Is inflation always and everywhere a monetary phenomenon?
Is inflation always and everywhere a monetary phenomenon?
The phrase "inflation is always and everywhere a monetary phenomenon" was first coined by the economist Milton Friedman in 1956. By this he meant that inflation can only be caused by increases in the money supply. If his statement holds true then controlling inflation is possible simply by controlling the money growth rate.
Inflation is usually taken to mean a continual increase of the general price level. Typically a small amount of inflation is seen as necessary in order to keep money active in the economy and allow flexibility in the labour market. The answer to the question depends largely on the qualification of the word inflation as Friedman originally meant it. Friedman's argument actually referred to high and persistent levels of inflation. High inflation was and is still seen as a bad thing, and control of it imperative for a successful economy.
The belief that an increase in the money supply causes inflation stems back to old Classical theory. The government can increase the money supply by printing more money. Classicalists believe that a policy of this kind is a pointless and even risky tactic as it can have no long-run effect on the level of output in the economy. The short-run and long-run Classical arguments are briefly illustrated below.
Figure 1.1 The short run effect of an increase in the money supply
An increase in the money supply would shift the LM curve to the right resulting in a temporary equilibrium at y1. The rate of interest falls from r to r1. The output effects of an increase in the money supply are unpredictable at best and can create severe problems. The equilibrium at y1 is temporary because it is beyond the natural level of employment and cannot be sustained in the long-run.
Figure 1.2 Long run money neutrality
At the new equilibrium output is above the natural rate, the excess demand causes prices to increase. This increase in prices reduces the real money supply (M/P) and shifts the LM curve back to its initial equilibrium. The effect of an increase in the money supply, in the long-run, is to increase prices, and increase interest rates with no effect on output. The increase in prices is proportionately the same as the initial increase in the money supply. The term for this argument is long-run money neutrality.
Friedman's argument was in response to Keynes and is a development of the quantity theory of money which attempts to explain the relationship between money and inflation. The original quantity theory had two key assumptions. First, money and inflation increase proportionately, and second, the relationship between money growth, and output growth and velocity must be orthogonal i.e. velocity and output are not affected by money growth. (In the equation MV=PT (or Y as Friedman used), V and T are constant, therefore any change in M will have an equally proportional effect on P). The whole theory was dependent on the belief that V and T are held constant.
Keynes then argued strongly against the belief that velocity is constant. He emphasized instead the role of interest rates on the demand for money. Dividing demand for money into two categories, money and bonds, he argued that there were three reasons that people would choose to hold money. One is for transaction purposes, that is, money is a medium of exchange and people sometimes unexpectedly need to make an immediate purchase. Another reason is for precautionary motives. The final and crucial reason is for speculative purposes, and it is this that Keynes argues is subject to interest rate ...
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Keynes then argued strongly against the belief that velocity is constant. He emphasized instead the role of interest rates on the demand for money. Dividing demand for money into two categories, money and bonds, he argued that there were three reasons that people would choose to hold money. One is for transaction purposes, that is, money is a medium of exchange and people sometimes unexpectedly need to make an immediate purchase. Another reason is for precautionary motives. The final and crucial reason is for speculative purposes, and it is this that Keynes argues is subject to interest rate changes. When interest rates are low then people can gain money by holding bonds, but when interest rates are low people will prefer to hold money. The fact that the demand for money is dependent upon the interest rate means that velocity in the QTM cannot be constant.1
Friedman's response was then to claim that V is not necessarily fixed but that it changes in a way which is stable and predictable which did not challenge the general thrust of the theory. He also stated that people take a long term view of the demand for money further emphasizing that interest rates play only a small part in the overall picture. However, this was not a small alteration to the original quantity theory. Although it still maintains that an incremental increase in the money supply will cause an increase in prices, this relationship is no longer directly proportional. This implies that there are other factors other than the money supply which cause inflation or, at least, change the level of inflation.
For the purpose of the question it must be seen whether inflation is fuelled purely by the money supply both in the short and long-run. It must first be ascertained if there actually is a relationship between the rate of money growth in a country and its level of inflation. There have been experiments in this area, some of which will be discussed in order to establish the link between money and inflation.
Paul De Graauwe and Magdalena Polan produced a paper entitled "Is inflation always and everywhere a monetary phenomenon?" for which they used a sample of 160 countries over the last 30 years to test the relationship between money growth and inflation. As Figure 1.3 shows they discovered a very strong positive correlation between the average money supply and average inflation rate over the 30 years. They did not identify such a strong correlation for those countries with less than 20% inflation. However, even in these countries the relationship was still positive.2
Figure 1.3
The results obtained by De Graauwe and Polan confirm the work of Vogel (1974), Dwyer and Hafer (1988, 1999), Barro (1990), Pakko (1994), Poole (1994), and McCandless and Weber (1995). All of their work establishes a strong positive correlation between money growth and inflation using various measures of money.3 So, we can safely assume that a high rate of money growth is almost always accompanied by a high level of inflation.
This does not in itself prove that inflation is always and everywhere a monetary phenomenon. It could be that the high levels of inflation are triggering the increase in the money supply. Increased prices mean that people demand more money and therefore money must be printed. This is the argument of Fischer et al. whose findings reveal that "more often than not, causation runs from exchange rate changes and inflation to money growth".4 Graham Dawson agrees saying that "no correlation between money and prices, however strong, is sufficient to establish a causal effect flowing from money to prices".5
However Fischer et al. also argue that "the data shows that the inflation-money link is exceptionally strong both in the long and short-run. While the relationship may not be instantaneous and precisely one-for-one, there can be no doubt that inflation can be ended if the monetary taps are turned off."6 This confirms the relationship of money and inflation once more and notes that it is also apparent in the short-run which goes against Classical theory. Although they do not believe that money growth is the only cause of inflation they agree that control of the money supply will prevent high, persistent inflation occurring. Consequently even if the money supply increase is caused by demand led inflation, the Government always has the potential to choke off demand by increasing interest or use of fiscal policy.
