Introduction

The danger of inflation has let loose a veritable torrent of literature, ranging from highly technical memoirs couched in mathe* The study was sustantially completed in September 1959. Part of this essay was presented to a Round Table Conference on Inflation of the International Economic Association in Elsinore, Denmark and will be published along with the other papers presented at that meeting by Macmillan, London and the St. Martin's Press in New York. [ 1 ] matical and econometric terms to popular pamphlets. Congressional committees alone have published a whole library of compendia and hearings on the subject which contain, buried in mountains of trash and partisan statements, much useful material and even original papers by leading experts. The flood of outpourings shows no sign of receding. In view of all this, it is hardly possible to say anything important that is both true and heretofore unsaid. But it may be worth while to give a rounded picture and to emphasize fundamental issues which seem in danger of being obscured by the great mass that has been and is being written. That is the objective of the present study. It does not attempt to cover all fine points, even if they seem to hold greater intellectual challenge than basic facts and principles which have been stated many times before.

MEANING OF INFLATION AND DEFLATION UNLESS A DIFFERENT meaning is clearly indicated, I shall take inflation to mean a condition of rising prices. This is what people usually mean by inflation. I shall also follow general usage by referring, as a rule, to the level of consumer prices as an indicator and rough measure· of inflation. Economic terms, however, are never quite precise, nor is the use of words entirely uniform and consistent. The word ((inflation" is most emphatically no exception. We shall, therefore, have to consider alternative definitions. But I hope to show that only unimportant marginal adjustments in the selected definition need be made. Instead of a rise in the price level, inflation is often defined as an expansion in the monetary circulation; more precisely, as an increase in the quantity of money times the velocity of circulation of money, MV for short. To define it in terms of an increase in the quantity of money, of M alone, would not be quite correct because it would overlook the possibility that an increase in expenditures and prices might be due to an increase in Valone. It is, however, safe to say that there has never been a case in monetary history anywhere of a prolonged and violent inflation without a sharp rise in the quantity of money. V is subject to slow secular changes (as a rule in a down ward direction) and to mild cyclical fluctuations (usually upward during business cycle upswings and downward during business cycle downswings) . But large, rapid (though temporary) increases in V occur only during periods of galloping inflation, which could never happen without sharp increases in M.

Precise definitions of M and V present many fine points which we need not discuss in detail. Suffice to say that M is usually defined as currency outside banks plus demand deposits; 1 and V is the· so .called ((income velocity of money," that is, the average number of 1 Occasionally, time deposits in commercial banks are included. If that is done, V becomes correspondingly smaller partly because tinlC deposits have a lower rate of turnover than dell1and deposits. The definitions of M and V are always so adj usted as to make MV equal total expenditure.

times a unit of money is used for income payments within a year. MV is then equal to the money value of national income or total monetary expenditure (out of income). Again, there arise questions of detail: Should we use Gross National Product (GNP) or Net National Income or some other measure of aggregate expenditure? Fortunately, there again is no need to go into fine points. The rea son is that, whenever there is a serious inflationary rise in total ex penditure, all these various measures, GNP, Net National Income, etc. will go up, although perhaps not in precisely the same propor tion. We remember then that inflation can be defined either as a rise in prices or as an expansion in aggregate income (expenditure) MV. In all cases of serious inflation, both definitions promptly indicate its existence, although the degree would not be quite the same the volume of expenditure usually (i.e., in a growing economy) exhibiting a sharper percentage rise than the price level. For example, during and after the war until 1947, and again in 1950-52 and 1956-57, prices went up as well as MV. There are, however, cases where we have to speak of inflation if we take aggregate ex penditure as a criterion while there is no inflation in terms of prices.

For example, consumer prices (as well as wholesale prices) were practically stable from 1953 to 1955, while GNP and Net Na tional Income rose (with a slight dip in 1954). Similarly, prices have been practically stable since the second quarter of 1958 while GNP, etc. have gone up. The political issue behind these two divergent definitions of inflation is this: consider a progressive economy in which aggregate output and output per head, in other words aggregate real national income and real national income per head, are increasing. Should it be the aim of monetary policy to stabilize the price level or national money income per head? If prices are stablized, money income and expenditure (MV) will have to go up. If money income per head is stabilized in a progressive economy, the price level will have to fall gradually as output per head rises as a result of technological im provements and the installation of new machinery and equipment made possible by saving and the accumulation of capital. In the first [4 ] case, progress takes the form of rising average money wages (money incomes) and stable prices; in the second case, it takes the form of constant average money wages (money incomes) and falling prices -real wages (real income per head) rising in both cases. Un fortunately, progress often takes the form of rising prices and faster rising money wages (incomes). This is, of course, inflation accord ing to both definitions.

