220

Monetary theory

(Mundell, 1963). Furthermore, what amounts to a tax on real cash balances

motivates people to allocate a given volume of saving less toward them and
more toward real capital formation. Allais (1947) and Tobin (1965 [1979])
recognize this possibility (see pages 5051 above). However, even if inflation
did prod individuals to accumulate more real capital and hold less real balances,
they would be getting less of real-balance services, which would itself tend to
impair real production (compare Marty and Thornton, 1995, p. 31).
Insofar as the propensity to save is diverted into and satisfied by bidding up
the prices of land and collectibles, our worry about capital formation is justified.
If inflation and disrupted asset markets make providing for the future difficult
and risky as illustrated by the resort to exotic inflation hedges why not live
for today? Total saving is thereby reduced. Furthermore, by impairing the functioning of money, inflation makes financial intermediation less efficient, thereby
tending to obstruct real capital formation and economic growth.
If the tax system continues treating interest income fully as income, not distinguishing between real interest and the inflation allowance in nominal rates,
the consequent reduction in the real after-tax rate of return, which may even
become negative, hinders capital formation. This effect could be counteracted
to the extent that borrowers receive a tax deduction for interest paid.
We question any attempts to measure accurately the costs of inflation. Many
of them are almost impossible to quantify but are nevertheless real. The traditional method of measuring these costs assumes a fully anticipated inflation. The
welfare cost is measured in terms of the appropriate area under an aggregate
demand-for-money function (Laidler, 1990c [1990a] and Dowd, 1996, pp.
381437). The area represents the value of the real cash balances forgone as
people adjust to the anticipated inflation. (Recall that inflation reduces the
demand for real balances as explained in Chapter 2.) But as a result of general
interdependence, the reduction in real balances affects in principle all real
magnitudes thus increasing the costs of inflation. Again we argue that superneutrality of money does not hold (see pages above).

THE MONETARY NATURE OF INFLATION

In Milton Friedmans famous dictum (1963 [1968c], p. 39), inflation is always
and everywhere a monetary phenomenon. This does not mean that an increase
in the money supply is the cause of every one-shot increase in the price level.
It means that every sustained inflation has a monetary basis.
Admittedly, a purely nonmonetary account of inflation is barely conceivable.
Even such an account would have to square with the equation of exchange. With
neither M nor V continuously rising, continuing price inflation would presuppose
a continuing fall in real economic activity, Q. This case is implausible.

Inflation

221

Alternatively, if the total flow of nominal spending were to keep on rising

despite a steady M, then V would have to keep on rising, and rising faster and
faster in such a way as to produce an accelerating inflation. A steady inflation
would not be sufficient, since it would be inconsistent with standard assumptions about how real balances demanded depend on the rate of change of the
price level. With inflation recognized as steady, real balances demanded would
be constant, though constant at a lower level than with no inflation. Yet the
arithmetic of inflation would be steadily shrinking their actual amount. It is
implausible that the price level would keep rising despite a growing excess
demand for money. Merely steady inflation would not motivate the continuing
rise of velocity that bootstrap inflation would require.
An accelerating inflation could do so. While actual real balances were
shrinking as a matter of arithmetic, the quantity demanded would shrink exactly
in step as people responded to the continuing rise in the cost of holding money.
Each shrinkage would cause the other: the accelerating erosion of real balances
would keep cutting the demand for them, while the falling demand would keep
shrinking the actual real stock.
Such phenomena, which might seem to shake the foundations of monetary
theory, rest on the assumption that people instantly readjust their real-balance
holdings to the changing current rate of inflation. However, significant lags
might characterize either peoples perceptions of the current inflation or their
adjustments of their real-balance holdings in accord with their revised perceptions. Such sluggish behavior would thwart a bootstrap process.5 Realistically,
continuing price inflation must involve continuing monetary expansion.
Let us consider the nature of the monetary disequilibrium in the inflationary
process. We suppose that an economy starts at full-employment equilibrium
without inflation. The monetary authority then increases the money supply.
The Wicksell Process helps explain why spending increases. If prices and wages
do not immediately adjust, an excess demand for goods and services is matched
by an excess supply of money. Chapters 6 and 7 illustrate that output may rise
under certain circumstances, if only temporarily, with a rise in prices eventually
following.
Suppose that the money supply and prices come to grow at a steady rate. Do
money supply and demand remain out of equilibrium during this process?
Hardly: ever-higher prices keep raising the nominal demand for money approximately in step with supply. A kind of moving equilibrium holds for both money
and goods. An actual excess supply of money keeps being staved off by the
rise in prices.
Stagflation is understandable if the monetary authority now reduces money
growth. Prices and wages continue rising for a while, thereby raising the
nominal demand for money into an excess demand, with goods in excess supply.
Inflation, though usually attributed to an excess supply of money and an excess

