Survey of Inflation

Department of Economics, Delhi School of Economics, University of Delhi
A SURVEY OF THEORIES OF INFLATION

Author(s): Harry G. Johnson
Source: Indian Economic Review, Vol. 6, No. 3 (FEBRUARY 1963), pp. 29-69
Published by: Department of Economics, Delhi School of Economics, University of Delhi
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A SURVEY OF THEORIES OF INFLATION*
Harry G. Johnson
Introduction
This article presentsa survey of recent workon the theoryof

inflation. The survey is a highly personal one, reflectingthe
author'sown judgmentas to the importantanalytical and policy
issues and contributionsratherthan attemptingto givefair repre-
sentationto the contributionsof variouswritersto the voluminous
literatureon the subject1. The work surveyedhas been concerned
withinflationin the advancedcountriesand primarilywith inflation
in the UnitedStates and the UnitedKingdom; whilethe analysis
and issues are also relevant to the problems of underdeveloped
countries,the articledoes not pretendto surveythe literatureon the
vexedquestionof inflationand economicdevelopment.
For the purposeof thissurveyI defineinflationas a sustainedrise
in prices. (There are otherdefinitionswhich I shall discuss subse-
quently.) Whilethe definitionof inflationas a sustained rise in
pricesis a simpleone, one encountersproblems of some difficulty
as soon as one triesto apply it in practice. The firstsuch problem
is thattheremay be price rises which are not inflationary but are
merelypart of the normal working of the competitivesystem. For
example,it is obvious thatifthereis a crop failure or somethingof
thatkind,therewill be some rise in prices to ration the reduced
supply; again, if the economyis movingupwardsfromthe bottom
of a recessionto a higherlevel of employment,there will inevitably
tend to be some rise in pricesdue to the increaseddemand forgoods
and labour. In both cases, the rise of pricesoughtnot to be regar-
ded as inflationary; first,because in the natureof thingsit will be
and second, because it does not in itselfrepresentany
self-limiting,
seriouspolicyproblem.
*Basedonthesecondoftwosurvey lecturesdeliveredto la Reuniónde

CentrosArgentinos de Investigation Económica,sponsoredby Centros de
Investigaciones Económicas,Instituto Torcuatodi Telia, Buenos Aires,
August1, 1963.
1. Foran officially-sposored
survey, an extensive
including biblography,
see MartinBronfenbrenner andF. D. Holzman, "Surveyof InflationTheory,"
American EconomicReview , Vol.LIII, No. 4, September 1963,pp. 593-661.
Thisarticleappearedafterthelectureon whichthe presentarticleis based
wasdelivered to ithavebeenaddedwhereconvenient
; references to economize
onextensive bibliography.

30 HARRYG. JOHNSON
A second problemarises when one begins to considerwhat prices

(or price index) should be referredto as indicatingthe presence or
absence of inflation. For example, if one chooses a priceindex
whichincludesthe price of services, then in a normallyadvancing
economyone would tend to observean inflationaccording to this
index,eventhoughconsumergoods priceswere stableor even falling
slightly,simplybecause the priceof labour tendsto rise relativelyto
the price of commoditiesas the economyprogresses. This bias of
generalpriceindexesis relevant to the common practice of using
implicitprice deflatorsforthe grossnationalproduct as indexes of
price movement. A similar problem is posed by the question
whetherpricesshould be measuredinclusive or exclusive of taxes;
the difficulty here is that if the governmentincreases taxes on
commoditiesor labour in orderto deflatethe economy,this will tend
to put up prices inclusive of taxes and will, therefore,appear to
contributeto the inflation,at least temporarily,ifpricesinclusiveof
taxes are taken to measure inflationarybehaviour. However, the
problemsarising from the fact that different price indexesbehave
somewhatdifferently will not be too serious if there is really a
significantinflationgoing on, thoughthe choice of price index will
affectthe measurementof the rate of inflation.
Not only are theredifficultiesconnected wiih the choice among
iudex numbers,but index numbersby their method of construction
contain biases whichmay be importantin the assessmentof whether
thereis an inflationor not, and the measurementof the degree of
inflation,if the inflationis of the mildkind. In particular,most
priceindexesdo not take adequate accountof improvementsin the
qualityofgoods, nor do theydo verywell withintroducing and incor-
porating the behaviour of the prices of new goods. Now one
importantpartof the process of economic growth comprises the
gradual improvementof the technicalqualityof existinggoods, so
that a good of the same name and general descriptionactually
providesmoreserviceand satisfactionif produced at a later date
than at an earlier one ; and anotherimportantpart of the growth
process comprises the introductionof new products, products
whichcommandhigh priceswhentheyare firstintroducedand then
becomemass-producedso thattheir pricesfall. But price indexes
typicallydo not correctquoted prices sufficiently for improvements
in product quality, nor do they typically begin to include new
IndianEconomicReview

