What Causes Inflation, and Do Lenders or Borrowers Benefit More from it? 10 common effects of inflation
We are all aware of inflation, which is an increase in prices throughout the economy. Who among us hasn’t thought back to when rent was inexpensive, or lunch was inexpensive? Who hasn’t seen costs from milk to movie tickets gradually rise? The main varieties of inflation are examined in this article, as well as the alternative hypotheses advanced by various economic schools.
Inflation is the term used to describe the rate of increase in a country’s prices for goods and services. The effects of inflation, which raises the cost of necessities like food, can be detrimental to society.
- Price rises brought on by rising production costs, such as those for labor and raw materials, can result in inflation.
- As people are prepared to pay more for the product, increasing demand for goods and services can lead to inflation.
- Some businesses profit from inflation if they can raise their prices due to the great demand for their products.
- Almost every good or service can experience inflation, including necessities like housing, food, healthcare, and utilities and wants like jewelry, cosmetics, and cars.
- Once inflation is pervasive across an economy, both consumers and companies share a common fear about the possibility of future inflation.
Central banks track inflation in industrialized countries, particularly the Federal Reserve in the United States. If prices increase too quickly or significantly, the Fed will alter its monetary policy to combat inflation, which it targets at about 2%.
Inflation may cause worry because it lowers the value of money saved today. Inflation reduces consumers’ purchasing power, making it challenging for them to retire.
For instance, if the inflation rate was 3% and an investor made 5% from stocks and bonds, the investor only received 2% in actual terms. In this post, we’ll look at the fundamental causes of inflation, various forms, and who profits from it.
The causes of inflation
In an economy, several things can influence pricing or inflation. Inflation typically occurs due to rising production costs or consumer demand for goods and services.
Factors Affecting Inflation
Costs drive inflation.
Cost-push When expenses for labor and raw commodities used in manufacturing, such as transportation and storage, increase, inflation develops. Due to rising production costs, there is a drop in the supply of commodities while the demand for goods remains constant. As a result, consumers pay higher prices for the final items due to the increased production expenses.
Since oil and metals are important production inputs, rising commodity prices indicate potential cost-push inflation. For instance, businesses that use copper in the production of their products may raise the cost of their products if the price of copper increases. If a market for the product is separate from the copper demand, the company will charge customers more for the raw materials. Without any change in customer demand for the consumed products, the outcome is higher pricing for consumers.
Wages, which are often the single largest expense for enterprises, also impact the cost of manufacturing. Labor or worker shortages can happen when the economy is booming and unemployment is low.
Companies then raise salaries to entice qualified candidates, which drives up production costs for the business. Cost-plus inflation occurs if the business raises prices due to rising employee wages.
Natural catastrophes can also raise prices. For instance, as maize is utilized in many items, prices may increase throughout the economy if a cyclone destroys a crop like corn.
Consumer Price Inflation
A product or service in high demand among consumers may experience demand-pull inflation. Prices for a wide range of commodities tend to rise as demand for those goods surges across an economy.
While short-term supply and demand imbalances are not a cause for concern, continuous demand can impact the economy and drive up prices for other items, leading to demand-pull inflation.
When unemployment is low, and salaries are rising, consumer confidence is frequently high, encouraging increased spending. An economy’s level of consumer spending is directly impacted by economic expansion, which might result in high demand for goods and services.
The amount of a certain available commodity or service decreases as demand rises. According to the economic concept of supply and demand, people are prepared to pay more for an item when there are fewer of them available. As a result, demand-pull inflation raises prices.
Companies can contribute to inflation, particularly if they produce well-liked goods. A business can raise pricing simply because customers are willing to pay the higher price. Companies may also freely raise prices when the good being sold is one that consumers must have on a daily basis, like energy and gas. Consumer demand, on the other hand, is what gives businesses the power to increase prices.
The Real Estate Market
For instance, the housing market has had ups and downs over time. Home prices will increase due to the economy’s progress if there is a demand for properties. The housing industry’s supporting goods and services are likewise impacted by demand.
