The quantity theory of money says changes in prices are caused by equivalent changes in
the nominal money supply. In practice, prices cannot adjust at once to changes in nominal
money, so interest rates or income alter, changing real money demand. Nevertheless, in the
long run changes in prices are usually associated with changes in nominal money.
The Fisher hypothesis is that 1 per cent rise in inflation leads to a similar rise in nominal
interest rates so real interest rates change little in the long run. Since the nominal interest
rate is the cost of holding money, higher inflation reduces real money demand. The flight
from cash during hyperinflation is a vivid example.
For a solvent government, there need be no close relation between the budget deficit and
nominal money growth. In the long run, persistent borrowing to finance large deficits may
leave the government so indebted that further borrowing is impossible. It must resort print
money of take fiscal action to cut the deficit.
The long-run Phillips curve is vertical at equilibrium unemployment. If people foresee inflation
and can completely adjust to it, inflation has no real effects.
The short-run Phillips curve is a temporary trade-off between unemployment and inflation in
response to demand shocks. Supply shocks shift the Phillips curve. The height of the shortrun
Phillips curve also depends on underlying money growth and expected inflation. The
Phillips curve shifts down if people believe inflation will be lower in the future.
Temporary supply shocks also shift the short-run Phillips curve. Stagflation is high inflation
plus high unemployment.
Some so-called costs of inflation reflect inflation illusion or a failure to see inflation as the
consequence of a shock that would have reduced real incomes in any case. The true costs
of inflation depend on whether it was anticipated and on the extent to which the economy’s
institutions allow complete inflation-adjustment.
Shoe-leather costs and menu costs are unavoidable costs of inflation and are larger the
larger the inflation rate. Failure fully to inflation-adjust the tax system may also impose costs,
even if inflation is anticipated.
Unexpected inflation redistributes income and wealth from those who have contracted to
receive nominal payments (lenders and workers) to those who have contracted to pay them
(firms and borrowers).
Uncertainty about future inflation rates imposes costs on people who dislike risk.
Uncertainty may be greater when inflation is already high.
Incomes policy may accelerate a fall in inflation expectations, allowing disinflation without a
large recession. But it is unlikely to succeed in the long run. Only low money growth can
deliver low inflation in the long run.
Operational independence of central banks is designed to remove the temptation faced by
politicians to print too much money.