A SURVEYÒt THEORIES
OF INFLATION 31
productsuntilaftertheyhave become mass-produced, so that the

initialphase of fallingpricesis not reflectedin the index. For both
these reasons indexes may, if one is not cautiousin usingthem,
create the impressionof inflationwhenin factno genuineinflation
is present; for the short-comingsof the typicalindex maygive an
upward bias to price measurmentsof as much as two or three
percent increase per year. For example,the StiglerCommitteeon
Price Statisticsin the United States2 found thatthe appearance of
inflationover the period since 1950, at the rate of about two
per centper year,mightbe entirelyaccountedforby the inadequacy
of theconsumerpriceindexin taking into account changes in the
qualityof goods and the introductionof new goods. But it is not
necessarilytruethat the indexof all countriesare upward-biased to
this extent- in fact,a similarstudyof the Canadian consumer price
indexfailedto reveal any substantialupwardbias.8
There is finallythe difficulty that in some countries,particularly
in the major European countries during and afterthe war and
evidentlyin many underdeveloped countries at the presenttime,
strong effortshave been made to suppress inflationby price and
wage fixing; mòreover,some of the more cunning governments
have attemptedto preventthe appearance of inflationin their price
indexes by subsidizing those commodities which are particularly
important components of the indexes while at the same time
rationingthem.
raisedby the definition
These are the difficulties of inflationI have
adopted, according to which inflationis identifiedwitha sustained
rise in prices. There are other definitionsof inflation,most of
whichattemptto go beyondthe descriptionof inflationto the causes
of it. For example, quite frequently,particularlyin popular dis-
cussion,inflationis definedas consistingin an increasein the quantity
of money,or in an increasein the quantityof moneyat a fasterrate
than real national output is expanding; frequently also inflationis
definedalternatively in termsof a sustained governmentalbudget
deficit; and again inflationis oftendefinedas a situationof chronic
excess demand for goods and services. These definitionshave in
2. GeorgeStigler,etalt ThePriceStatistics
oftheFederalGovernment
,
NationalBureauforEconomic New York,1961.
Research,
3. A. Asimakopulos, of PriceIndexesas Measuresof
"TheReliability
Poce Trends,"StaffStudy,Royal Commission on Bankingand Finance,
Tronto;1962(mimeographed).
Vol. VIII No. 2, August1963

32 HARRYG. JOHNSON
common that they attemptto defineinflationin termsof what is

thoughtor alleged to cause it ; and this,in my judgment,is a serious
errorof theoreticalapproach to inflation,inasmuchas the conditions
to which these definitionscall attentioncould exist without there
beingany inflationin the sense of a sustainedrise in prices.
The erroris particularlyseriouswhen it appears*in discussionsof
economic policy, since definition of inflationin termsof thepolicies
held to be responsiblefor it induces opposition to those policies
regardlessof whethertheirapplicationwould be inflationary or not,
and thusstandsin the way of intelligentuse of those policies when
the problem is not inflationbut deflation. In the early 1930s,for
example,therewas a greatdeal of oppositionto monetaryexpansion
as a policy for overcomingmass unemployment, on the grounds
derived from post-war experience that such a policy would be
gravelyinflationary.As it proved, what expansion of the money
supplytherewas in the 1930s was not inflationarybut, to use the
word that was coined preciselyto circumventthe opposition just
mentioned,reflationary-that is, it servedto increasenationalincome
withoutinducinga significantrise in prices. Similarly,thereis at
the presenttimein the United Statesa greatdeal ofopposition to the
proposal to reducetaxes as a means of stimulating economicactivity
and employment,on the grounds that this would mean a larger
budget deficitand that a budget deficitis inherently inflationary.
Causal definitionsof inflation,therefore,tend to impede thought
rather than facilitateit, and should accordinglybe avoided as faras
possibleand used onlywithgreatcare.
In the main body of the article I propose to discuss six topics,
each of which,obviously,I shall have to deal with fairlybriefly. I
shall firstpresentan historicalsketch of the problem of inflation
and the viewsconcerningit, because I believethat in this particular
area of economics and economic policy economistsare more the
slaves of ideas derivedfrompast experiencethan in most areas, and
I find it useful to try to keep in mindthe historicalbackgroundof
current discussionsin order to maintain a proper scientificper-
spective. There is always a great temptation in economics,
particularlyin economics concerned with public policy, for the
economistsimplyto accept some popular definitionof the problem
and to tryto work with that conception,whenwhatthe economist
shouldbe doing is examine whetherthe conceptionof the problem
Indian EconomicReview

