Editing Inflation (section)

=== Historical approaches ===

Theories of the origin and causes of inflation have existed since at least the 16th century. Two competing theories, the [[quantity theory of money]] and the [[real bills doctrine]], appeared in various guises during century-long debates on recommended central bank behaviour. In the 20th century, [[Keynesian]], [[monetarist]] and [[New classical macroeconomics|new classical]] (also known as [[rational expectations]]) views on inflation dominated post-World War II [[macroeconomics]] discussions, which were often heated intellectual debates, until some kind of synthesis of the various theories was reached by the end of the century.

==== Before 1936 ====
{{main|Real bills doctrine}}

The [[price revolution]] from ca. 1550–1700 caused several thinkers to present what is now considered to be early formulations of the [[quantity theory of money]] (QTM). Other contemporary authors attributed rising price levels to the debasement of national coinages. Later research has shown that also growing output of [[Central Europe]]an silver mines and an increase in the [[velocity of money]] because of innovations in the payment technology, in particular the increased use of [[bill of exchange|bills of exchange]], contributed to the price revolution.<ref name=Dimand>{{cite book|last1=Dimand |first1=Robert W. |chapter=Monetary Economics, History of |title=The New Palgrave Dictionary of Economics |date=2016 |pages=1–13 |doi=10.1057/978-1-349-95121-5_2721-1 |chapter-url=https://link.springer.com/referenceworkentry/10.1057/978-1-349-95121-5_2721-1 |publisher=Palgrave Macmillan UK |isbn=978-1-349-95121-5 |language=en}}</ref>

An alternative theory, the [[real bills doctrine]] (RBD), originated in the 17th and 18th century, receiving its first authoritative exposition in [[Adam Smith]]'s ''[[The Wealth of Nations]]''.<ref>{{cite journal |last1=Green |first1=Roy |title=Real Bills Doctrine |journal=The New Palgrave Dictionary of Economics |date=2018 |pages=11328–11330 |doi=10.1057/978-1-349-95189-5_1614|isbn=978-1-349-95188-8 }}</ref> It asserts that banks should issue their money in exchange for short-term real bills of adequate value. As long as banks only issue a dollar in exchange for assets worth at least a dollar, the issuing bank's assets will naturally move in step with its issuance of money, and the money will hold its value. Should the bank fail to get or maintain assets of adequate value, then the bank's money will lose value, just as any financial security will lose value if its asset backing diminishes. The real bills doctrine (also known as the backing theory) thus asserts that inflation results when money outruns its issuer's assets. The quantity theory of money, in contrast, claims that inflation results when money outruns the economy's production of goods.

During the 19th century, three different schools debated these questions: The [[British Currency School]] upheld a quantity theory view, believing that the [[Bank of England]]'s issues of bank notes should vary one-for-one with the bank's gold reserves. In contrast to this, the [[British Banking School]] followed the real bills doctrine, recommending that the bank's operations should be governed by the needs of trade: Banks should be able to issue currency against bills of trading, i.e. "real bills" that they buy from merchants. A third group, the Free Banking School, held that competitive private banks would not overissue, even though a monopolist central bank could be believed to do it.<ref>{{cite journal |last1=Schwartz |first1=Anna J. |title=Banking School, Currency School, Free Banking School |journal=The New Palgrave Dictionary of Economics |date=2018 |pages=694–700 |doi=10.1057/978-1-349-95189-5_263|isbn=978-1-349-95188-8 }}</ref>

The debate between currency, or quantity theory, and banking schools during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century, the banking schools had greater influence in policy in the United States and Great Britain, while the [[British Currency School|currency schools]] had more influence "on the continent", that is in non-British countries, particularly in the [[Latin Monetary Union]] and the [[Scandinavian Monetary Union]].

