Regardless of what causes it or how it is measured, inflation is a real phenomenon. The most common explanation of inflation is the monetary theory focusing on the correlation between inflation and the amount of money in circulation or the availability of credit. Milton Friedman famously said that inflation “is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”[see Friedman]

In the simplest model when there is a dramatic increase in the amount of money in circulation without a corresponding increase in the amount of goods and services available for purchase, prices will rise. The idea is that they will be “bid up” when people have more money at their disposal. The first questions that occur are why consumers will “bid prices up” rather than save or invest and why an increase in the demand does not result in an increase in production.

The Samuelson-Nordhaus textbook saves the discussion of inflation for the penultimate chapter, and it does not really offer a coherent account of the causes of inflation. It takes inflation as a given historically and focuses mainly on its impact on the economy or “costs” along with policies that have attempted to prevent it or cure it. The closest it comes to explaining the causes of inflation is to point out that while inflation prior to the industrial revolution might be explained by the supply of money, recent history shows that “shocks to the economy” are what make inflation deviate from its expected rate.

The economy is constantly subject to changes in aggregate demand, sharp oil- and commodity-price changes, poor harvests, movements in the foreign exchange rate, productivity changes, and countless other economic events that push inflation away from its expected rate. [Samuelson/Nordhaus p.617]

Perhaps what this reveals is that the economy is not a closed system of producers and consumers. It is dependent on natural resources which may be subject to depletion or at least extreme fluctuations, and it is dependent on economic decisions of foreign suppliers of energy or raw materials. It is even dependent on the weather. Perhaps the ultimate cause of long-term inflation is the increasing dependence on non-renewable natural resources. If more and more products and services require energy that comes from limited resources (and may be controlled by foreign governments or multinational corporations immune to competition), then it seems likely that the price charged for the energy will keep rising. What is not explained by these “shocks to the economy,” however, is why prices continue to rise rather than stabilizing after the shock has been absorbed. This is almost universally attributed to a vicious circle between wages and prices.

Economists distinguish between “cost-push” inflation and “demand-pull” inflation. Cost-push inflation is rising prices associated with rising costs of production. This is easy to understand, especially if it is the cost of raw materials which rises. OPEC decides to cut oil supplies in retaliation for U.S. involvement in the Yom Kippur war, and we get not only lines at the gas pump but also double digit inflation which persists for years. Since the entire economy depends largely on energy generated from oil and gas, an increase in energy costs is bound to result in an increase in prices across the board.

What is not immediately obvious is why inflation continues or accelerates rather than just having a one time bump-up in prices. The standard answer to this is that price increases result in demands for higher wages, which in turn require further price increases. The problem with this explanation is that it seems to imply a one-to-one relationship between labor costs and pricing. Labor costs are only one factor determining prices, even if “wages” include all the costs of sub-contracted services associated with marketing and distribution as well as the salaries of managers who are not normally included in the category of “labor.” If a 1% increase in labor costs does not require a 1% increase in prices to yield the same profit, then there should be a dampening of the feedback effect rather than accelerating inflation. Perhaps the whole system has too many feedback loops to be simplified to this degree, and, as economists are fond of pointing out, expectations of further inflation can actually amplify the inflation as contracts are written to compensate for it.

Deflation or Recession

The cure for a decline in economic activity is surely to increase economic activity, and the government is in a unique position to do this by investing directly in the economy. Infrastructure projects will increase economic activity by employing more people. Their income will presumably result in more retail sales. In the longer term, government funded research will eventually result in new products and services adding to the economic activity.