Over the last century many countries throughout the world have experiencedinflation as their major economic problem. Expensive wars have traditionally beenrecognized as the sources of inflation. Governments, in effort to squeeze more productionout of an economy, have often resorted to printing or releasing more money to finance thepurchase of arms and soldiers1. In an economy already producing at full capacity, theissuing of additional money serves to bid up the prices of the output of the economy,resulting in inflation. It was generally assumed from past experience, that once theeconomy returned to its normal state, the persistent tendency for overall prices to risewould disappear, bringing inflation rates back to normal. World War II brought thepersistent inflation that economists came to expect.
In the 50’s and early 60’s inflationresumed to very low rates concomitant with large growth increases and lowunemployment. But, from 1967 to 1974 the rates of inflation reached alarming proportionsin many countries, such as Japan and Britain, for no apparent reason. This acceleration ininflation has forced many economists to reevaluate their views, and often align themselveswith a specific school of thought regarding the causes and cures for inflation.
There are two opposite theories regarding inflation. Monetarism indicates thatinflation is due to increases in the supply of money. The classic example of thisrelationship is the inflation that followed an inflow of gold and silver into Europe, resultingfrom the Spanish conquest of the Americas. According to monetarists, the only way tocure inflation is by government action to reduce growth of the money supply. At the other end is the cost-push theory. Cost-pushers believe that the source ofinflation is the rate of wage increases. They believe that wage increases are independent ofall economic factors, and generally are determined by workers and trade unions.
Morespecifically, inflation occurs when the wages demanded by trade unions and workers addup to more than the economy is capable of producing. Cost- pushers advocate limiting thepower of trade unions and using income policies to help fight off inflation. In between the cost-push and monetarism theory is Keynesianism.
Keynesiansrecognize the importance of both the money supply and wage rates in determininginflation. They sometimes advise using monetary and incomes policies as complimentarymeasures to reduce inflation, but most often rely on fiscal policy as the cure. Before we can understand the policies suggested by these different schools ofthought, we must look at the historical development of our understanding of inflation. For approximately 200 years before John Maynard Keynes wrote the GeneralTheory of Employment, Interest , and Money, there was a broad agreement amongeconomists as to the sources of inflationary pressure, known as the quantity theory ofmoney2.
The Quantity theory of money is easily understood through fisher’s equationMV=PY( money supply times velocity of circulation of money equals pricetimes real income)Quantity theorists believe that over an extended period of time the size of M, themoney supply, cannot affect the overall economic output, Y. They also assume that for allpractical purposes V was constant because short term variations in the circulations ofmoney are short lived, and long term changes in the velocity of circulation are so small asto be inconsequential . Lastly, this theory rests on the belief that the supply of money is inno way determined by the economic output or the demand for money itself.The central prediction that can now be made is that changes in the money supplywill lead to equiproportionate changes in prices. If the money supply goes up thenindividuals initially find themselves with more money. Normally individuals will tend tospend most of their excess money. The attempt of people to buy more than they normallydo must result in the bidding up of prices because of the competitive nature of the market,inflation.
Also essential to the quantity theory is the belief that in a competitive market,where wages and prices are free to fluctuate, there would be an automatic tendency forthe market to correct itself and full employment to be established. In figure 1, w stands for the real wage rate (the amount of goods and services thatan individuals money income can buy), L d for the demand for labor and L s for the supplyfor labor. Suppose now that the economic system inherited a real wage rate w 1, Thesupply of