3.3.8.3 Inflation, Monetarism and the Role of Central Banks

(This is a current page, from the Patterns of Power Edition 3 book contents.  An archived copy of this page is held at http://www.patternsofpower.org/edition03/3383.htm)

Inflation, in economic terms, can be loosely described as an increase in the prices paid by individuals and companies for goods and services, or a fall in the purchasing power of money.  It can be caused by increases in the prices of imports, or by wage demands which are not accompanied by corresponding increases in productivity, or by an increase in the effective supply of money.

Governments can literally ‘print money’, putting more currency into circulation, but recently several central banks have introduced ‘quantitative easing’ – where they buy back government bonds and thereby increase the liquidity of the bond-holders.  This could increase the velocity of circulation of the money in the economy, which has the same effect as printing money: it stimulates the economy by helping consumers to borrow and buy, but also causes prices to rise and causes inflation.[1]  In practice, though, when quantitative easing was used after the great recession it did not result in inflation because banks built up their reserves rather than lending it to consumers – reducing the velocity of circulation.[2]

Inflation can help a government to make debt repayments; it also indirectly reduces the pain of having a structural deficit (3.3.8.1) and high debts:

  • It causes nominal prices and incomes to rise, which reduces the fiscal deficit by increasing the tax revenue.[3]
  • Those who lend money to governments by buying fixed-interest securities find that their real value has been diminished by the time that repayment falls due.

Inflation is a politically easy solution.  By the time its effect is felt, people don’t connect the pain to the political decisions that caused it, but it reduces the real value of their incomes and savings so very high inflation causes hardship; money becomes almost worthless – as described in an Economist article about the hyperinflation in Germany in the 1920s, entitled Loads of money.

Deflation (falling prices), as experienced during the Great Depression and in Japan in the 1990s and described in an Economist article entitled Diagnosing depression, is the opposite of inflation but is equally serious because it creates unemployment as businesses fail.

Control of inflation is therefore important, and various approaches have been tried:

  • Some governments have attempted to apply direct controls to prices and incomes, but this has been unsuccessful (3.3.6).
  • Governments can increase interest rates to reduce people’s willingness to borrow, which reduces the money supply and thereby controls inflation with the type of ‘monetarist’ approach that was advocated by Milton Friedman, among others.[4] This policy also reduces economic activity by reducing demand and by increasing the costs of providing goods and services.   When it was applied in the UK during the 1980s, to correct a previous period of high inflation, the resulting unemployment was painful.[5]
  • It is also possible to restrain inflation by increasing taxes to reduce demand and slow the rate of economic growth; this in turn reduces wages, as there is less demand for labour, and shoppers become keener on finding lower prices. Keynes advocated this use of fiscal policy to control inflation, but monetarism is more popular now.[6]

Nowadays the central banks manage inflation in most countries, in accordance with targets set by government, using a monetarist approach.  A depoliticised monetary policy prevents governments from using easy credit as a way of engineering an economic boom to win an election, but a disciplined fiscal policy is also necessary to maintain stability and avoid what the Economist described as Boom, bust and hubris when describing the British government’s reluctance to raise taxes prior to the 2005 General Election.

© PatternsofPower.org, 2014

Next

Back

[1] On 28 August 2015, Mises.org published a helpful article by Frank Shostak entitled Money Supply and the Velocity of Money; it was available in April 2018 at https://mises.org/blog/money-supply-and-velocity-money.  Despite some minor inaccuracies in the text, it was clear and was simply expressed.

[2] On 8 November 2013, economicshelp.org published a reply to a reader who wanted to know why quantitative easing had not resulted in increased inflation.  The article was entitled Velocity of circulation and inflation and was available in April 2018 at http://www.economicshelp.org/blog/9373/inflation/velocity-circulation-inflation/.

[3] Gene Epstein described how inflation had the effect of reducing a government’s debt repayments, in an EconTalk podcast in June 2008.  The 1985 reform that indexed the federal tax brackets reduced, but has not eliminated, the phenomenon.  The relevant point appears in paragraph 3 of the text transcript of the podcast highlights, which was available in April 2018 at http://www.econtalk.org/archives/2008/06/gene_epstein_on.html#highlights.

[4] Milton Friedman’s contribution to economic thinking was summarised in a special article: A heavyweight champ, at five foot two, in the Economist, 23 November 2006.  The article, which was available in April 2018 at http://www.economist.com/node/8313925, cited his 1971 book A Monetary History of the United States, 1867-1960, which demonstrated the link between money supply and inflation.

[5] The January 2018 report from the Office of National Statistics, available in April 2018 at https://www.ons.gov.uk/employmentandlabourmarket/peopleinwork/employmentandemployeetypes/bulletins/uklabourmarket/january2018#unemployment, showed UK unemployment figures dating back to 1971.  Unemployment peaked at 11.9% in 1984, before returning to the more normal figure of around 5% of the workforce in Britain.

[6] Samuelson and Nordhaus compare the efficacy of fiscal and monetarist policies in chapter 23 of Economics.