OF INFLATION
A SURVEYOF THEORIES 33
held by government, the generalpublic, newspaper editorialwriters,
and so forthis reallya relevantand fruitfulone, or a misconception
that distracts attention from the fundamentaleconomics of the
situation. Next I shall sketchout thetwo major approaches to the
analysis of inflationthat have been developed, the Keynesian
approach and the quantity theory approach. The quantity theory
approach is probably best knowniunderthe generaldescriptionof
the theory of the inflationtax. Then I shall commenton the
debate that raged a few years ago, but whichseemsto have died
down considerablyin the last two years, the debate over cost-push
versusdemand-pullinflation. This debate originatedin theeconomic
situation of the United States in the latter 1950s, which was
characterizedby risingprices coupled with a lowerlevel of employ-
mentand activitythan had been customary,and which raised the
question whether inflationwas due to the autonomous upward
movementof costs or whetherit could be explainedby thepull of
demand. In this connection I shall also deal with a particular
piece of analyticalapparatusthat has had considerableinfluenceon
thepracticalanalysisof the inflationproblem, the so-called Philips
curve. Then I shall summarizesome empiricalfindingson inflation,
and finallydiscussthe policy issues involved in the choice among
pricestabilityand othereconomic objectives.
II
A BriefHistoricalSketchof InflationProblemsand Theory
In understanding currentargumentsabout and views on inflation,

it is, I think, necessaryto attach a greatdeal of importanceto the
impacton public opinionof the inflationsthat took place during
World War I and continued after that War in the continental
European countries,and particularlyto the impactof the German
hyperinflation in the early 1920s. That experiencecame after a
longperiod stableor decliningprices,and had tremendous
of political
implications; and one of its resultswas to build into popular and
a
professionalideas about economicproblems series of ideas about
inflationthatare not necessarilygenerallyvalid.
In the firstplace, in both the United Kingdom and the United
States the War was financedby inflationary policies whichinvolved

Í4 ÖAkkYG. JOHNSON
risingprices,risingwages,and rising rates of interest. One of the