In the past, many distinguished economists have argued that for the sake of growth and long-run stability, as well as for re'asons of social justice, it is preferable that prices should be allowed to fall when technological improvements lead to a decline in the average cost of production (rise in output per head). This is equivalent to saying that inflation in the sense of a rise in money income (or expenditure) per head should be avoided. 2 Much is to be said for this view on grounds of social justice. For instance, when prices decline receivers of fixed money incomes, such as pensioners, beneficiaries of life insurance, and holders of bonds and savings deposits share in the fruits of economic progress which some of them through their frugality have helped to bring about. On the other hand, it is not easy to see why the combination of constant money wages and falling prices is more conducive to economic stability than that of stable prices and rising money wages.

Clearly, under certain by no means unrealistic assumptions, the oppo site is true. For example, if money wages are under strong upward pressure exerted by powerful labor unions, an attempt by the mone tary authorities to enforce a regime of falling prices by refusing to expand the circulation of money (by keepingMV per head stable, not by contracting it) would necessarily lead to unemployment how much depending upon the pressure exerted by the unions. 2 Some writers have even urged that the best policy would be to stabilize aggregate national income (expenditure), not just income per-head of the population or of the working force. Ho,vever, few would accept that precept today because it would imply that an increase in the labor force would entail a decline in average money wages (though not in real wages because prices would fall faster than money wages). [ 5 ] In fact, we all know that the upward thrust on wages has become so strong, that we shall be lucky if we can barely hold the price line and prevent a continuous upcreep of prices. More on this later.

In the meantime, we reluctantly conclude that it is inadvisable to set up an unattainable perfectionist superstandard for monetary policy, as would be implied by the policy of keeping MV per head constant. We shall, therefore, continue to define inflation in terms of prices and shall not speak of inflation when in a growing economy MV expands but prices remain approximately stable. However, in order to avoid confusion, two factors must be kept well in mind, especially by those who advocate the more stringent definition. First} when we speak of prices being kept stable by mone tary policy and wages being allowed to rise parallel with productivity, we refer to the average price level and average wage level. Prices of individual commodities (economists speak of ((relative prices" as distinguished from the ((general price level") must remain flexible in .a smoothly working economy and the wage structure «((relative wages") should not be frozen. That is to say, there should be a flexible system of wage differentials as between different skills and localities, and between expanding and contracting industries in order to provide sufficient inducement for the labor force to adjust itself to the changing needs of the economy.3 An· important corollary is this: Technological progress is never uniform, but affects different industries to an unequal degree. Cost of production is reduced faster in some industries than in others, or expressed differently, output per man-hour rises faster in the more progressive industries. If the average price level is to remain stable, if full employment is to be maintained, and if the best use is to be 3 Since it is easier to bring about desired wage differentials by wage increases than by wage decreases, the system of stable prices and rising wage .levels will work better than the system of stable wage levels and falling prices. But downward adjustment of wages in declining indus tries should not be ruled out altogether. If they are ruled out, unemploy ment and premature abandonment or scrapping of still serviceable capital equipment (e.g., in the railroads) entailing waste, slower growth, and lower average real wages are the unavoidable consequences.

[ 6 ] made of productive resources, then the industries where costs have fallen more than elsewhere must reduce their prices. (If they produce a better quality product at the same price, this is equivalent to a fall in price but may not find sufficient expression in the indices.) If they fail to reduce their prices, demand for their products will not increase and since output per head .has increased, employ ment will decline. This would also imply the emergence of large profits, and labor unions can be depended on to capture some of these profits in the form of higher wages. So long as the prices of the cheapened products do not fall,. the producers keep the fruits of techno.1ogical progress in the form of higher wages and higher profits for themselves, instead of passing them on to the community at large, and employment suffers. But since the American economy is rather competitive, the chances are that sooner or later excess profits will be whittled away by com petition. Wages, on the other hand, are notoriously sticky in the downward direction. There are then two possibilities. Either wages remain higher in the progressive industries in comparison with wages elsewhere, implying an unjustified and uneconomical discrimination between different groups of workers and a loss of employment; or, and this is the more likely outcome, wages in the less progressive industries will tend to be pushed up to be brought in line with the standard set by the progressive industries. This, of course, necessitates a rise of prices in the less progressive industries which have not ex perienced the same reduction in cost as the more progressive indus tries and hence, if they are not to reduce output and employment, must raise their prices when wage costs go up.

