Further notes on inflation and the quantity theory of money

A theory of inflation (originally posted on my earlier blogspot blog Sept 19, 2010)
Throughout the history of monetary theory the subject of inflation and the role of the money stock has loomed large. One can go back to Copernicus and discover rudiments of the quantity theory of money .

The doctrine that there was a direct relationship between money stock, its speed of circulation and prices at which goods and services sold in the economy is a very old doctrine. The problem with it and the problem that writers and financial market actors had with the doctrine from John Law in the 18th century to Keynes in the twentieth century was that it developed into a dogma that aserted that any increase in money stock automatically led to price rise or inflation. The original classical statement of the theory that MV=PT argued that since both velocity was so stable so as to be a constant and T (transactions a proxy for output) was because of Say’s law and Walras’s law also a constant at full employment. Hence there was a direct relationship between money and prices.

The problem was, as Keynes and others pointed out, Say’s law that supply always created its own demand was false and Walras’s invisible auctioneer who cleared temporary gluts through the process of tâtonnement was not always operational and velocity also varied in unpredictable ways. The consequence then of moving from a barter economy to a money economy was therefore that money was not neutral, could be held for its own sake, markets would not always clear and thus the direct relationship between changes in the money stock and inflation did not always hold.

Instead it is more insightful to consider that money is a vector in the economy that operates along side other vectors to influence economic activity. Sometimes its force acts largely upon output other times largely upon prices but often affects both output and prices. Since the economy is measured by P*O increases in the money stock can act largely to increase O but also to affect P somewhat. But as the supply of unemployed factors drops, more of the impulses can affect prices.The neoclassicals argue that when this occurs in an accelerating fashion you have reached the point just beyond the NAIRU rate.But my argument is that they have set this rate far too high.

Hence , it is possible to have simultaneously both some unemployment and some price rise without experiencing accelerating inflation or inflationary expectations.In fact, some of this price rise is a necessary lubricant for the operation of the economy and the forward investment planning of the private sector. It ought not to be misdiagnosed as accelerating inflation.

The real economy,as opposed to the black box economy that the quantity theory operates with, is composed of many industries and sectors. In some, strong trade unions and powerful oligopolies dominate. In others, there are many very small firms and entrepreneurs and little opportunity for price rise until full capacity is reached. In the more oligopolized unionized industries the inflationary process can begin at much lower rates of capacity utilization.

Hence, to get the overall picture we have to aggregate all the industries and sectors with the appropriate weights given to each in order to see whether or not we are likely to experience price rises that can be called inflationary. We can think of the money stock as a wave of water that washes across the variegated economy , in some place simply lubricating investments and activity in other places facilitating inflationary price rise. Supply bottlenecks, wage push, profit push and elasticity of demand as well as the decisions to save and the decisions to invest will affect the overall outcome.

Any modern theory of inflation must also take into account internet technology, just in time production, globalization and free trade all of which act as anti-inflationary forces. The problem with our central banks is that they appear to be taking decisions based on a much more restrictive theory of the inflationary process. One that places excessive weight on inflationary expectations and a narrow conception of the quantity theory.


About haroldchorneyeconomist

I am Professor of political economy at Concordia university in Montréal, Québec, Canada. I received my B.A.Hons (econ.&poli sci) from the University of Manitoba. I also completed my M.A. degree in economics there. Went on to spend two years at the London School of Economics as a Ph.D. student in economics and then completed my Ph.D. in political economy at the University of Toronto. Was named a John W.Dafoe fellow, a CMHC fellow and a Canada Council fellow. I also was named a Woodrow Wilson fellow in 1968 after completing my first class honours undergraduate degree. Worked as an economist in the area of education, labour economics and as the senior economist with the Manitoba Housing and Renewal Corporation for the Government of Manitoba from 1972 to 1978. I also have worked as an economic consultant for MDT socio-economic consultants and have been consulted on urban planning, health policy, linguistic duality and public sector finance questions by the governments of Manitoba, Saskatchewan,the cities of Regina and Saskatoon, Ontario and the Federal government of Canada. I have also been consulted by senior leaders of the British Labour party, MPs from the Progressive Conservative party, the Liberal party and the New Democrats on economic policy questions. Members of the Government of France under the Presidency of Francois Mitterand discussed my work on public sector deficits. I have also run for elected office at the municipal level. I first began to write about quantitative easing as a useful policy option during the early 1980s.
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