inflation

Open full sized image

No matter how you define it, inflation pulls down pricing power.

© alphaspirit/stock.adobe.com

Inflation refers to the general increase in prices or the money supply, both of which can cause the purchasing power of a currency to decline.

From a consumer’s perspective, inflation is most visible in rising prices for goods and services. Economists, however, have developed several theories to define inflation and explain what causes it.

Thesis: Inflation is determined by the money supply.

As the first and oldest of the inflation theories, the quantity theory of money views inflation as primarily a “monetary” occurrence. In other words, the influence of the amount of money in the economy takes precedence over all other factors, including income levels, demand for goods, and frequency of spending (aka, the velocity of circulation or velocity of money).

Although these other factors may fluctuate in the near term, over time and on average, their changes may not be consequential enough to drive up prices in any significant manner. Dramatic increases in the money supply, however, can cause a notable shift in prices. For example, if the money supply doubles, according to the theory, price levels are expected also to double. Inflation, therefore, is first and foremost a monetary matter.

The quantity theory was originally formulated in 1517 by mathematician Nicolaus Copernicus, revived in the 18th century by a number of philosophers—particularly David Hume—and refined in the 1950s and ’60s by a group of economists at the University of Chicago, led by Milton Friedman.

Why was it refined in the middle half of the 20th century by Friedman and his fellow Chicago School colleagues? The quantity theory ran into a few major bumps between World Wars I and II—particularly during the Great Depression of the 1930s. The theory assumes that a nation is at or near full employment. Its productive capacity, therefore, would be running at an optimal level. During the Great Depression, the lack of employment opportunities brought national production to crippling levels.

Open full sized image

Milton Friedman, 1989.

Chuck Nacke/Alamy

Although a shift toward a Keynesian approach to economic policy (see below) is largely credited for pulling the U.S. economy out of its Depression-era slump, culminating in the production boom during World War II, Milton Friedman and the Chicago School revisited the basic tenets of quantity theory in the decades that followed.

They agreed that short-term changes in the money supply may not be very effective in controlling short-term movements in the economy. However, they contended, changes in the money supply can cause longer-term changes in income, frequency of consumer spending, and eventually, the prices of goods and services. Therefore, to achieve price stability in the long term, it may be necessary to increase the money supply on a regular basis, and at a rate equal to that of an economy’s estimated expansion.

Not all economists agree with this view. Many argue that in highly developed economies, the demand for goods and higher wages takes precedence over the money supply. In other words, consumer demand and the need for spending are what support the case for increasing the money supply; increasing the money supply alone will not increase demand or consumption. And if rising demand outpaces available supply, the velocity of money will increase—if not through actual “cash” transactions, then through credit expansion.

Thesis: The cost of goods and services rises when demand is greater than the available supply.

Open full sized image

John Maynard Keynes, detail of a watercolour by Gwen Raverat, c. 1908; in the National Portrait Gallery, London.

Courtesy of the National Portrait Gallery, London

This second basic approach to inflation, a key tenet of John Maynard Keynes’s theory of economics, claims that aggregate demand influences output and inflation. One of Keynes’s aims was to devise a way in which an economy can pull itself out of a recession.

Keynes believed that increasing aggregate demand and expenditure is key to boosting economic growth. But how does a country stimulate demand? According to Keynes’s theory, the government needs to spend money in order to get money flowing in the economy. This has usually taken the form of government infrastructure projects to boost employment (although there are other variations of economic stimulus that governments have implemented, such as the cash payments sent directly to American households during the COVID-19 pandemic). Newly generated income (from jobs or cash stimulus) can boost demand for consumer goods, which can increase spending and consumption.

Keynes also believed that interest rates—essentially the cost of borrowing money—can significantly affect both consumption and investment on a private and corporate level. Lower interest rates tend to encourage spending and business investment, which also stimulates the velocity of money. Higher interest, on the other hand, tends to have the opposite effect, encouraging savings over consumption.

