Inflation is more than just a vague feeling that your grocery bills are going up. In the economy, it refers to a visible rise in the price level. This is generally considered an excessive increase in the general price level. If you want to understand why your money buys fewer things each year, you need to study the mechanisms that move money. There is no single answer. Four theories are commonly used to explain inflation. Everyone sees problems through different lenses.
Money supply and economic growth
The first and oldest explanation is quantity theory. It was proposed by David Hume in the 18th century. The hypothesis is simple. When the money supply increases, prices rise. More money for the same amount of goods means a higher price.
Milton Friedman completed his quantity theory in the middle of the 20th century. He believed that the recipe for stabilizing prices was to increase the money supply at the same rate as economic growth. If the economy grows by 3%, the money supply should also grow by 3%. Deviation from this leads to instability. This approach focuses strictly on the supply side of the equation. It assumes that controlling the monetary base is the primary means of controlling inflation.
Requirements and government intervention
Another approach is John Maynard Keynes’s theory of income determination. This assumes that inflation occurs when the demand for goods and services exceeds the supply. Too much money chasing too little product can drive up prices.
It urges the government to curb inflation by adjusting spending and taxation and by raising or lowering interest rates. This is an active administrative view. If the demand gets too high, the government can cool it down. raise taxes. Reduce expenses. Raising interest rates increases loan costs. This theory supports the use of fiscal and monetary policy in balancing scales.
Wage price spiral
A third approach is the cost-push theory. It follows inflation into a phenomenon known as the price-wage spiral. Hence, workers’ demands for higher wages lead to employers raising prices to reflect higher costs. Workers are demanding more funds to cover their living expenses. The company pays. The company then raises prices to protect profits. The price increases justify the following wage demands: It sowed the seeds for a new wave of wage demands. It becomes a self-reinforcing cycle. The focus here is on production costs, not total demand.
Structural problems in developing countries
The fourth approach is structural theory. It highlights the structural imbalance of the economy. This is especially important for developing countries. In this case, imports grow faster than exports. This causes the international value of developing countries’ currencies to fall. A weakened currency increases the price of imported goods. This increases the internal price. Inflation here is caused by foreign trade balances and exchange rate appreciations rather than domestic disruptions in money supply or demand.
Knowing which theory holds true can help you read the news differently. Will central banks raise interest rates to curb demand? It’s Keynes. Will wages skyrocket? This is cost pressure. Is the currency collapsing? This is structural. Stickers change solutions.
*See also deflation and price index.