apparentfeatures of this inflationwas what is commonlyknownas
thewage-pricespiral- the processof wages risingbecause prices rise
and of pricesrisingbecause wages rise, in a continuous sequence;
and one of the main prevailingideas about that sequence was the
belief that wages always lag behind prices, in other words that
inflationhas the effectof cheating the workingforceout of real
income,to the benefitof the recipientsof profitincome. This idea
about the inflationary sequence has been an importantone ever since
then; nevertheless,it turnsout on closer analysisthatin most infla-
tionsone does not findthis lag of wages behindprices- one cannot
detecta significant shiftof the distribution of incomeaway fromthe
wage earners. Earl Hamilton'smajor study of theinfluenceof the
inflowof gold into Spain in the great Spanishinflation4appeared to
find such a vwage-pricelag ; but recent research has shownthat
Hamilton's statisticswerebiased and that one cannotin factfindsuch
a lag the classical Spanish case5 and one certainlycannotdetectit in
the statisticsof otherinflations (so long as theseare open inflations)6.
A second contributionof the World War I inflationand the
Germanhyperinflation to ideas on inflationwas the viewthatthe
course of inflationis necessarilybudgetdeficitsand the resortto the
printingpress to finance governmentexpenditure. A third idea,
which derived particularlyfrom the German hyperinflation, was
thatinflationinevitablyleads to the destructionof the rentierclass,
the people livingon interestand the rentof property,and also tends
to wipe out the middleclass who live on salariesand otherkinds of
fixedincomes Finally,the World War I experiencegreatlyreinforc-
ed the quantitytheoryapproach to monetaryproblems. This is not
onlyevidentin prevailingviewsof what*caused the inflation,that
is resortto the printingpresses,but was also manifest,for example,
in the developmentof the purchasingpowerparitytheoryof exchan-
ge rates.
4E.J. Hamilton, AmericanTreasureandthePriceRevolutioninSpain, 1501-
1650, Cambridge,1934; Money, Prices, and Wagesin Valencia
, Aragon,and
Navarre, 1351-1500,
Cambridge 1936; War and Pricesin Spain, 1651-1800.
Cambridge, 1947.
5R.A. KesselandA. A. Alchian,"TheMeaning and Validity
of the Inflation
InducedLagofWages,BehindPrices",American EconomicReviewVol.L, No. 1
March1960,pp 43-66.
6C/.KesselandAlchian,op.cit.;A. J.Brown,TheGreatInflation
, 1939-1951.,
London,1955; BronfenbrennerandHolzman,op.cit.,pp.674-48.

A SURVEYOF THEORIES
OF INFLATION 35
All of theseideas about inflation,which were derived from the

World War I experience, were driven into the thinkingof politi-
cians, newspaper editorial writers,the general public,and profes-
sional economistsby the tremendousemotionalshock of the eruption
of inflationaftera long historicalperiod of a relativelystable value
of money; and these ideas, I have alreadymentioned,had a strong
influenceon thinkingabout the great depression in the 1930s,
inasmuchas the fearof inflation,and of any policies that might
provoke it such as budget deficitsand monetaryexpansion,was a
formidablebarrierto the adoption of intelligent policy to overcome
the depression. For example,whenthe pound sterlingwas even-
tuallyforcedoffgold the immediatereaction of financial opinion
was to expect an immediaterise in prices sufficient to offsetthe
devaluation,the idea beingthatcurrencydepreciationmustinevitably
be accompaniedby an equivalent inflationof prices in domestic
currency. There was also greatopposition in Britainto the idea of
deficitbudgeting,and in factthe ConservativeGovernment,at the
same time as it went off the gold standard, introduceda severe
increasein taxes and a reductionin variousgovernmentexpenditures
to demonstrateits financial orthodoxy,a policy obviously not
designed to help solve the depression. And the subsequentpolicy
of cheap moneywas adopted only with considerable worry about
its inflationaryeffects,one of the main argumentsforit beingthat
it would assist the government to balance the budget by reducing
the interestcharges on the debt inheritedfromWorld War I. In
the UnitedStates,Roosevelt was elected on a promise to restore
budgetarybalance ; and his revaluationof gold restedon the extre-
mely naive idea thatraisingthe dollar priceof gold would automati-
cally raise the pricesof commodities back to their pre-depression
levels, and so cure the depression. In this and otherways the
World War I inflationary experience created a climate of opinion
thatinhibitedintelligent policy-makingin the 1930s, whenthe prob-
lem foreconomicpolicy was not inflationbut severedeflation.
This conflictbetween orthodox ideas on policyderivedfromthe
early 1920s and the realitiesof the situationof the 1930s had a great
deal to do with the success of the Keynesian revolution. The
conflictcreatedan impasse in policy-making, a conflictwhichcentred
on monetary and fiscal policy, and the new theoriesof Keynes
offeredan intellectuallyrespectabledetour around the impasse to a
Vol. VIII No. 2 August 1963