Eventually, the increase in aggregate demand may surpass aggregate supply, causing prices to rise. In other words, when consumer demand increases amid limited supply, prices tend to be bid (or pulled) higher. Hence, the term “demand-pull” inflation.

The Keynesian approach and all its variations are significant because they give governments a framework to influence the economic cycle through fiscal policy. Keynesian economics has dominated the economic policies of many industrialized countries since the mid-20th century. Still, Keynes’s approach does not eliminate all uncertainties. For example, there’s a time lag between fiscal and (central bank) monetary policy actions and their effects on demand and consumption. Nevertheless, many economists believe the Keynesian approach has led to better control over short-term changes in employment and real income.

The big caveat to Keynes’s approach emerged in the period following World War II until the end of the 1970s. It had no viable response to stagflation, in which high inflation coincided with slow economic growth.

Thesis: Inflation is driven by rising production costs.

The cost-push theory for analyzing inflation concerns the impact of production costs. It assumes the prices of goods are determined primarily by their manufacturing costs. When manufacturers have to pay more for materials, they sometimes transfer the extra costs to consumers by raising the price of produced goods.

The rise in consumer prices can also be associated with a rise in wages, sometimes causing a “price-wage spiral.” Workers trying to pay for higher-priced goods may demand higher wages from their employers. Employers who begin offering higher wages, in turn, may need to raise the prices of their goods and services to compensate for their loss in profits. This new round of higher prices may prompt workers to demand even higher wages. This process potentially creates a perpetual “spiral” of price and wage increases.

If the money supply were fixed, this process would lead to a stringent cycle of ballooning prices amid eroding “real” incomes. Eventually, there might come a point at which businesses might be unable to adequately raise wages to help their workers afford the rising cost of goods, as every round of higher wages would only increase the cost of goods.

A note on inflation vs. unemployment (the Phillips curve). In the 1960s, there was much discussion of the Phillips curve, which posits that economic growth—often leading to higher inflation—also correlates with an increase in wages and employment (and a decrease in unemployment). It suggests the price-wage spiral tends to proceed more rapidly at higher (not lower) levels of economic activity.

Ultimately, the empirical evidence for the Phillips curve was not entirely satisfactory. The idea that a “politically tolerable” level of unemployment might reduce or end inflation was shaken by the rapid wage inflation that occurred during severe recessions in later decades.

Thesis: Inflation is caused by “structural” weakness in a country’s capacity to produce goods or maintain an adequate flow of supply.

This fourth basic approach to understanding inflation concerns structural weakness in a given economy.

One version of structural maladjustment concerns the theory of wage stickiness. This theory claims that it’s much easier for employers to increase wages than reduce them, as workers will strongly fight the latter. If business productivity decreases, companies are more likely to lay off workers than to decrease worker pay across the board. But if wages continue to boost demand amid limited supply, the resulting inflation erodes real wages. Wages may be “nominally” the same, but their purchasing power declines, resulting in what’s essentially a wage cut.

Another version of the structural theory of inflation, this one concerning developing countries, focuses on conditions of underproductivity and the relationship to the gap between imports and exports. In this case, imports tend to increase faster than exports. If a country imports more goods than it exports, it risks pushing down the international value of its own currency. That can increase domestic prices, especially for goods using imported components.

But what causes underproductivity in a country’s domestic production and exports? Many developing countries may not have adequate infrastructure to produce, store, or transport goods. In many cases, there are scant capital resources or human resources to spend on research and development, preventing countries from innovating or updating their existing technologies. Governmental policies may also contribute to structural maladjustments in the economy.

For each of the four theories, the concern isn’t just the presence of inflation; perception and expectations also play a big part. If consumers expect inflation, it might become a self-fulfilling prophecy. In other words, inflation, when persistent enough, can cause people to normalize and expect it. This perception can increase demand, causing inflation to become built in.

Inflation tends to rise and fall over time. Although these theories form a solid basis for understanding its root causes, a specific inflationary environment won’t necessarily fall neatly into one category. It might be tied to one of the scenarios described above, or it might be a combination. And sometimes, the reasons aren’t clear.