3.3.8.3 Inflation, Monetarism and the Role of Central Banks

Money facilitates the exchange of goods and services, enabling a transfer of wealth between buyer and seller at an agreed price, but it can also be regarded as a commodity itself.  It can be bought and sold on foreign exchange markets.  Currency traders can assess whether or not it is likely to increase in value, compared to other currencies.  That assessment is based on a view of the country’s economic performance.

Inflation 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, as explained in a BBC article: What is quantitative easing?  This increases the volume of money that is circulating in the economy; it has the same effect as printing money: it stimulates the economy by helping consumers to borrow and buy, but it can also cause prices to rise and increase inflation.  The technical term for this is an increased ‘velocity of circulation’, as described in Frank Shostak’s helpful article: Money Supply and the Velocity of Money.

When quantitative easing was used after the 2007-8 recession, it didn’t result in inflation because banks built up their reserves rather than lending it to consumers: reducing the velocity of circulation, as explained in an economicshelp.org article, Velocity of circulation and inflation.

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 increases the tax revenue and reduces the fiscal deficit – as described in an EconTalk podcast: Gene Epstein on Gold, the Fed, and Money. [paragraph 3 of the highlights]
  • 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 people’s incomes and savings.  Very high inflation causes hardship: money becomes almost worthless – as described in an Economist article about the hyperinflation in Germany in the 1920s: Loads of money.

Deflation (falling prices), as experienced during the Great Depression in the 1930s and in Japan in the 1990s, is the opposite of inflation – but it is equally serious.  It creates unemployment because businesses cannot meet the lower prices and they fail, as described in an Economist article: Diagnosing depression.

It is therefore important to steer a path between inflation and deflation.  It is therefore important to steer a path between inflation and deflation.  Some governments have attempted to apply direct controls to prices and incomes, but this has been unsuccessful (3.3.6.1).  There are two viable policy tools: ‘monetarism’ and the fiscal approach (often referred to as Keynesian).

The monetarist approach, which was advocated by Milton Friedman among others, is to increase interest rates to reduce inflation.  It works by reducing people’s willingness to borrow and reducing the velocity of circulation.  Milton Friedman’s contribution to economic thinking was summarised in a special Economist article, A heavyweight champ, at five foot two, which cited his 1971 book A Monetary History of the United States, 1867-1960.  It demonstrated the link between money supply and inflation.

The fiscal approach restrains 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 became more popular in the 1980s.  Samuelson and Nordhaus compare the efficacy of fiscal and monetarist policies in chapter 23 of Economics.

Reduced economic activity leads to increased unemployment, as illustrated when the British government acted during the 1980s to correct a previous period of high inflation.  The January 2018 report on UK unemployment, from the Office of National Statistics, revealed that unemployment peaked at 11.9% in 1984 before returning to the more normal level of around 5% of the workforce.

An Economist article in July 2004, Boom, bust and hubris, commented on the British government distorting its management of the economy for electoral reasons:

“In short: contrary to Mr Brown’s claims, monetary and fiscal policy are no longer working together to achieve stability.  Instead they are pulling in different directions.  Fiscal policy remains highly expansionary: the budget deficit will remain around 3% of GDP this year and next.  That’s because, with an election looming in summer 2005, the chancellor has run scared of new tax increases.”

As the Economist had warned, the housing boom had to end and Britain was not well placed for the economic crisis of 2008.  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 – and a disciplined fiscal policy is also necessary to achieve stability.

Back

Next

This is a current page, from the Patterns of Power Edition 3a book, © PatternsofPower.org, 2020.  An archived copy of it is held at https://www.patternsofpower.org/edition03/3383a.htm