The demand for building materials like steel and lumber, as well as the nails and rivets used in houses, may rise as a result of the increased demand for housing.
Broad-Based Fiscal Policy
Governments’ expansive fiscal policies can raise the disposable income available to both enterprises and consumers. Tax reductions allow businesses to invest in new projects, pay employees more, or hire more people. Additionally, consumers might buy more products. Government expenditure on infrastructure improvements is another way to boost the economy. The outcome might be a rise in the demand for goods and services, which would raise prices.
Interest rates can be lowered by central banks’ expansionary monetary policies.
The cost of lending for banks can be reduced by central banks like the Federal Reserve, enabling banks to lend more money to consumers and companies. More spending and a higher demand for products and services result from more money being made available across the economy.
Calculations of Inflation
The inflation rate is calculated using a few different indicators. The Consumer Price Index (C.P.I.), which gauges costs for a variety of economic goods and services like food, cars, education, and recreation, is one of the most well-known.
The seasonally adjusted Consumer Price Index grew by 0.3% in April 2022. The whole index saw a gain of 10.8% over the previous year, the highest percentage increase since November 1980.
The Producer Price Index (PPI), which tracks price changes that have an impact on domestic producers, is another indicator of inflation. The PPI tracks the cost of metals, chemicals, agriculture items (meats and grains), and gasoline. The Consumer Price Index will be affected if the price increases that cause the PPI to soar are passed on to consumers.
Who benefits more from inflation?
While individuals don’t benefit much from inflation, investors can profit if they have investments in markets where inflation is a factor. For instance, if energy costs are rising, investors in energy businesses may experience a boost in the value of their stocks.
If they can raise the price of their products in response to a spike in demand, some businesses profit from inflation. Building businesses can charge more for selling homes when the economy is doing well, and there is a great demand for housing.
Inflation can therefore give companies more pricing power and boost their profit margins. In the event that profit margins are increasing, this indicates that product prices are rising faster than increases in production costs.
Additionally, company owners can purposefully stop supplying the market, allowing prices to increase to a desirable level.
However, if inflation is brought on by a rise in production costs, businesses may also suffer. If businesses are unable to pass on the higher expenses to customers through higher prices, they run the danger of failing. Their prices wouldn’t have to go up if, for instance, the increase in production costs had no impact on the competition from abroad. In order to avoid losing clients to enterprises with foreign roots, American businesses may have to absorb the increased production expenses.
Do Lenders or Borrowers Benefit More from Inflation?
When there is a broad increase in the cost of goods and services and a decline in buying power, inflation is present.
The worth of a currency is measured by the number of products and services that may be purchased with one unit of money.
The long-term impacts of inflation are dependent on the money supply, according to many economists. In other words, over the long run, the money supply and price levels are directly and proportionally related. As a result, the cost of products and services rises according to the amount of cash in circulation.
Consider the scenario where everyone’s bank account and pay increased the following day. Although we could first feel twice as wealthy as we did before, the cost of products and services would fast increase to keep up with this new wage rate. The true value of our currency would soon revert to its earlier levels due to inflation. As a result, raising the money supply raises price levels. Depending on the situation, inflation may be advantageous to either the lender or the borrower.
- A general increase in the cost of goods and services that results in a decline in the buying power of money is known as inflation.
- Depending on the situation, inflation might be advantageous for both borrowers and lenders.
- Prices may rise as the money supply increases, assuming no change in economic activity. The money supply can have a direct impact on prices.
Borrowers gain from inflation because it enables them to repay lenders with money that is now worth less than it did when they first borrowed it.
When inflation raises prices, there is a greater demand for loans, which results in higher interest rates that are advantageous to lenders.
The Quantity Theory of Money and Inflation
In the long run, the quantity theory of money is the most effective method to think about money and inflation. M is the amount of money in circulation, V is the velocity of money, P is the general level of prices, and Q is the real production of the economy or real G.D.P. P=MV/Q is then obtained by solving the quantity theory for P.