The upshot, to repeat, is that if the price level is to remain stable and employment is to be maintained, prices of products of industries where costs have been reduced more than elsewhere must go down while prices of the products of less progressive industries should go up. This results from the fact that in a progressive economy, if the price level is to remain stable, the generdl wage .level has to go up roughly in proportion to the averagerise in productivity. If the wage level behaves that way in the more progressive industries, wages rise less than productivity in. those industries, hence prices must fall; in the less progressive industries wages rise more than productivity in these industries, hence prices must rise. We shall have occasion to return to these crucial relationships repeatedl y in the course of our analysis. The second point to remember is this: The postulate that the price level should be kept approximately stable for the long run does not mean that the price level· should never be allowed to decline. The reason is very simple. It will hardly be possible, even apart from war and periods of acute international tension requiring large defense expenditure, to avoid periods of rising prices altogether. Business cycle upswings are almost always characterized by price rises. If then the long-term price trend should be horizontal, i.e., if long-run in flation is to be avoided, the price level must be allowed to fall in depressions to make up for the price rise during boom periods. It is well known that this did not happen during the last two depressions (1953-54 and 1957-58).

In short, the implications of long-run price st~bility are more exacting and far-reaching than appear at first glance. This must be kept in mind when deciding whether· absence of inflation should be defined as stable prices or stable money national income per head. Before we discuss types of inflation and their causes, a few words should be said about the correlative concept of deflation. If inflation is defined as a condition of rising prices, it would seem natural to define deflation symmetrically as a condition of falling prices. But just as in the case of inflation, we have in the case of deflation an alternative definition 'which runs in terms of income and expenditure (MV) rather than in terms of prices. In the case of deflation, more than in the case of inflation, the general usage of the word seems to favor the alternative definition. In deference to that we shall under stand by deflation a condition of falling MV. One consequence of our definition is that we shall not speak of deflation if in a growing economy prices fall because the volume of output and the flow of goods for sale increases as distinguished from the case where prices fall because of contraction in aggregate expenditure (MV).

4 4 There exists a corresponding situation in the case of inflation which [ 8 ] This definition of deflation does not settle the question whether the policy of letting prices fall when output increases is advisable or not. It will be remembered, however, that reasons were given why we might well be satisfied if we are able to keep the long-run price level stable and that· it would be unrealistic to expect a long-run decline of the price level. But it should also be observed that there is a basic difference between areal deflation, that is, a decline in MV brought about by a contraction of credit (fall in M), or a wave of hoarding (fall in V) 'on the one hand, and a decline in prices resulting from an increase in output on the other hand. Deflation is often defined (or implicitly interpreted) in still another sense, namely, as equivalent to Hdepression," or ((recession" (the latter being merely a euphemism for a mild depression) that is, a low or falling level of output and employment. While everybody is, of course, free to define the terms he uses as he likes (provided he is clear about the implications and does not change the meaning in the middle of an argument), it would seem to be better to keep the two terms, deflation and depression (recession), apart. Deflation wil~ usually bring about depression, but there may be exceptions to that rule: if wages and prices were perfectly flexible, deflation would result only in lower prices without ill effect (at least in the some what longer run) on output and employment.

At any rate, if deflation were defined as depression (not only as a possible cause of depression), deflation and inflation could exist at the same time, as was shown by the mild depression of 1957 -58, when prices went on rising for months after output and employment should perhaps be mentioned, although it is less frequent and of lesser importance. When an economy contracts, i.e., when the volume of out put falls, prices will rise if MV remains constant. Examples are crop failures or loss of output due to war destruction. One may well choose not to classify as inflation a price rise which reflects a decline in output rather than a rise in MV. ·Another, perhaps more important (for small countries), case is a rise in prices due to a rise in import prices implying a deterioration of the country's international "terms of trade."

had started to go down. It would seem rather confusing to say that an economy can simultaneously suffer from high and low blood pres sure. We shall, therefore, distinguish between deflation and de pression, as well as between prosperity and inflation. At the same time, we remain alert to the possibility that inflation may be com bined with depression (or recession). While the coexistence of rising prices and falling output and employment is somewhat unusual, it is not at all unlikely that inflation will either eventually bring about deflation and depression or make it difficult to counteract a depression that has arisen independently. This is, in fact, one of the main economic dangers (apart from the social injustices which it en genders) of even a mild inflation. More on that in the section entitled ((Causesof Inflation." [ 10 ] TYPES OF INFLATION BEFORE CONSIDERINGcarefully the proximate and more remote causes of inflation, it will be well to clear the ground by distinguishing several general types.