36 HARRYG. JOHNSON
solutionof the urgentproblemof mass underemployment.

The experienceof World War I also had a stronginfluenceon
the policies followedin financingWorld War II, policieswhich were
derivedin part fromthe lesson of the earlierexperienceand in part
from the ascendant ideas of the Keynesians. (In his role as an
adviserto the Treasury,Keynes himselfplayed an importantpart
in the designingof wartimefinancein England). There was, in the
firstplace considerablepopular oppositionto inflationary financing
of the war in a predominantly freeenterpriseenvironment,derived
fromtheexperienceof World War I and particularlyfromthe idea
thatinflationinevitablyinvolves a reductionin the real incomesof
the wage earnersto the benefitof the entrepreneurial and managerial
classes. A great deal of the pressure for the typeof wartime
economicpolicythatwas adopted came from the fear that infla-
tionary financingwould deprive the wage earnersof the gains they
had made in theinterwar period, and that it would promote an
undesirable redistributionof incomein favourof the ' 'profiteers",
the villainsof the popular mythologyof the World War I inflation;
it was thispressurethatunderlaythe earlyintroduction of wage and
price controls. Another aspect of World War I finance that
influencedfinancial policy in World War II was the experienceof
risinginterestratesunder inflation,which had createdconsiderable
difficultyforwar financein World War I ; rising interestrates had
made it difficult to floatgovernment loads, because the marketwould
expectinterestratesto rise and hence would be unwilling to subs-
cribe to new issues, and thisin turnwould forcethe interestrates
on government debt up still further,reinforcingthe expectationof
risingrates.
The resultof paying attention to the lesson of World War I,
togetherwith the Keynesian insistencethat "interestis a purely
monetary phenomenon," was a method of war financingthat
primarilyinvolved heavy reliance on physical controls (rationing
and allocation) and on controlsof pricesand wages as a means of
obtainingcommandof the real resources the governmentsneeded
withoutbiddingup theirprices and on the financial side relied on
deficitfinancingto meet the requirementsthatwere not met by
taxation,usinga combination of cheap money and a system of
issuinggovernment debt moreor less on demand, to keep interest
rates steady. The centralprincipleof wartime financingwas that

A SURVEYOF THEORIES
OF INFLATION 37
the physicalcontrolswould preventcheap money from leading to

an inflationarybidding-up of prices, confining its influenceto
depressinginterestrates,and thatpreventionof rising interestrates
would in turnencouragesubscriptionsto issuesof governmentdebt.
In fact,the resultwas some downward movementof interestrates,
because the stabilization of rates removed the uncertaintythat
underlaythe wide marginbetween short-termand long-termrates
thatdevelopedin the 1930s ; and the downward movement helped
sell the govermentdebt because the expectationsfactor worked in
the opposite direction to what it had done in World War I. The
Keynesiancontributionto wartimeeconomicpolicyconsisted in the
developmentof thetechniqueof analysingthe problem of obtaining
resourcesforthe effortin terms of the so-called inflationarygap
(as it was called-inthe UnitedStates- in the United Kingdom, such
analysisconcentratedon the "manpower budget"). This technique
involvedforecastingtotalproductionand theprospectivedemandson
it,the difference constituting the prospectiveexcess of demand over
supply,as a basis fordevisingpoliciesto trimthe demand to fit the
supply.
The methodsof financingWorld War II did succeed in preventing
substantialinflationduringthe war,but theydid so at the expense
of pilingup troublewhichwas accentuated by the continuationin
the postwarperiodof the cheap moneypolicies adopted during the
War. A large part of the motivationfor both the wartime policy
and itscontinuanceafter the War was the belief that there was
likelyto be a catastrophicpostwar recession which could be miti-
gated by givingthe public plenty of liquid wealth to sustain its
postwarexpenditures. This beliefreflected both the success of the
Keynesian Revolution and the ''secular stagnation" theories that
developed from it in the United States, and the tendencyof
economiststo be undulyinfluenced by their contemporaryenviron-
mentof opinion. Most wars have been followed by inflations,not
by depressions,and World War II was no exception; moreover,
the pilingup of liquid assets in the hands of the public during the
War and the postwarcontinuanceof wartimecheap money policies
made it exceptionallyeasy to financeinflationary demandson limited
productiveresources. In some European countries the wartime
pilingup of liquiditywas offsetby monetaryreforms; but in other
countries,particularlythe United States and the UnitedKingdom,
Vol, VIII No. 2, August1963