If V is taken to be fairly constant, then if the money supply grows more quickly than real output, P or prices will rise. When real output does not change in the short term, such as throughout an overnight period, prices are likely to rise proportionately to the money supply. On the other hand, the rise in the actual output should eventually moderate the rise in prices. In other words, inflation can result over time if the money supply grows more quickly than real output does.
When salaries and bank accounts in an economy double, according to the P=MV/Q formula, M doubling without a matching rise in output Q (under the assumption of constant V) would result in a doubling of P or prices.
Factors Increasing the Supply of Money
Addition than creating more money, a number of other variables can raise the amount of money in an economy. Both interest rates and the reserve requirement for banks could be decreased (the percentage of deposits the bank keeps in cash reserves).
Bank reserves and lower rates would probably result in more people wanting to borrow money at reduced rates and provide banks with more money to lend. With more money in the economy, there would be more spending and demand for commodities, which would raise prices.
Bondholders may sell their government securities or corporate bonds to a central bank like the Federal Reserve Bank (Fed). The holders of the bonds would have more money, which would lead to increased expenditure.
The Fed’s policy of purchasing corporate bonds would encourage companies to issue additional bonds in order to generate funds for company expansion, which would result in more consumer spending and business investment.
Inflation May Benefit Lenders
If wages rise together with inflation and the borrower had debts prior to the inflation, the latter will benefit from the former. This is because even while the borrower’s debt remains unchanged, they now have the extra money in their salary to pay it off.
If the borrower utilizes the extra cash to settle their loan ahead of schedule, the lender pays less interest as a result.
When a business takes out a loan, the cash it obtains now will be paid back with future profits. The basic law of inflation states that over time, the value of a currency will decrease. So, money today is more valuable than money tomorrow. Inflation enables debtors to repay lenders with money that is now worth less than it was when they first borrowed it.
Inflation Can Benefit Lenders as Well
Lenders can benefit from inflation in a number of ways, particularly when providing new finance.
First, as prices rise, more people will seek loans to purchase expensive products, especially if their wages have not improved. This results in an increase in the number of borrowers for lenders. Additionally, the greater costs of those things bring in additional interest for the lender.
For instance, if the cost of television rises from $1,500 to $1,600 as a result of inflation, the lender will profit more because the rate of interest (10% on $1,600 vs. 10% on $1,500) is higher. The extra $100 and all the additional interest may also take longer to pay off, increasing the lender’s profit.
Inflation frequently has a detrimental effect on lower- and middle-class households in a way that upper-middle-class families and highly rich families do not.
Cost of Living and Inflation
The expense of living increases along with price increases. If people spend more money on their daily needs, they will have less money left over to pay their debts (assuming their incomes have remained the same). People’s purchasing power declines as a result of rising costs and stagnant income. Because of this, it may take longer for the borrowers to pay off their prior loans, allowing the lender to continue collecting interest.
However, if it leads to higher default rates, the situation can backfire. Failure to pay back a debt, including interest or principal on loan, is known as default.
People may be compelled to spend more of their income on non-discretionary expenses like rent, mortgage, and utilities when the cost of living increases. As a result, they will have less money available to pay off debts, which increases the risk of default on their obligations.
Who is Affected by Inflation?
Borrowers and lenders can both profit from inflation. For instance, borrowers benefit financially since they end up repaying lenders with money that is worth less than what was borrowed in the first place. But inflation also raises interest rates and prices and can increase demand for credit lines, all of which are advantageous to lenders.
The Process of Inflation
A way for economists to gauge how quickly prices for goods and services are rising in an economy is through inflation. Because of inflation, everyday goods like food and gas may cost more, even while wage increases are insufficient to offset the increase in these costs.
Why does inflation occur?
Prices rise as a result of both increased demand and rising production costs, such as those associated with raw materials, as demand for goods and services increases or supplies of goods and services become scarce. Because customers must pay more for products and services due to the increase in demand, inflation may result.
