Theories of Inflation: Explained

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Following the Golden Age and the 1973 crisis, inflation became a major challenge for Western economies. Accompanied by the unexpected rise in unemployment, this phenomenon, nicknamed “stagflation” (stagnation + inflation), became a formidable economic monster.

Understanding and combating inflation became an absolute priority for Western governments, and among the various theories, it was Milton Friedman’s analysis that ultimately took center stage.

Traditional Approaches

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

Supply-side factors

Following the oil shock, economists initially attributed inflation to rising production costs – first the surge in oil prices, followed by increases in raw material and wage costs. 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, considering inflation as a consequence of rising wages and public spending, saw it as 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, involving monopolies, oligopolies, powerful unions pushing for higher wages, and employers compensating for these increases by raising prices. The psychological dimension, where individuals integrate inflation into their behaviors, also played a role in the chronicity of inflation.

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 supply of money increases.

Friedman held central banks and governments solely responsible for controlling monetary creation, emphasizing that limiting it should be their main concern, as inflation is the fundamental economic scourge triggering other problems.

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

Friedman sharply criticized the Phillips curve, arguing that it ignored the non-accelerating inflation rate of unemployment (NAIRU), an unemployment rate of about 5% that does not accelerate inflation. By ignoring this natural rate, governments tried to reduce unemployment to levels observed 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: Theories of Inflation

In conclusion, the landscape of theories surrounding inflation is vast, with each approach offering unique perspectives on this complex phenomenon. Friedman’s emphasis on the monetary roots of inflation has become a pillar of economic policies since the 1980s. The fight against inflation through austerity measures remains one of the essential doctrines shaping government approaches to economic challenges.

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

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