During the Bullionist Controversy during the [[Napoleonic Wars]], [[David Ricardo]] argued that the Bank of England had engaged in over-issue of bank notes, leading to commodity price increases. In the late 19th century, supporters of the quantity theory of money led by [[Irving Fisher]] debated with supporters of [[bimetallism]]. Later, [[Knut Wicksell]] sought to explain price movements as the result of real shocks rather than movements in money supply, resounding statements from the real bills doctrine.<ref name=Dimand/>

In 2019, monetary historians [[Thomas M. Humphrey]] and [[Richard Timberlake]] published "Gold, the Real Bills Doctrine, and the Fed: Sources of Monetary Disorder 1922–1938".<ref>{{cite book |last1=Humphrey |first1=Thomas M. |last2=Timberlake |first2=Richard H. |title=Gold, the Real Bills Doctrine, and the Fed : sources of monetary disorder 1922–1938 |date=2019 |publisher=Cato Institute |location=Washington, D.C. |isbn=978-1-948647-13-7 |edition=First}}</ref>

==== Keynes and the early Keynesians ====
{{further|Keynesian Revolution}}
{{further|Keynes's theory of wages and prices}}
John Maynard Keynes in his 1936 main work ''[[The General Theory of Employment, Interest and Money]]'' emphasized that wages and prices were [[Nominal rigidity|sticky]] in the short run, but gradually responded to [[aggregate demand]] shocks. These could arise from many different sources, e.g. autonomous movements in investment or fluctuations in private wealth or interest rates.<ref name=parkin/> Economic policy could also affect demand, [[monetary policy]] by affecting interest rates and [[fiscal policy]] either directly through the level of [[government final consumption expenditure]] or indirectly by changing [[Disposable and discretionary income|disposable income]] via tax changes.

The various sources of variations in aggregate demand will cause cycles in both output and price levels. Initially, a demand change will primarily affect output because of the price stickiness, but eventually prices and wages will adjust to reflect the change in demand. Consequently, movements in real output and prices will be positively, but not strongly, correlated.<ref name=parkin/>

Keynes' propositions formed the basis of [[Keynesian economics]] which came to dominate macroeconomic research and economic policy in the first decades after World War II.<ref name=Blanchard/>{{rp|526}} Other Keynesian economists developed and reformed several of Keynes' ideas. Importantly, [[William Phillips (economist)|Alban William Phillips]] in 1958 published indirect evidence of a negative relation between inflation and unemployment, confirming the Keynesian emphasis on a positive correlation between increases in real output (normally accompanied by a fall in unemployment) and rising prices, i.e. inflation. Phillips' findings were confirmed by other empirical analyses and became known as a [[Phillips curve]]. It quickly became central to macroeconomic thinking, apparently offering a stable trade-off between [[price stability]] and employment. The curve was interpreted to imply that a country could achieve low unemployment if it were willing to tolerate a higher inflation rate or vice versa.<ref name=Blanchard/>{{rp|173}}

The Phillips curve model described the U.S. experience well in the 1960s, but failed to describe the [[1973–75 recession|stagflation experienced in the 1970s]].

==== Monetarism ====
[[File:CPI 1914-2022.webp|thumb|alt=CPI 1914–2022|upright=1.8|
{{legend|#0076BA |Inflation}}
{{legend|#EE220C |[[Deflation]]}}
{{legend-line|#1DB100 solid 3px|[[Money supply|M2 money supply]] increases Year/Year}}
]]
[[File:M2 and Inflation USA.svg|thumb|right|upright=2.4|Inflation and the growth of money supply (M2)]]
{{Further|Monetarism}}

During the 1960s the Keynesian view of inflation and macroeconomic policy altogether were challenged by [[Monetarism|monetarist]] theories, led by [[Milton Friedman]].<ref name=Blanchard/>{{rp|528–529}} Friedman famously stated that ''"Inflation is always and everywhere a monetary phenomenon."''<ref>{{cite book|first1=Milton|last1= Friedman|first2=Anna Jacobson |last2=Schwartz|title=A Monetary History of the United States, 1867–1960|url=https://archive.org/details/monetaryhistoryo00frie|url-access=registration|year=1963|publisher=Princeton University Press}}</ref> He revived the [[quantity theory of money]] by [[Irving Fisher]] and others, making it into a central tenet of monetarist thinking, arguing that the most significant factor influencing inflation or deflation is how fast the [[money supply]] grows or shrinks.<ref name="Lagassé2000">{{cite book |author=Lagassé, Paul |title=The Columbia Encyclopedia |publisher=Columbia University Press |location=New York |year=2000 |chapter=Monetarism |isbn=0-7876-5015-3 |edition=6th |url-access=registration |url=https://archive.org/details/columbiaencyclop00laga }}</ref>

