I’ve just moved to a new city and have therefore been looking for a place to live and the idea for today’s post came about by trying to explain how interest rates are important to housing prices to my brother and my dad and I started discussing monetary theory. I argued that the central banks should try to implement Friedman’s helicopter money (Milton Friedman’s parable of monetary expansion) almost literally to get inflation going and my dad responded that the last decade, or two in the case of Japan, have shown that monetarist theory is wrong and that wage growth is the real driver of inflation, so in today’s post I will contrast monetarist theory of inflation with Keynesian theory.
Monetarist theory is built on the idea that inflation is always and everywhere a monetary phenomenon, i.e. that inflation comes from the central bank printing more money. It’s a very intuitive idea but it doesn’t seem to hold true. Quantitative Easing, or QE, is quite close to the idea of helicopter money but it hasn’t produced as high inflation as one might have expected given how much new money has been created. Now this doesn’t necessarily mean that monetarist theory is wrong and that inflation is due to other forces than the creation of money. As I’ve written on the blog before I believe the real problem with QE is less the underlying theory and more the transmission mechanism, i.e. the mechanism for getting the money from the central bank to real people who will use the money.
On the other hand, Keynesian theory on inflation is based on the idea that inflation is a product of high aggregate demand, essentially in good times demand increases faster than supply and therefore prices rise. As businesses demand more labour wages increase and therefore consumption increases which leads to inflation. This view cannot perfectly explain the lack of inflation much of the West and Japan has experienced over the last decade. Surely inflation should have been significantly higher in the US given how strong the American labour market have been over the last year or two if strong labour markets really were the root cause of inflation.
I’m personally more positively inclined towards monetarist theory but I have to concede that neither theory can explain the current situation well. Finally I want to make the point that it might be unfair to dismiss either theory based on the current moment given how unique it is from a historical perspective. At the end of the day, both theories are more than 50 years old and neither had anticipated negative interest rates. It could be that the current monetary climate is too bizarre for any theorist to have considered before it happened. In order to get a satisfactory explanation I think we might need new theories.
If you’d like to read more of my writing on monetary theory you can find a post about the current lack of inflation here. Please share this with a friend or co-worker and come back next week for a new blog post.
Written by Karl Johansson, Founder of Ipoleco
Cover Photo by Chokniti Khongchum from Pexels
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