Central banks, including the Federal Reserve, may raise interest rates in an effort to reduce inflation if it is rising while the economy is expanding. Consumer borrowing may slow down as a result of higher interest rates as they take out fewer loans. The increase in interest rates, especially for variable-rate credit instruments like credit cards, can help lenders increase their earnings.
10 Common Effects of Inflation
The general increase in the cost of goods and services over time is referred to as inflation. Between 1914 and 2022, the U.S. yearly inflation rate averaged 3.27 percent.
So for more than a century, modest inflation has been a fact of life and the normal status of the economy.
Because of this, it’s critical to distinguish between the consequences of inflation at all rates and those that only manifest themselves during periods of extremely high inflation. Identifying inflation’s most significant consequences on consumers, investors, and the economy will be done below.
Purchasing power is reduced by inflation, which is the long-term, widespread increase in the cost of goods and services.
While a high inflation rate has a tendency to spiral out of control and harm the economy’s long-term performance, a low but positive inflation rate is economically advantageous.
Value equities, energy commodities, and real estate have typically performed better when inflation is high or growing.
On the other hand, as inflation reduces the present value of their future cash flows to investors, bonds and pricey growth stocks tend to lag.
1. Reduces Buying Power
This is the main and most significant impact of inflation. A general increase in prices over time diminishes customers’ purchasing power because a constant quantity of money will eventually allow for less consumption.
Whether inflation is running at 2% or 4%, consumers still lose purchasing power; the higher inflation rate only doubles that loss. If long-run inflation doubled, compounding would ensure that the aggregate price level would rise more than twice as much.
2. Hurts the Poor Disproportionately
lower incomes typically spend a bigger percentage of their total income and on needs than do those with higher incomes, leaving them with less of a defense against the erosion of buying power caused by inflation.
This is what economists mean when they say that a higher marginal propensity to consume is correlated with lower incomes.
Policymakers and players in the financial markets frequently concentrate on “core” Inflation, which excludes the costs of food and energy because they are more volatile and hence less representative of the longer-term inflation trend.
However, lower-income wage earners in industrialized economies and the majority of people in emerging economies spend a disproportionately high amount of their weekly or monthly household budgets on food and energy, which are difficult to substitute or forgo as prices rise.
The ownership of assets like real estate, which has historically been used as a hedge against inflation, is also less common among the poor.
A cost of living adjustment based on an index of consumer prices for hourly wage earners and clerical workers is provided to beneficiaries of Social Security benefits and other government transfer payments as inflation protection.
3. Prevents Deflation
In order to fulfill its goals for stable prices and maximum employment, the Federal Reserve aspires for inflation of 2% over the long term.
Instead of aiming for constant prices, it aims for modest inflation since this helps the economy function, gives room for error in the event that inflation is overestimated, and prevents Deflation, which can be far more destabilizing than equivalent inflation.
Lenders might charge interest to make up for the inflation, which would likely reduce repayment amounts. By allowing borrowers to make future repayments with inflated money, inflation also aids in the debt servicing process. In contrast, Deflation increases the cost of debt repayment because borrowers’ income would presumably decrease along with prices.
Deflation deviates from the usual, so it’s also more likely to inspire predictions of greater Deflation, leading to further losses in spending and income and eventually a widespread loan default that might spark a banking crisis.
Because wages are sticky to the downside, mild inflation rather than Deflation is more common. Layoffs are the most likely option for businesses facing a decline in demand because workers typically oppose attempts to reduce their pay during an economic slump.
A wage freeze will result in a decrease in actual labor costs if inflation is positive.
As soon as inflation rises above the usual and anticipated pace, since inflation can potentially become out of control if it is high enough, its benefits as a hedge against Deflation begin to diminish.
4. Feeds on Itself When High
As we’ve spoken about, a little inflation might be a sign of a strong economy and is unlikely to raise inflation expectations. If the rate of inflation remains at 2 percent from last year, it is basically unnoticeable. In that scenario, businesses, employees, and consumers would probably anticipate that inflation will stay at 2% in 2019.
