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The great debate: Why economists continue to argue over inflation

The great debate: Why economists continue to argue over inflation

A great amount of the work economists do ultimately comes back to the question of inflation: how to anticipate it before it arrives, and how to deal with its threat once it materialises.

Such is the centrality of price growth that when the Bank of England was granted independence from the government in 1997, it was given a mandate linked to controlling inflation at or near 2 per cent. Unemployment, GDP growth and other similar preoccupations were deemed secondary, or at least outside its remit.

Those who believe in monetarism, the economic system which prevailed under the Thatcher government, take the view that the velocity of money – that is, the speed at which it moves through the economy – is constant, and that the supply of money (the amount circulated by banks via loans) is variable.

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This means, to a monetarist, that higher inflation is caused by there being too much money circulating in the economy, leading to excess inflation and an economic crash. Those who subscribe to this view believe that the correct response to a recession is to reduce the supply of money in the economy. That should push inflation downwards, increasing the spending power of consumers, raising the level of demand in the economy, and lifting the country out of recession. To monetarists, therefore, inflation is always an evil to be combated.

Followers of the economist John Maynard Keynes attribute far more weight to the idea that the velocity of money is not constant, and that speed is what influences its supply. Advocates of this argument take the view that velocity is more important than supply.

If consumers, banks and businesses lack confidence in their individual economic prospects, then they will horde the capital they have, rather than spend it. Such hoarding slows down the pace at which money moves in an economy, and if economic participants are hoarding, then banks have little need to increase the supply of money by issuing new debt.

The Keynesian response to a recession is to have the government increase the supply of money by borrowing, and its velocity by spending quickly, to stimulate growth. Spending should, in theory, increase the velocity because it would help reduce unemployment, causing individual spending power to rise. 

Keynesians would then treat the subsequent inflation as a temporary phenomenon to be managed by reducing government spending in times of plenty. Consequently, this approach is more relaxed about inflation.

Theory behind QE

Since the global financial crisis of 2007-08, the consensus pursued by policymakers around the world has been that of quantitative easing, an attempt to merge the concerns of both of the above theories.

Advocates of QE argue that the great depression of the 1930s happened because failing banks reduced the money supply, and that the solution was for a rapid injection of excess supply into the banking system.

This theory supposes that by directing the extra capital to banks, the velocity of money will also rise because banks make a profit by lending. Interest rates are kept low to ensure the velocity of money also increases, as this should improve help velocity by making the hoarding of cash less attractive.