The quantity theory of money says changes in prices are
caused by equivalent changes in the nominal money supply. In practice, prices
cannot adjust at once to changes in nominal money, so interest rates or income
alter, changing real money demand. Nevertheless, in the long run changes in
prices are usually associated with changes in nominal money.
The Fisher hypothesis is that a 1 per cent rise in inflation
leads to a similar rise in nominal interest rates so real interest rates change
little. Since the nominal interest rate is the cost of holding money, higher
inflation reduces real money demand. The flight from cash during hyperinflation
is a vivid example.
For a solvent government, there need be no close relation between the budget
deficit and nominal money growth. In the long run, persistent borrowing to
finance large deficits may leave the government so indebted that further borrowing
is impossible. It must resort to printing money or take fiscal action to cut
the deficit.
The long-run Phillips curve is vertical at equilibrium
unemployment. If people foresee inflation and can completely adjust to it,
inflation has no real effects.
The short-run Phillips curve is a temporary trade-off
between unemployment and inflation in response to demand shocks. Supply shocks
shift the Phillips curve. The height of the short-run Phillips curve also
depends on underlying money growth and expected inflation. The Phillips curve
shifts down if people believe inflation will be lower in the future.
Temporary supply shocks also shift the short-run Phillips curve. Stagflation
is high inflation plus high unemployment.
Some so-called costs of inflation reflect inflation illusion
or a failure to see inflation as the consequence of a shock that would have
reduced real incomes in any case. The true costs of inflation depend on whether
it was anticipated and on the extent to which the economy’s institutions
allow complete inflation-adjustment.
Shoe-leather costs and menu costs are
unavoidable costs of inflation and are larger the larger the inflation rate.
Failure fully to inflation-adjust the tax system may also impose costs, even
if inflation is anticipated.
Unexpected inflation redistributes income and wealth from
those who have contracted to receive nominal payments (lenders and workers)
to those who have contracted to pay them (firms and borrowers).
Uncertainty about future inflation rates imposes costs on people who dislike
risk. Uncertainty may be greater when inflation is already high.
Incomes policy may accelerate a fall in inflation expectations,
allowing disinflation without a large recession. But it is unlikely to succeed
in the long run. Only low money growth can deliver low inflation in the long
run.
Operational independence of central banks is designed
to remove the temptation faced by politicians to print too much money.
