Inflation: Theoretical perspectives

One of the oldest theories in economics the quantity theory of money postulates that “the general price level of goods and services is proportional to the money supply in an economy.”⁶ If money supply grows higher than the relative size of the economy, then prices rise eroding purchasing power of consumers. In other words, expansionary monetary policy causes higher inflation. Aggregate demand fueled by fiscal stimulus and lower interest rates, among other factors, and supply shocks such as energy shortage can cause inflation- the former and latter known as “demand-pull” and “cost-push” inflation, respectively. The macroeconomic theory of the 1960s on the trade-off between inflation and unemployment, known as the Phillips curve, ended in the stagflation of the 1970s.⁷ Lately, following the advent of rational expectation theory which was popularized by economists Robert Lucas⁸and T. Sargent in the 1970s⁹ as part of the new classical revolution, numerous studies find that households’ and firms’ expectations of future inflation are a key determinant of actual inflation. The mechanism in which it works is that “expectations determine households’ savings and consumption through the relationship between perceived real interest rates and consumption.”¹⁰ Former Federal Reserve (Fed) Chairman Ben Bernanke find that “inflation expectations also drive agents’ wage bargaining, durable investment including housing, and portfolio choices.”¹¹ The New Keynesian Phillips curve which explains the determination of realized inflation attributes an important role to inflation expectations.¹²