Theories of Inflation: Explained

In the aftermath of the Golden Age and the 1973 crisis, inflation emerged as a significant challenge for Western economies. Accompanied by the unexpected rise in unemployment, this phenomenon, dubbed “stagflation” (stagnation + inflation), became a daunting economic monster.

Understanding and combating inflation became a top priority for Western governments, and amidst various theories, it was Milton Friedman’s analysis that eventually took center stage.

Traditional Approaches

Economists traditionally explained inflation through three lenses: supply, demand, and structural factors.

Supply-Side Factors

In the aftermath of the oil shock, economists initially attributed inflation to rising production costs—first, the surge in oil prices, followed by increases in raw material costs and wages. However, these factors only partially accounted for the soaring inflation rates, reaching 15% in developed countries.

Demand-Side Factors

Another explanation for inflation pointed to demand. Keynesians, accepting inflation as a consequence of rising wages and public spending, considered it a preferable trade-off to unemployment in the Phillips curve dilemma.

Structural Factors

As inflation became endemic, attempts were made to explain it through structural elements, implicating monopolies, oligopolies, powerful unions pushing for higher wages, and employers offsetting these increases with price hikes. The psychological dimension, where individuals incorporate inflation into their behaviors, also played a role in making inflation chronic.

Friedman’s Lesson: Inflation as a Monetary Phenomenon

Amidst a multitude of theories, Milton Friedman decisively asserted that “inflation is everywhere and always a monetary phenomenon.” This echoes the timeless principle of the quantity theory of money—prices rise when the money supply increases.

Friedman held central banks and governments solely responsible for controlling money creation, emphasizing that limiting it should be their primary concern, as inflation is the fundamental economic plague triggering other issues.

Friedman drew a parallel between inflation and alcoholism—initially stimulating but escalating to detrimental levels. Governments were criticized for believing they could combat unemployment by accepting inflation, only to create more inflation and unemployment in the process.

Friedman sternly criticized the Phillips curve, arguing that it overlooked the Non-Accelerating Inflation Rate of Unemployment (NAIRU), an unemployment rate around 5% that doesn’t accelerate inflation. Ignoring this natural rate, governments attempted to reduce unemployment to levels seen during the Golden Age, exacerbating the situation.

Since the 1980s, the fight against inflation through monetary and fiscal austerity measures has become the norm. This approach was briefly set aside after the subprime crisis, giving rise to another economic challenge: deflation.

Conclusion

In conclusion, the landscape of theories surrounding inflation is vast, with each approach offering unique insights into the complex phenomenon. Friedman’s emphasis on the monetary roots of inflation has become a cornerstone of economic policies since the 1980s. The battle against inflation through austerity measures stands as one of the essential dogmas shaping governmental approaches to economic challenges.

As the economic world grapples with evolving challenges, from inflation to deflation, these theories provide a foundation for understanding past intricacies and navigating future uncertainties.

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