However, expectations of future inflation will eventually start to rise in line with the inflation rate when it suddenly accelerates and remains high. A wage-price spiral results from firms passing on costs by rising output prices as expectations rise and workers seek higher salary increases.
A poorly executed policy reaction to excessive inflation could, in the worst instance, result in hyperinflation.
However, there is no need to include in the wheelbarrow loads of trillion dollar notes from Zimbabwe or the worthless marks from the Weimar Republic’s five years of hyperinflation following World War I when calculating the price of rising inflation expectations.
In the United States, rising inflation expectations during the 1970s led to annual inflation rising beyond 13 percent by 1980 and the federal funds rate reaching more than 20 percent by 1981. Following the subsequent recessions, unemployment peaked at 10 percent in the middle of 1983.
5. Raises Interest Rates
Governments and central banks have a strong motive to control inflation, as the aforementioned examples indicate. Over the past century, monetary policy has been used in the U.S. and other countries to control inflation.
Policymakers can increase the minimum interest rate when inflation threatens to surpass a central bank’s target (usually 2% in industrialized economies and 3% to 4% in emerging economies), which raises borrowing costs throughout the economy by limiting the availability of money.
As a result, inflation and interest rates frequently follow one another. Central banks can tame the economy’s animal spirits or risk appetite and the ensuing price pressures by boosting interest rates as inflation soars.
The projected monthly payments for that yacht or the corporate bond issue for a new expansion project suddenly appear to be a bit excessive. In the meanwhile, newly issued Treasury bonds will often offer higher risk-free rates of return, rewarding savings.
6. Reduces Debt Service Charges
While individuals with fixed-rate mortgages and other loans gain from repaying these with inflated money, cutting their debt service costs after accounting for inflation, new borrowers are likely to incur higher interest rates when inflation rises.
Let’s say you take out a $1,000 loan with an interest rate of 5% per year. The annual decrease in your inflation-adjusted loan balance will outweigh your interest charges if annual inflation rises to 10% in the future.
This does not apply to adjustable-rate mortgages, credit card debt, or home equity lines of credit, all of which normally permit lenders to raise interest rates in response to inflation and increases in the Federal Reserve’s benchmark rate.
7. Promotes Employment and Growth in the Short Term
Short-term economic growth can be accelerated by rising inflation.
Between 1970 and 1979, the U.S. real Gross Domestic Product (G.D.P.) increased by 3.2 percent annually on average, far faster than the economy’s subsequent average growth rate. However, the 1970s are remembered as a decade of stagflation.
High inflation makes saving less appealing since it gradually reduces the purchase value of money. Consumer spending and company investment may increase as a result of that possibility.
As a result, unemployment frequently initially drops as inflation increases. The Phillips curve, which expresses the relationship, was developed in response to historical findings of the inverse link between unemployment and inflation. Higher inflation can, at least temporarily, increase demand while cutting inflation-adjusted labor costs, resulting in job growth.
But eventually, a hard recession that resets expectations will be required to pay the price for chronically high inflation, or else the economy will continue to perform poorly.
8. May Lead to Difficult Recessions
The issue with the trade-off between inflation and unemployment is that, as happened in the United States during the stagflation of the 1970s, Inflation expectations may rise to the point where they start an inflationary spiral of price increases and wage increases if persistently greater inflation is accepted in order to protect jobs.
The Federal Reserve was then compelled to boost interest rates significantly higher and maintain them high for a longer period of time in order to rebuild lost confidence and persuade everyone once again that it would control inflation.
As a result, unemployment shot up and remained high for longer than it would have if the Fed hadn’t permitted inflation to rocket to such heights.
9. Damaged bonds and rising stocks
Bonds are often lower-risk investments that offer consistent interest income at a fixed rate. By reducing the present value of that income, Inflation, and particularly significant Inflation depreciates the value of bonds.
The yield on freshly issued bonds rises as interest rates rise in response to rising or high inflation. Since bond prices are the inverse of bond yields, the market price of bonds that were previously issued at a lower yield then decreases accordingly.
