Introduction to Economics                                            Lesson 06 / 07



Inflation is one of the most discussed topics in Economics.  It is however one of the least understood and most widely confused, even amongst economists.  To a large part, this arises from its close connection to, and intertwining with, the political process.


What is Inflation ? 

Confusion begins with defining just what is Inflation.  The most popular and accepted definition is that Inflation is a persistent and general increase, within an economy, of prices, and a commensurate decrease in the value of money.  Critics of this definition maintain that this merely identifies a typical symptom of inflation.  A better economic definition of inflation is any increase in the volume of money.


Attitudes towards Inflation

One of the most significant distinguishing features of the various schools of economic thought is their understanding of, and attitudes towards, inflation.  This in turn is a key towards the acceptance and application of the teachings of one or other particular school. In so far as any particular school regards inflation as capable of having a beneficial affect it can be described as, to a greater or lesser extent, inflationist. 

Only those schools that regard and teach that inflation is, and always is, detrimental to the general well being of a society can be properly described as non-inflationist.  With that distinction in mind we can examine 3 particular major modern schools of economic thought; the Keynesian, Chicago [or Friedmanite], and the Austrian.

In simple terms an inflationist would be one who regarded any increase in the quantity of money as always being of benefit to a society.  In affect, more money equals more wealth or purchasing power.  More purchasing power will lead to the creation of the various goods and services that will enable the increased purchasing power to be used and enjoyed by the holders thereof.

Generally speaking, most people can see the flaw in a pure inflationist policy.  After all if more money is the answer where are we to stop.  Should every member of a society be given $1 million, $10 million, $50 million?  Would anyone be better off?

Since WW2 the major school of economic thought has been the Keynesian.  In certain circumstances it regards inflation as having a beneficial affect.  In particular it regards it as a cure for depression.  More money can be used to get industry moving again and to restore full employment.  Once this has been achieved judicial use of the taxing power can be used to fine tune the economy and prevent the inevitable rise in prices from becoming rampant.  Keynesians are thus qualified inflationists.

Disillusionment with the dominant Keynesian policies became widespread in the 1970’s with the advent of stagflation, that is to say rampant rising prices accompanied by low or falling productivity.  In 1977 the US dollar was losing value at the annual rate of 6%, the Spanish peseta at 17.5%, the Italian lira at15.7%, the British pound at 14.5%, the Swedish Krone at 9.5%, and the Japanese yen at 9.1%.  Other parts of the world, including, in particular, Latin America did significantly worse.  Australia too suffered.

Keynesian theory called for the government to inflate during depressed periods.  This was attractive to those who benefit from inflation, in particular the government.  In good times the excess purchasing power was to be soaked up by increased taxation and reduced spending.  The problem is that increasing taxation and reducing spending is politically difficult at any time.

As people have lost faith in Keynesianism the views of the Chicago school, particularly those of Milton Friedman have gained favour.  Members of the school are sometimes referred to as Monetarists.

 Monetarism regards inflation, by which is meant a persistent and general growing increase in prices, as an unqualified evil.  It is caused by the increase in the creation of money exceeding the increase in the supply of useable goods and services.  The solution, initially, was seen to be to match the increase in the creation of money to the increase in production of goods and services.  In that way prices would remain stable.  Subsequently, as the difficulties in actually doing that have become more apparent, the suggestion has been that the money supply should simply be increased annually at a predetermined and unchanging fixed rate.  If not productive of absolutely stable prices it would ensure a degree of predicability.

Unlike the Keynesians and the Monetarists, the Austrian school is opposed to any increase in the money supply whatsoever.  It is this that they regard as inflation and which is unqualifiedly bad.  To help achieve their goal, many members advocate a return to commodity money.  Eschewing inflation renders the school particularly unattractive to those who benefit therefrom.  Relatively the school is marginal with little political influence.  Economically however its ideas are innovative and convincing.


