Conflicts between macroeconomic policy objectives
Inflation review
Inflation is the general increase in prices over time, equivalent to a decrease in the
value of money
Deflation is the general decrease in prices over time, equivalent to an increase in the
value of money
Causes of demand pull inflation
Classical Keynesian
Quantity Theory of Money argues that the An increase in AD will lead to an increase in
money supply influences price level the price level
The Quantity Theory of Money
Argues that inflation results from too much money circulating in the economy
chasing too few goods
Rests on the 17th century Equation of Exchange
Example
The money supply M = £100
Each £1 changes hands 4 times per year, so V = 4
Therefore MV = £400
The equation of exchange states that MV = PT
Therefore PT (i.e. P x T) will also = 400
If [the price level] is £2 then we can calculate T by moving P to the other side of the
equation:
T = 400 ÷ P i.e. 400 ÷2 = 200, meaning there are 200 transactions per year.
Similarly, if we knew that T = 200, P would equal 400 ÷ 200 = 2
, Simplifying the Fisher equation (i.e. the Quantity Theory of Money)
The Fisher equation (i.e. the Quantity Theory of Money) holds that both velocity of
money and volume of transactions are fixed in the short-term.
Thus if M and T are both constants, the equation can be simplified thus:
Therefore, a change in the money supply will cause an equivalent change in the
price level
The QTM in action
The QTM argues that inflation will occur because of two main reasons:
1. The government allows or encourages an increase in the money supply that is
greater than the increase in real output by
o printing more money and/or withdrawing less money from the economy
o loosening lending and credit controls
2. Households quickly spend the additional money on goods and services rather
than save or retain it, creating additional AD
Keynesian criticism of the QTM
There are three main criticisms by Keynesian economists of the QTM
1. Households will hold/retain excess money, especially when the price of financial
assets such as shares are likely to fall. This means that the velocity of the circulation
of money is not constant.
2. Additional money will lead to increased output without an increase in inflation if
there is spare capacity. (This can be seen on the horizontal portion of a Keynesian
LRAS curve when AD rises.)
3. Reverse causation: Changes in the price level lead to changes in the money supply,
not – as the QTM argues – the other way around.
To some extent, the monetarist view of controlling the money supply as means of
controlling inflation can be criticised using Goodhart’s Law
This states that “When a measure becomes a target, it ceases to be a good
measure.”
Cost Push inflation
Later in the Keynesian era (i.e. the 1960s and 1970s), economists began seek an
explanation for inflation not on the demand-side of the economy but on the supply-
side
They argued that it was mainly increased costs of supply (i.e. increased costs of the
factors of production) that can cause inflation.
There are two major areas of costs that lead to inflation: resources and commodities
(land) and labour (wages)
Inflation was particularly high in the UK during the 1970s and much of this was
attributed to higher oil prices (i.e. land) and higher wages (labour).
Inflation review
Inflation is the general increase in prices over time, equivalent to a decrease in the
value of money
Deflation is the general decrease in prices over time, equivalent to an increase in the
value of money
Causes of demand pull inflation
Classical Keynesian
Quantity Theory of Money argues that the An increase in AD will lead to an increase in
money supply influences price level the price level
The Quantity Theory of Money
Argues that inflation results from too much money circulating in the economy
chasing too few goods
Rests on the 17th century Equation of Exchange
Example
The money supply M = £100
Each £1 changes hands 4 times per year, so V = 4
Therefore MV = £400
The equation of exchange states that MV = PT
Therefore PT (i.e. P x T) will also = 400
If [the price level] is £2 then we can calculate T by moving P to the other side of the
equation:
T = 400 ÷ P i.e. 400 ÷2 = 200, meaning there are 200 transactions per year.
Similarly, if we knew that T = 200, P would equal 400 ÷ 200 = 2
, Simplifying the Fisher equation (i.e. the Quantity Theory of Money)
The Fisher equation (i.e. the Quantity Theory of Money) holds that both velocity of
money and volume of transactions are fixed in the short-term.
Thus if M and T are both constants, the equation can be simplified thus:
Therefore, a change in the money supply will cause an equivalent change in the
price level
The QTM in action
The QTM argues that inflation will occur because of two main reasons:
1. The government allows or encourages an increase in the money supply that is
greater than the increase in real output by
o printing more money and/or withdrawing less money from the economy
o loosening lending and credit controls
2. Households quickly spend the additional money on goods and services rather
than save or retain it, creating additional AD
Keynesian criticism of the QTM
There are three main criticisms by Keynesian economists of the QTM
1. Households will hold/retain excess money, especially when the price of financial
assets such as shares are likely to fall. This means that the velocity of the circulation
of money is not constant.
2. Additional money will lead to increased output without an increase in inflation if
there is spare capacity. (This can be seen on the horizontal portion of a Keynesian
LRAS curve when AD rises.)
3. Reverse causation: Changes in the price level lead to changes in the money supply,
not – as the QTM argues – the other way around.
To some extent, the monetarist view of controlling the money supply as means of
controlling inflation can be criticised using Goodhart’s Law
This states that “When a measure becomes a target, it ceases to be a good
measure.”
Cost Push inflation
Later in the Keynesian era (i.e. the 1960s and 1970s), economists began seek an
explanation for inflation not on the demand-side of the economy but on the supply-
side
They argued that it was mainly increased costs of supply (i.e. increased costs of the
factors of production) that can cause inflation.
There are two major areas of costs that lead to inflation: resources and commodities
(land) and labour (wages)
Inflation was particularly high in the UK during the 1970s and much of this was
attributed to higher oil prices (i.e. land) and higher wages (labour).
