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.