Chapter 29 — Inflation: Causes, Consequences, and the Central Bank's Dilemma

Chapter 23 taught you how inflation is measured and what it costs. This chapter asks: what causes inflation, and what can central banks do about it? The answer involves one of the oldest equations in economics (the quantity theory), one of the most famous relationships (the Phillips curve), and one of the most important insights of modern macroeconomics (expectations matter more than tools).

29.1 The quantity theory of money

The oldest theory of inflation, dating back to David Hume (1752) and formalized by Irving Fisher (1911):

MV = PY

M = money supply, V = velocity of money (how many times each dollar is spent per year), P = price level, Y = real output (GDP)

Rearranging: P = MV/Y. The price level is proportional to the money supply, adjusted for velocity and output.

The quantity theory's prediction: if V and Y are roughly constant (or grow slowly), then changes in M drive changes in P. Double the money supply → double the price level. This is the long-run relationship between money growth and inflation. The historical data broadly supports it: countries with high money growth have high inflation; countries with low money growth have low inflation. Hyperinflation episodes (Chapter 23) are always associated with explosive money growth.

The short-run qualification: V is NOT constant in the short run. It varies with interest rates, financial innovation, and confidence. And Y is not constant either — it responds to monetary policy. So the quantity theory is a good long-run framework but an incomplete short-run framework. In the short run, we need additional tools.

29.2 Demand-pull vs. cost-push inflation

Two short-run mechanisms:

Demand-pull inflation: too much aggregate demand chasing too few goods. When the economy is overheating (spending exceeds production capacity), firms raise prices because they can. Demand-pull inflation typically arises from expansionary monetary or fiscal policy, consumer confidence booms, or asset-price booms (the wealth effect from rising stocks or housing).

Cost-push inflation: rising input costs push up prices. When oil prices spike, when wages rise faster than productivity, when supply chains are disrupted — the cost of producing goods rises, and firms pass the cost increase to consumers. Cost-push inflation typically arises from supply shocks (oil, food), labor market tightness, or regulatory changes that raise costs.

Most real-world inflation episodes involve both. The 2021–23 surge was demand-pull (fiscal stimulus) AND cost-push (supply-chain disruption) simultaneously, which is why it was so severe and so hard to diagnose in real time.

The 1970s stagflation: the most famous example of cost-push inflation. OPEC oil embargoes (1973, 1979) raised energy costs sharply, pushing up prices throughout the economy. The simultaneously high inflation and high unemployment — "stagflation" — was the crisis that traditional Keynesian economics could not easily explain (Keynesian models assumed inflation and unemployment were inversely related).

29.3 Inflation expectations: the most important variable

Modern macroeconomics holds that expectations about future inflation are the single most important determinant of actual inflation. If everyone expects 2% inflation, wages and prices are set accordingly, and inflation turns out to be about 2%. If everyone expects 10% inflation, wages and prices adjust to match, and inflation turns out to be about 10%.

Anchored expectations: when people believe the central bank will maintain low inflation, expectations stay near the target regardless of short-term shocks.

Unanchored expectations: when people lose confidence in the central bank, expectations drift upward, wages and prices follow, and inflation becomes self-reinforcing.

The 1970s were a period of unanchored expectations: the Fed had lost credibility, everyone expected inflation to continue rising, and it did. The Volcker disinflation (Chapter 27) re-anchored expectations at a steep cost (10.8% unemployment). The 40 years of low inflation that followed were the dividend of that re-anchoring.

The 2021–23 episode was a test: would expectations remain anchored despite 9% inflation? They did — the Michigan Survey, the Cleveland Fed's expected-inflation measures, and bond-market breakeven rates all remained near 2–3%, even as actual inflation soared. This is why the disinflation was achievable without a deep recession: the public believed the Fed would bring inflation back to 2%, so wages and prices didn't spiral.