222

Monetary theory

demand for goods, can thus coexist with recession, usually attributed to an
excess demand for money and an excess supply of goods. Stagflation exhibits
the consequences of both excessive and deficient growth in the quantity of
money, the excess occurring earlier and the deficiency currently. The earlier
excessive growth establishes an inflationary momentum that now keeps eroding
the real value of the money supply, which is no longer growing so fast. (Pages
2314 below elaborate on inflationary momentum.) Against a background of
too much spending earlier, spending becomes deficient in real terms now and
output falls. This diagnosis does not necessarily recommend, however, revving
up money again. It also illustrates that one need not resort to supply shocks in
order to explain stagflation. On page 237 below we argue that this analysis can
account for stagflation in the United States during the mid-1970s.
What causes the monetary expansion that fuels inflation? No one answer
always applies: different causes have operated in different historical episodes.
Saying this is no mere lame eclecticism. It corresponds to the way things are.
As an expository device the distinction is far from sharp we may classify the
causes or sources of monetary expansion under two headings. First are factors
exogenous to the process of setting wages and prices. Money growth is cause
rather than consequence. Second are ways in which money growth accommodates nonmonetary upward pressures on prices and wages instead of occurring
independently. Several different circumstances belong under each heading.

EXOGENOUS MONETARY EXPANSION

Gold discoveries and improvements in mining and refining provide examples of
exogenous monetary expansion under a gold standard. Another obvious example
involves government deficit spending, perhaps in wartime, with the deficit
covered by printing money or the equivalent. A government deficit may result
from the pressures of democratic politics, which lead to governmental hyperactivity and a bias toward overspending. As has often been illustrated in Latin
America, money issue may cover the deficits of government-owned enterprises.
Monetary expansion may result from pursuit of a low-interest-rate policy,
perhaps again in response to political pressures. In early twentieth-century
Chile, a conservative government dominated by a landowner class with heavy
mortgage debts apparently pursued almost deliberately inflationary policies
(Fetter, 1931).
The early 1970s provide many examples, although hardly historys earliest
examples, of imported inflation. Trying to keep the exchange rate of a
countrys currency fixed in the face of balance-of-payments surpluses expands
the home money supply. Monetary expansion of that sort hardly occurs in
response to domestic wage and price setting, so it belongs on our list of

