THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 698

CHAPTER 26 Money and Inflation LE A RNI NG OB J ECTI VES After studying this chapter you should be able to define inflation discern between monetarist and Keynesian views of inflation explain Milton Friedman s famous proposition that inflation is always and everywhere a monetary phenomenon characterize the activist versus nonactivist and rules versus discretion policy debates PRE VI EW 666 Since the early 1960s, when the inflation rate hovered between 1% and 2%, the economy has suffered from higher and more variable rates of inflation By the late 1960s, the inflation rate had climbed beyond 4%, and by 1974, it reached the double-digit level After moderating somewhat during the 1975 1978 period, it shot above 10% in 1980 and 1981, slowed to around 3% from 1982 to 1990, declined further to around 2% in the late 1990s, and remained around that level through 2008 Inflation, the condition of a continually rising price level, has become a major concern of politicians and the public, and how to control it frequently dominates the discussion of economic policy How we prevent the inflationary fire from igniting and end the roller-coaster ride in the inflation rate of the past 40 years? Milton Friedman provides an answer in his famous proposition that inflation is always and everywhere a monetary phenomenon He postulates that the source of all inflation episodes is a high growth rate of the money supply: simply by reducing the growth rate of the money supply to low levels, inflation can be prevented In this chapter we use aggregate demand and supply analysis from Chapter 24 to reveal the role of monetary policy in creating inflation You will find that as long as inflation is defined as the condition of a continually and rapidly rising price level, almost all economists agree with Friedman s proposition that inflation is a monetary phenomenon But what causes inflation? How does inflationary monetary policy come about? You will see that inflationary monetary policy is an offshoot of other government policies: the attempt to hit high employment targets or the running of large budget deficits Examining how these policies lead to inflation will point us toward ways of preventing it at minimum cost in terms of unemployment and output loss