Investors who hold a Treasury bond are still eligible to receive the anticipated coupon payments and the principal repayment when the bond matures. But because of the higher market yields, individuals who sell before maturity will earn less money.
There is less agreement on whether rising inflation generally harms or benefits equities. The 1970s, a lost decade for U.S. stocks under stagflation, may or may not be included in the historical record mentioned, depending on the definition of high inflation used.
Inflation is notoriously allergic to growth stocks, which tend to be more expensive. As a result, inflation reduces the present value of growth stocks’ future cash flows more severely than it does for high-duration bonds. Stocks in the consumer and technology sectors have trailed during previous periods of high or rising inflation.
10. Strengthens Value, Real Estate, and Energy Stocks
Real estate has long been used as a buffer against inflation because landlords can do so by rising rents, even while inflation reduces the real cost of fixed-rate mortgages.
Inflation can increase as a result of growing commodity prices, but once it occurs, commodities, particularly energy commodities, tend to outperform. However, this can alter when growth slows.
Unsurprisingly, during periods of high or growing inflation, energy equities, real estate investment trusts, and value stocks have historically outperformed.
What Is the Main Effect of Inflation?
A typical basket of goods and services becomes steadily more expensive as a result of inflation, which reduces the purchasing power of a currency.
How Can Homeowners Benefit from Inflation?
Inflation benefits homeowners with fixed-rate mortgages because it lowers the present value of their upcoming mortgage payments. Home equity rises as a result of rising housing prices brought on by inflation. And lastly, landlords who rent out their properties can raise rents in line with inflation.
Understand the Different Types of Inflation
The rate at which the average price of different products and services in an economy increases over time is known as inflation.
As a result, money loses value since it can no longer buy as much as it once could; a nation’s currency loses purchasing power.
Inflation that is significantly higher than that target level could result in extreme circumstances like hyperinflation or stagflation, but central banks aim to maintain mild inflation of up to 3 percent to support economic growth.
A time of rapid inflation is known as hyperinflation, while stagflation is characterized by rapid inflation, weak economic growth, and significant unemployment.
Reduced costs entail lower profits for businesses, which may lead to layoffs. Deflation occurs when prices decrease dramatically as a result of an excessively large money supply or a decline in consumer expenditure.
Two Extremes: Stagflation and Hyperinflation
Although many economists feel a reasonable level of inflation is good for a country’s economy, consumers may dislike price increases. Typically, central banks strive to keep inflation between 2 and 3 percent.
Fears of potential hyperinflation, a terrible scenario in which inflation climbs quickly out of control, can arise when inflation rises dramatically beyond this range.
Throughout history, there have been a number of noteworthy examples of hyperinflation. Germany’s early 1920s inflation rate of 30,000 percent a month is the most notable example.
An even more extreme example is Zimbabwe. Steve H. Hanke and Alex K. F. Kwok’s analysis indicates that in November 2008, monthly price hikes in Zimbabwe reached an estimated 79,600,000,000 percent.
Stagflation, a period of both inflation and economic stagnation, may also cause devastation. A witch’s brew of economic hardship, this sort of inflation combines weak economic growth, significant unemployment, and extreme inflation all at once.
Stagflation is a very uncommon phenomenon, but it did affect the United States and the United Kingdom in the 1970s, much to the dismay of both countries’ central banks.
Stagflation raises the risks associated with monetary and fiscal policy responses, which presents a particularly difficult issue for central banks.
While central banks can typically increase interest rates to counteract excessive inflation, doing so in a stagflationary environment could risk making unemployment worse. In contrast, because doing so could lead to an increase in inflation, central banks are constrained in their ability to lower interest rates during stagflation.
As a result, central banks are effectively trapped by stagflation and have no choice except to surrender. The most challenging sort of inflation to control is stagflation, in my opinion.
Negative inflation, also referred to as Deflation, happens when prices decline for a variety of causes. A decreased money supply raises the value of the currency, which lowers prices.
