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
1. define inflation
2. discern between monetarist and Keynesian views of inflation
3. explain Milton Friedman s famous proposition that inflation is always and
everywhere a monetary phenomenon
4. characterize the activist versus nonactivist and rules versus discretion policy
debates

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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 do 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.