federal Reserve in the United States. Volcker enacted a policy of aggressively reducing the US money supply to reduce the high rate of inflation. Several G20 nations followed Volcker’s lead by reducing their own country’s money supply. Volcker’s policy proved to be incredibly successful, as global inflation was substantially reduced. Of course, Volcker’s plan to sharply reduce the money supply was in stark contrast to the monetarist view of maintaining a steady supply of money. And since it was so successful, many economists began to question Friedman’s theory of monetarism. Although monetarism failed to produce the desired results in the late-1970s, this economic theory is still an important piece of economic history.

The monetarist view of inflation has been largely disregarded during the past 20 years, particularly since 2008. As you know, monetarism states that inflation is caused by an excessive increase in the money supply. Of course, central banks are responsible for controlling the supply of money. Following the global financial crisis in 2008, central banks dramatically increased the money supply to stimulate the economy.

Money supply growth was very stable before 2008. For example, the average annual growth rate of the United States money supply was 3.05% from 2000 through 2007. Immediately following the financial crisis in 2008, the growth rate of the money supply exploded. During the past 12 years, the average annual growth rate has been 19.8%. These numbers represent an enormous increase in the supply of money. Other G20 countries experienced similar increases in their money supply.

Based on Milton Friedman’s monetarism theory, the rate of inflation should have blasted to the upside in response to the dramatic increase in the money supply. However, the global rate of inflation has remained very low for the past several years. Consequently, many economists have questioned the validity of monetarism during the past decade. As we mentioned earlier, even though monetarism failed to produce the desired results, Friedman’s theory is still an important piece of economic history.

Brief Summary of Inflation

  • Inflation is the general rise in the price level of goods and services in an economy.
  • When the general price level rises, each currency unit buys fewer goods and services.
  • Each country has its own method for measuring the level of inflation.
  • All G20 nations use the consumer price index (CPI) to calculate the rate of inflation.
  • Economists agree that inflation is harmful to the overall health of an economy.
  • Many economists disagree on what causes inflation.
  • Essentially, there are two schools of thought regarding inflation.
  • Keynesian view is based on demand-pull inflation and cost-push inflation.
  • Monetarist view is based on the money supply.
  • During the past few decades, the Keynesian view has been more accurate.
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