Negative inflation can also result from a decline in consumer expenditure or a decrease in demand due to an excessive supply. In the short term, Deflation can have a detrimental impact on the economy since it lowers the prices of products and services, making them more accessible. Businesses that sell less of their goods are compelled to reduce costs by firing or terminating workers, which raises unemployment rates.
Why does inflation occur?
We can fairly easily identify inflation, but it is much more difficult to determine what causes inflation. Although there are many ideas, Keynesian and monetarist economics are undoubtedly the two most important schools of thought.
Monetarist economists think that central banks should maintain stable growth for the money supply in line with G.D.P., while Keynesian economists contend that inflation originates from economic factors such as the higher cost of manufacturing and look to government intervention as a solution.
John Maynard Keynes, a British economist who lived from 1883 to 1946, is the source of the name and intellectual underpinnings of the Keynesian school of thought.
Keynesian economics is widely characterized by its emphasis on aggregate demand as the main driver of economic development, even though its modern interpretation is still evolving.
As a result, supporters of this school support governmental intervention through fiscal and monetary policy as a way to get the intended economic results, such as raising employment or reducing business-cycle instability.
According to the Keynesian school of thought, economic factors like growing production costs or rising aggregate demand are what causes inflation. They specifically distinguish between cost-push inflation and demand-pull inflation, two main categories of inflation.
Cost-push inflation is caused by broad rises in the prices of the production components. These elements—capital, land, labor, and entrepreneurship—are the basic ingredients needed to make commodities and provide services. Producers who want to keep their profit margins must raise the price of their goods and services as the cost of these components goes up.
When these production costs grow on an overall economic level, it may result in higher consumer prices across the board as producers pass along the cost increases to customers. Thus, production expenses actually drive up consumer prices.
Demand-pull inflation happens when total demand outpaces total supply. Take a popular product as an illustration where demand exceeds supply. The merchandise’s cost would go up. According to the demand-pull inflation theory, prices will go up across the board if total demand outpaces total supply.
Despite not having a clear founder, the monetary theory is closely related to the American economist Milton Friedman (1912–2006).
Monetarism, as its name implies, is primarily interested in how money influences economic processes. In particular, it is focused on how changes to the money supply affect the economy.
The effectiveness of government involvement in the economy is viewed with greater skepticism by monetarists than by Keynesians. Such interventions run the danger of doing more harm than good, according to monetarists.
Perhaps the most well-known of these criticisms were made by Friedman himself in their influential book, A Monetary History of the United States, 1867-1960, which they co-authored with Anna J. Schwartz. In this book, Friedman and Schwartz argued that the Federal Reserve’s policy choices unintentionally worsened the severity of the Great Depression.
Friedman proposed that central banks should focus on preserving a stable rate of expansion for the country’s money supply in line with the gross domestic product in light of this criticism (G.D.P.).
Monetarists: Money is Everything
In the past, monetarists have claimed that a rising money supply causes inflation. Friedman’s statement that “inflation is always and everywhere a monetary phenomenon” sums up the monetarist viewpoint nicely.
This perspective holds that the main driver of inflation has little to do with factors like labor prices, material costs, or consumer demand. Instead, the availability of money is everything.
The quantity theory of money, which contends that the link between the money supply and inflation is controlled by that relationship, is at the core of this viewpoint.
M=The money supply
V=The velocity of money
P=The average price level
T=The volume of transactions
This equation assumes that assuming transaction volume and money velocity remains constant, an increase (or reduction) in the money supply will result in an equal increase (or drop) in the average price level.
This relationship is not as simple as it may seem at first because the velocity of money and the volume of transactions are, in fact, never consistent. Nevertheless, this equation is a useful representation of the monetarists’ view that inflation is primarily caused by the expansion of the money supply.
From historically high episodes of hyperinflation and stagflation to the five- and ten-cent rises we rarely notice, there are many different types of inflation.
The fact that economists from the Keynesian and monetarist schools can’t agree on what causes inflation highlights the fact that it’s far more complicated than one might first think.