The quantity theory of money, simply stated, says that any change in the amount of money in a system will change the price level. This theory begins with the [[equation of exchange]]:

:<math>MV = PQ,</math>
where
:<math>M</math> is the nominal quantity of money;
:<math>V</math> is the [[velocity of money]] in final expenditures;
:<math>P</math> is the general price level;
:<math>Q</math> is an index of the [[real versus nominal value (economics)|real value]] of final expenditures.

In this formula, the general price level is related to the level of real economic activity (''Q''), the quantity of money (''M'') and the velocity of money (''V''). The formula itself is simply an uncontroversial [[accounting identity]] because the velocity of money (''V'') is defined residually from the equation to be the ratio of final nominal expenditure (<math> PQ </math>) to the quantity of money (''M'').<ref name=Mankiw2002/>{{rp|81–107}}

Monetarists assumed additionally that the velocity of money is unaffected by monetary policy (at least in the long run), that the real value of output is also [[exogenous]] in the long run, its long-run value being determined independently by the productive capacity of the economy, and that money supply is exogenous and can be controlled by the monetary authorities. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money.<ref name=Mankiw2002/>{{rp|81–107}} Consequently, monetarists contended that monetary policy, not fiscal policy, was the most potent instrument to influence aggregate demand, real output and eventually inflation. This was contrary to Keynesian thinking which in principle recognized a role for monetary policy, but in practice believed that the effect from interest rate changes to the real economy was slight, making monetary policy an ineffective instrument, preferring fiscal policy.<ref name=Blanchard/>{{rp|528}} Conversely, monetarists considered fiscal policy, or government spending and taxation, as ineffective in controlling inflation.<ref name="Lagassé2000"/>

Friedman also took issue with the traditional Keynesian view concerning the Phillips curve. He, together with [[Edmund Phelps]], contended that the trade-off between inflation and unemployment implied by the Phillips curve was only temporary, but not permanent. If politicians tried to exploit it, it would eventually disappear because higher inflation would over time be built into the economic expectations of households and firms.<ref name=Blanchard/>{{rp|528–529}} This line of thinking led to the concept of [[potential output]] (sometimes called the "natural gross domestic product"), a level of GDP where the economy is stable in the sense that inflation will neither decrease nor increase. This level may itself change over time when institutional or natural constraints change. It corresponds to the Non-Accelerating Inflation Rate of Unemployment, [[NAIRU]], or the "natural" rate of unemployment (sometimes called the "structural" level of unemployment).<ref name=Blanchard/> If GDP exceeds its potential (and unemployment consequently is below the NAIRU), the theory says that inflation will ''accelerate'' as suppliers increase their prices. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will ''decelerate'' as suppliers attempt to fill excess capacity, cutting prices and undermining inflation.<ref>{{cite journal | last = Coe | first = David T. | title = Nominal Wages. The NAIRU and Wage Flexibility | publisher = Organisation for Economic Co-operation and Development (OECD) | url = http://www.oecd.org/dataoecd/59/19/33917832.pdf | year = 1985 | id = MPRA Paper 114295 | journal = OECD Economic Studies | issue = 5 | pages = 87–126 | s2cid = 18879396 | access-date = February 24, 2010 | archive-date = February 26, 2018 | archive-url = https://web.archive.org/web/20180226211933/http://www.oecd.org/dataoecd/59/19/33917832.pdf | url-status = live }}</ref>