Why credibility matters more than tools: the Fed's tools (interest rates, QE) work partly through their direct effect on borrowing and spending, but even more through their signaling effect on expectations. When the Fed raises rates, it's not just making borrowing more expensive — it's communicating "we are serious about fighting inflation." If the market believes the Fed is serious, expectations stay anchored, and less actual tightening is needed. If the market doesn't believe the Fed, expectations become unanchored, and much more tightening (and economic pain) is required.

29.4 The Phillips curve

In 1958, A.W. Phillips observed an inverse relationship between unemployment and wage growth in UK data: when unemployment was low, wages rose fast; when unemployment was high, wages rose slowly. Paul Samuelson and Robert Solow adapted this to a relationship between unemployment and price inflation — the Phillips curve.

The short-run Phillips curve: there IS a trade-off between inflation and unemployment in the short run. When the Fed pushes unemployment below the natural rate (NAIRU), inflation tends to rise. When unemployment is above NAIRU, inflation tends to fall. The trade-off exists because of sticky wages and prices — it takes time for the economy to adjust to changes in demand.

The long-run Phillips curve is vertical. Milton Friedman (1968) and Edmund Phelps (1967) independently argued that the short-run trade-off disappears in the long run. When inflation has been high for a while, workers and firms expect it and adjust their behavior (demanding higher wages, setting higher prices). The economy returns to the natural rate of unemployment at whatever inflation rate prevails. There is no permanent trade-off.

The accelerationist hypothesis: if the central bank tries to keep unemployment permanently below NAIRU, inflation doesn't just stay high — it accelerates. The only way to keep unemployment below NAIRU is to keep surprising people with more inflation than they expected. This requires ever-increasing inflation, which is unsustainable.

The 1970s as the Phillips-curve crisis: policymakers in the 1960s believed in a stable Phillips-curve trade-off (we can have low unemployment if we accept some inflation). The 1970s proved this wrong: both inflation and unemployment rose simultaneously (stagflation), as Friedman and Phelps had predicted. The short-run trade-off is real; the long-run trade-off is an illusion.

29.5 The central bank's dilemma

The Fed faces a fundamental tension between its two mandates: - Maximum employment → keep rates low, stimulate the economy - Stable prices → keep rates high enough to prevent inflation

When unemployment is high and inflation is low, both mandates point the same way (ease). When unemployment is low and inflation is high, the mandates conflict (to fight inflation, the Fed must raise rates, which raises unemployment).

The Phillips curve captures this dilemma: in the short run, reducing inflation requires accepting higher unemployment (or at least slower growth). The question is how much unemployment is "enough" — and the answer depends on expectations, on the supply side, and on luck.

The 2022–23 episode was unusual: the Fed managed to reduce inflation without significantly increasing unemployment — the soft landing. This was possible because: (1) expectations were anchored, (2) supply chains healed independently, and (3) immigration expanded the labor supply. In a less favorable scenario (unanchored expectations, persistent supply shock, tight labor supply), the trade-off would have been much sharper.

29.6 Where this is going

Part VI is complete. You now understand money, banking, the Fed, monetary policy, the financial system, and the causes of inflation. Part VII applies all of this to the big macro questions: the business cycle (Chapter 30), the AS-AD model (Chapter 31), fiscal policy (Chapter 32), and the open economy (Chapter 33).

Key terms recap: quantity theory (MV=PY) — money supply × velocity = price level × real output; long-run link between money and inflation demand-pull — inflation from too much spending relative to production capacity cost-push — inflation from rising input costs (oil, wages, supply disruptions) anchored expectations — the public believes the central bank will maintain low inflation Phillips curve — short-run trade-off between inflation and unemployment; disappears in the long run NAIRU — the unemployment rate consistent with stable inflation Volcker disinflation — 1979–82; the Fed raised rates above 20%, caused a recession, broke inflation, and re-anchored expectations

Themes touched: Disagreement (about the Phillips curve, about the 2021–23 causes), Behavioral (expectations are partly behavioral — they depend on trust and credibility), Affects daily life (inflation determines your purchasing power, your mortgage rate, your real wage).

PART VI COMPLETE.