Inflation

223

exogenous types. A dubious contention that even such a monetary expansion

comes by way of accommodation to already accomplished price and wage
increases a contention made by the strong version of the monetary approach
to the balance of payments is examined on pages 2645.
The causes of monetary inflation have sometimes included fallacious ideas
underlying policy. One has been the idea (compare Chapters 6 and 7) that expansionary policy can reduce unemployment and stimulate production beyond the
full-employment level, and better than just temporarily.
Another influential fallacy involves failure to understand the relation between
nominal and real quantities of money. In Germany in 1923, eminent financiers
and politicians and even economists (notably Karl Helfferich) argued that no
monetary or credit inflation was occurring. Although the nominal value of the
paper money supply was enormous and skyrocketing, its real value or gold
value was much lower than that of the money supply before the war. This
doctrine overlooked the obvious reason why the real money stock had become
so small: inflation itself was deterring people from holding wealth in that form.
Rudolf Havenstein, president of the Reichsbank, expounded a related fallacy
the doctrine that exchange rate depreciation was due to an unfavorable balance
of payments (involving, in this instance, Germanys heavy reparations obligations). This fallacy dates at least as far back as discussions of the high price
of bullion in Great Britian during the Napoleonic wars, when the Bank of
England had temporarily been relieved of the gold-redemption restraint on
banknote issue but when anti-quantity-theorists could blame depreciation on
outward payments to support allies on the Continent.6 The fallacy consists in
emphasizing a minor nonmonetary factor, whether merely imagined or even
actual, at a time when the dominant cause of price increases and exchange rate
depreciation is monetary expansion.
In August 1923, Havenstein denied that money and credit expansion had
been feeding inflation in Germany, observing that the loan and investment
portfolio of the Reichsbank was worth well under half of its pre-war value in
gold (Bresciani-Turroni, 1937, pp. 1556). As the Reichsbank kept pouring out
new money on loan to the deficit-spending government and to businesspeople,
who borrowed eagerly in the warranted expectation of repaying later in sharply
depreciated marks, its president adhered to the real-bills or needs-of-trade
fallacy. He considered it his duty to supply the growing amounts of money
needed to conduct transactions at the ever higher price level. At one point
Havenstein seriously expressed hope that installation of new high-speed
currency printing presses would overcome the supposed shortage of money.7
The just-mentioned real-bills doctrine, although demolished as long ago
as 1802 by Thornton (1802 [1978]), keeps being rediscovered as if it were a
profound and original truth.8 In essence but variations do occur the doctrine
holds that new money is not inflationary if used to finance productive activities,

224

Monetary theory

since additional goods to spend it on will soon match it (compare Humphrey,

1982a). In part, the fallacy consists in believing that what happens to the price
level depends not so much on the quantity of money as on the particular way
in which new money initially comes into circulation. The doctrine fails to realize
that creating new money to finance particular activities ordinarily does less to
increase total production than to bid productive resources from other activities
into the favored ones, while at the same time the intensified bidding for
productive resources raises costs and prices.
Related to the fallacy that the quantity of money is less important than its
quality or the nature of its issue is the notion that money is not inflationary if
it is solidly backed. Proponents of issuing the assignats during the French
Revolution argued that the issues would be harmless, indeed beneficial, because
they were backed by nationalized lands. Preoccupation with backing has
sometimes made the authorities passive in the face of the danger of imported
inflation. Creation of money to buy up gold and foreign exchange was
supposedly acceptable because, after all, the new money was being backed by
the additional reserves acquired in the process.
Another fallacy is that the introduction of floating exchange rates promotes
inflation. For example, the acceleration of worldwide inflation in 1973/1974
occurred at about the same time that floating rates replaced the Bretton Woods
system of pegged but adjustable exchange rates. While some economists blame
the speed up of inflation on the new regime of floating rates, Chapter 9 argues
instead that it was a result of the last-ditch attempts to defend the Bretton
Woods system.
An idea often encountered is that the monetary authority is not responsible
for what happens to the quantity of money because it is passively responding
in part to changes in income and prices. Indeed it may be, as when the
authority is subordinating control of the money supply to some other objective,
such as low interest rates or a fixed exchange rate. Having institutions that
made the money supply behave passively in some such way would count as
an action of the monetary authority, interpreted broadly to include legislators
or constitution-makers.

ACCOMMODATING MONETARY EXPANSION

The real-bills doctrine recommends monetary expansion to accommodate
supposedly increased needs of trade. Meeting an increasing demand for real
cash balances associated with real economic growth need not be inflationary,
true enough, since it may simply avoid price deflation. What bears on theories
of inflation is meeting the need for additional nominal money at increased
wages and prices that trace in turn to nonmonetary upward pressures.