The data also shows that in some instances there can be high inflation low money growth or low inflation with high money growth. This implies that inflation is not induced solely by increases in the money growth rate but that there are other forces involved. A vital aspect that the theory leaves out is that of productivity growth (which is in effect Y). The level of inflation is also a function of productivity growth because even with a high money supply, inflation will be reduced if there is a high level of productivity. The equation MV = PY is too simplistic. If there is productivity growth then in the long run Y cannot be stable. If V and Y are stable then inflation is a monetary phenomenon. In more developed countries the increasing productivity growth helps to counter the effect of any increase in the money supply. That is why there is less correlation in the relationship between money supply and inflation in more developed countries, than countries which are less developed and have less knowledge of inflation control. In the countries that have very high levels of money growth, any productivity growth (or other factor) is not large enough to distort the general effect of the money supply on inflation. This explains why countries with money growth of over 20% almost always have high levels of inflation also. Productivity growth can distort the relationship between the money supply and inflation but in cases of very high money supply growth, productivity growth is not a large enough factor to have a real influence.
A third criticism is that it is not known what should count as money in a modern economy. Until it is known what to count as money it is impossible to measure and hence confirm the stability of velocity (V).
The main dispute with the statement that 'inflation is always and everywhere a monetary phenomenon' arises when one considers the short-run. Terry J. Fitzgerald argues that "even if a close relationship between money growth and inflation exists over the long-run, that relationship largely disappears when one considers relatively short time horizons such as a year or a quarter."7
Figure 1.4
Figure 1.4 shows the discrepancies between money and inflation for the two, four and eight year averages. The two year averages indicate that money or inflation cannot be used to predict the other. It must be remembered though that the long-run is merely a series of short-runs and this relationship must not be disregarded. Especially (as Fitzgerald goes on to argue) considering that the long-run may be as short as a four year period. Friedman rubbishes the whole argument by simply stating that people take a long term view of the demand for money. This makes the short-run relationship between money and inflation irrelevant. Maybe this response was his only answer to the lack of correlation in the short run.
The question asks is inflation always and everywhere a monetary phenomenon and strictly the answer to this is no. This is because in the equation MV=PY we have established that V is dependent on interest rates, not constant and only stable at best, Y can be affected by the level of productivity growth and, there is no accurate measurement of money. However, it has also been established that very high money supply growth is almost always accompanied by high levels of inflation and it would be very foolish to assume that there is not a strong relationship between the two. It is generally accepted that control of the money supply will provide control of inflation. Therefore we can conclude that a high and persistent level of inflation is always and everywhere a monetary phenomenon. That is V and Y have only a small effect in the equation. Whilst the effect of an increase in the money supply may not have a directly proportional effect on prices, any increase in the money supply will have some effect on prices.
Seeing as the link between the money supply and inflation is so clear, it seems strange that any government would choose to continue printing money. One explanation, particularly in less developed countries, may be that if an economy is not growing then people get upset which may result in anarchy. If people are getting better off then there is less industrial unrest. If you are not getting better off then you will be miserable, things can be made 'better' by allowing the money supply to increase. This, though, is not sustainable as only real things can be given to people, otherwise there will be hyperinflation. Moderate control or monitoring of the money supply must always be a policy for any government that wishes to be successful.
Appendix
Table 1
Source: Paul De Graauwe
Figure 1
Source: Paul De Graauwe
Bibliography
Fischer, S., R. Sahay and C.Vegh (2002), "Modern High and Hyper Inflations", Journal of Economic Literature, V40 (September)
Dawson, Graham "Inflation Edward and Unemployment" Elgar Publishing Ltd (1992)
De Graauwe, P and Polan, M "Is inflation always and everywhere a monetary phenomenon?"
Fitzgerald, Terry J., "Money Growth and Inflation: How Long is the Long-Run?" Federal Reserve Bank of Cleveland, (August 1, 1999)
Mishkin, F "The Economics of Money Banking and Finance" (6th Edition Update) Addison-Wesley Longman, Inc., (2003)
Also referred to:
Lucas, Robert E, Jr, 1996 "Nobel Lecture: Monetary Neutrality" Journal of Political Economy Vol. 104
Assignment Topic
Subject: Money, Banking and Finance BS2551
Is Inflation Always and Everywhere a Monetary Phenomenon?
Name: Richard Denton
Date: 23rd April 2004
Words: 2000
Mishkin, F "The Economics of Money Banking and Finance" (6th Edition Update) (2003) pp.123
2 Source of pictures and information: De Graauwe and Polan. The charts for countries with less than 20% inflation can be seen in the Appendix Figures 1
3 See Appendix Table 1
4 Fischer, S., R. Sahay and C.Vegh (2002), "Modern High and Hyper Inflations", Journal of Economic Literature, V40 (September), p.847
5 Dawson, Graham "Inflation and Unemployment" Elgar Publishing Ltd (1992) p.16
6 Fisher et al. ibid p.849
7 Fitzgerald, Terry J., "Money Growth and Inflation: How Long is the Long-Run?" Federal Reserve Bank of Cleveland, (August 1, 1999) - Pictures also from same source.