What’s Wrong with Inflation

The creation of new money does not mean that goods and services will forthwith exist to be purchased with the new money.  More money chasing the same amount of goods and services means higher prices.

Inflation creates various groups of winners and losers.  The primary winner, at least in the short term, is government, which creates and gets to spend the new money first, before the rise in prices.  Thereafter those who receive the new money early, often those directly involved with government receive a benefit, but one decreasing as the new money loses value.  Those towards the end of the queue, including those on relatively fixed incomes such as wage earners, pensioners, retirees and creditors generally suffer significant losses, since they pay higher prices, before and often without any increase in nominal income.  Inflation is generally hard on the middle class.  Conversely borrowers do particularly well since they can eventually repay their loans in devalued money.

Inflation is a tax.  For a variety of reasons it is a particularly bad tax.  It is an indirect and surreptitious tax, easy to introduce, difficult to remove and hard to quantify.  By creating new money government is able to pursue its ends, which we can assume are admirable in themselves.  Nontheless, in so doing they perforce consume resources for which government would otherwise have had to raise the money to pay for, either by tax or by borrowing.

Inflation is unsustainable.  As money loses value people begin to lose faith in it and avoid accepting or holding it, preferring items more likely to retain value. This leads, if unchecked, to the demise of the currency, which in turn leads, absent a medium of exchange, to the destruction of the economy and possibly to civilisation itself

Inflation leads to scapegoating.  It is a monetary phenomenon which first and always is the creation of government.  Yet as the difficulties associated therewith increase there arises a desire and need to shift the blame.  The usual suspects are then trotted out and popular resentment directed towards them; greedy shopkeepers, the oil companies, Arab sheikhs, the unions, speculators, farmers or whatever.  Needless to say it is none of their fault.

Inflation leads to the introduction of counterproductive policies such as wage and price controls and indexation.  The way to stop inflation is to cease creating new money.  Indexes and controls merely mask the problem; indexes inevitably lag and controls prevent the market from operating or are avoided.  Both target those who are not to blame and penalise the ones suffering the most.


Can Inflation be used to Cure Unemployment?

It used to be thought that you could have a trade off between inflation and unemployment.  Arguably if unemployment existed the government could create money to employ the unemployed on public works.  However, as the stagflation of the 1970’s, [when there co-existed both inflation and unemployment], showed, such solution can be short term at best, and thereafter the consequential effects on the economy are such as to create a situation worse than before.



During the era of commodity money, particularly that of gold and silver, the ability of rulers and governments to inflate was severely constrained.  They were largely confined to debasing or clipping the currency.  Inflation when it occurred was, with one major exception, temporary and episodic, associated with major events such as the American and French Revolutions, the Napoleonic and US Civil Wars or with major discoveries of gold and to a lesser extent silver, such as in California, Australia, Alaska and South Africa.  The major exception was the C16th, the century following the discovery of the New World, when gold flooded into Europe through Spain causing, major and persistent inflation throughout the century in a number of countries, and leading in no small way to the demise of the Imperial Spanish economy.

Traditionally the alchemist’s dream was to turn lead into gold. The world’s rulers and governments have been more pragmatic and more successful.  Combined with Legal Tender laws they have discovered a way, via paper money, to turn paper into gold.  This has led to an era of persistent inflation. 

Since WW1 the typical national currency has lost approximately 90% of its value and inflation has become accepted as a constant fact of life.  From time to time and from country to country when a government has become particularly greedy or proved especially inept the inflation becomes overwhelming and the particular economy collapses.

Currently one of the world’s leading contenders for economic collapse is Zimbabwe.  Fuelled by its government’s resort to the printing press, its present rate of consumer price rise is estimated at 1,730 % annually.  As a side effect of this, the Zimbabwe stock exchange is the best performing in the world, up 12,000 % in the last 12 months.  This is not, however, a sign of economic success. Holders of Zimbabwean money, desperate to find something that might hold its value, have been pouring it into shares.


                                                        David Sharp

                                                         24 April 2007 




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