NCPA - National Center for Policy Analysis

Monetary Policy and Inflation

November 6, 2003

Although neoclassical or Austrian school economists have argued for more than a century that inflation is solely a monetary phenomena, "mainstream" economists thought that prices were determined by costs, and inflation -- defined as rising prices -- resulted from rising costs or the market power of monopolists.

Milton Friedman's work has been influential in changing the mainstream view, says Virginia Postrel, and his work has been empirically verified.

Most economists were puzzled by the stagflation of the 1970s. The so-called Phillips curve claimed there was a trade-off between inflation and unemployment. They proposed the "cost push" theory of inflation: aggressive unions, greedy businesses or even oil cartels raised the prices of the factors of production, pushing up retail prices, and encouraging higher wage demands and price increases to keep up.

In reality, in an attempt to maintain full employment, the Federal Reserve of the 1970s pumped out money faster than the real economy grew. In a 1970 essay, "The Counterrevolution in Monetary Theory," Milton Friedman succinctly stated, "inflation is always and everywhere a monetary phenomenon."

  • Empirically, Friedman argued, changing the money supply raises or lowers nominal national income -- production multiplied by the price level -- after six to nine months.
  • That change appears initially in output, so an increase in the money supply spurs production. After another six to nine months, however, prices adjust. Real, as opposed to nominal, income does not change.
  • Long-term economic growth, argued Friedman, depends on real factors like innovation, investment and entrepreneurship.

"The most fundamental policy recommendation put forth by Milton Friedman," said Federal Reserve governor Ben S. Bernanke at a recent Dallas Federal Reserve Bank conference, "is the injunction to policy makers to provide a stable monetary background for the economy," avoiding both inflation and deflation.

Source: Virginia Postrel, "Rethinking Milton Friedman," Economic Scene, New York Times, November 6, 2003.


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