==== Rational expectations theory ====

{{Further|Rational expectations}}

In the early 1970s, [[rational expectations theory]] led by economists like [[Robert Lucas Jr.|Robert Lucas]], [[Thomas J. Sargent|Thomas Sargent]] and [[Robert Barro]] transformed macroeconomic thinking radically. They held that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate [[opportunity cost]]s and pressures.<ref name=Blanchard/>{{rp|529–530}} In this view, future expectations and strategies are important for inflation as well. One implication was that agents would anticipate the likely behaviour of central banks and base their own actions on these expectations. A central bank having a reputation of being "soft" on inflation will generate high inflation expectations, which again will be self-fulfilling when all agents build expectations of future high inflation into their nominal contracts like wage agreements. On the other hand, if the central bank has a reputation of being "tough" on inflation, then such a policy announcement will be believed and inflationary expectations will come down rapidly, thus allowing inflation itself to come down rapidly with minimal economic disruption. The implication is that [[credibility]] becomes very important for central banks in fighting inflation.<ref name=Blanchard/>{{rp|467–469}}

==== New Keynesians ====

Events during the 1970s proved Milton Friedman and other critics of the traditional Phillips curve right: The relation between the inflation rate and the unemployment rate broke down. Eventually, a consensus was established that the break-down was due to agents changing their inflation expectations, confirming Friedman's theory. As a consequence, the notion of a [[natural rate of unemployment]] (alternatively called the structural rate of unemployment) was accepted by most economists, meaning that there is a specific level of unemployment that is compatible with stable inflation. [[Stabilization policy]] must therefore try to steer economic activity so that the actual unemployment rate converges towards that level.<ref name=Blanchard/>{{rp|176–189}} The trade-off between the [[unemployment rate]] and inflation implied by Phillips thus holds in the short term, but not in the long term.<ref>Chang, R. (1997) [https://www.frbatlanta.org/filelegacydocs/ACFC7.pdf "Is Low Unemployment Inflationary?"] {{webarchive|url=https://web.archive.org/web/20131113212953/https://www.frbatlanta.org/filelegacydocs/ACFC7.pdf|date=November 13, 2013}} ''Federal Reserve Bank of Atlanta Economic Review'' 1Q97: 4–13.</ref> Also the [[1970s energy crisis|oil crises of the 1970s]] causing at the same time rising unemployment and rising inflation (i.e. [[stagflation]]) led to a broad recognition by economists that [[supply shock]]s could independently affect inflation.<ref name=parkin/><ref name=Blanchard/>{{rp|529}}

During the 1980s a group of researchers named [[New Keynesian economics|new Keynesians]] emerged who accepted many originally non-Keynesian concepts like the importance of monetary policy, the existence of a natural level of unemployment and the incorporation of rational expectations formation as a reasonable benchmark. At the same time they believed, like Keynes did, that various [[market imperfection]]s in different markets like labour markets and financial markets were also important to study to understand both inflation generation and [[business cycle]]s.<ref name=Blanchard/>{{rp|533–534}} During the 1980s and 1990s, there were often heated intellectual debates between new Keynesians and new classicals, but by the 2000s, a synthesis gradually emerged. The result has been called the ''new Keynesian model'',<ref name=Blanchard/>{{rp|535}} the "[[new neoclassical synthesis]]"<ref name=Goodfriend>{{cite journal |last1=Goodfriend |first1=Marvin |title=How the World Achieved Consensus on Monetary Policy |journal=Journal of Economic Perspectives |date=1 November 2007 |volume=21 |issue=4 |pages=47–68 |doi=10.1257/jep.21.4.47|s2cid=56338417 |doi-access=free }}</ref><ref>{{cite journal |last1=Woodford |first1=Michael |title=Convergence in Macroeconomics: Elements of the New Synthesis |journal=American Economic Journal: Macroeconomics |date=1 January 2009 |volume=1 |issue=1 |pages=267–279 |doi=10.1257/mac.1.1.267}}</ref> or simply the "new consensus" model.<ref name=Goodfriend/>