38 HARRYG. JOHNSON
monetaryreformswerenot attempted.
In this general situation of postwarinflation,it was naturalfor
economiststo turntheirattentionto the analysis of inflation; and
it was also naturalthattheyshould attemptto apply the Keynesian
model of income determinationto this analysis. What, in fact,
theytended to do was to apply the Keynesianmodel and the algeb-
raic techniquesassociated withit to the analysis of the inflationary
process,in the courseof so doing elaboratingon the model in various
ways suggested by the contemporarypolitical argumentsabout
inflation. In general, these models were based on the simplest
saving-investment versionof the Keynesian analytical system,and
paid littleor no attentionto the monetaryelementsof that system.
They assumed,in effect - which was indeed fairly realistic in the
circumstancesof contemporarypolicy- that demand could always
be financed,and concentratedon other determinantsof demand
than the quantity of money, rates of interest,or the availability
of funds.
The inflationof the immediatepostwarperiodcan be described
fairlydefinitelyas one of excess demands based on the availability
of financeat low ratesof interest. But the inflationcontinuedpast
what was then called the conversion period into the middleand
latter1950s.7In the latter1950s,in theUnitedStates,unemployment
was higherthan it had been in the immediateposwar period and
yet prices still seemed to be rising;at the same time,the wartime
fearsof postwarrecessionhad belatedly been replaced by serious
concernabout the problemof inflation. The resultwas a prolonged
debate over whetherit was appropriateto use monetaryrestriction
to combatinflation, a debate which centredon the question of the
causes of the contemporaryinflation. On one side of the debate
was the "cost-push" school of thought,whichmaintainedthat there
was no excess demand, but thatpriceswere risingbecause in parti-
cular marketswageswerebeingpushedup by trade union bargaining
power,or priceswerebeing pushed up by the administrativeaction
of oligopolistic firmswith marketpower. On the otherside was
the "demand-pull" school which maintainedthatthe cause of the
inflationwas excessive demand. Later, in the UnitedStates,there
developeda thirdschool of thought, associated with the name of
shouldbe qualifiedby reference
7. This statement ofthe
to the findings
Committee
Stigler to intheprevious
referred section.
IndianEconomicReview ;

A SURVEYOF THÉORIES
OF INFLATION 39
Charles Schultze, which advànced the "sectoral demand-shift"
theory of inflation. This was a combination of the demand-pull
and cost-push theories,the central notionbeing neitherthat wages
and prices were being pushed up without economic reason by
autonomousforces,nor thattheywere beingpushed up by a general
excess of demand, but instead thatin a growingeconomydemand
keeps shifting fromone sectorto anotherand the wages and prices
rise readily in the sector to which demand has been shifted,but
do not fall as readilyin the sectorfromwhich demand has shifted,
so that there is a general process of escalation of prices based
neitheron "cost-push" nor on the pull of excess demand.
The debate over cost-push versus demand-pull reflectsthe
revival of the monetary explanation of inflation that emerged
graduallyfromthe experienceof the late 1940s and early 1950s,an
explanation which concentrateson the propositionthat inflationis
fundamentallya monetary phenomenon and that to stop inflation
it is necessaryto take action to limitthe expansion of the quantity
of money. The latter 1950s were distinguisedby a change in the
generalclimateof opinion among economists, in that much more
emphasis came to be placed on monetaryfactorsand on monetary
policythan had been the case sincethe early 1930s. At the same
time,a whole new set of policy considerationscame into the picture.
The experienceof the 1920s had establishedprice stabilityas a goal
of economic policy. In the 1930s, fullemploymentbecame estab-
lishedas a primarypolicy goal, and thiswas formalizedby legisla-
tion passed during and after the war by the United States and
variousothercountries. Withthe cold war and the emphasis that
has come to be placed on promotingthe economicgrowthof the
underdeveloped countries, economic growth has gradually been
elevatedto an objectiveof economicpolicy in advanced countries,
along withprice stabilityand highemployment. At the same time,
the defects of the BrettonWoods system,particularlythe failureof
thepostwarinternationalmonetaryarrangements to provide for an
adequate internationalreservemoney, have led to thebalance of
paymentsappearing as a difficultpolicy problem, firstfor the
> European countries,of course, but more recentlyforthe United
States;consequently,the objectiveof balance-of-payments stabilityor
^ balance-of-payments equilibrium has been raised to the positionof a
major policy objectiveas well. Thus, recentdiscussionsof economic
Vol. VIII No. 2, August 1963

40 HARRYO. JOHNSON
policyproblemshave been concernedwiththe relativeimportanceof

thesevarious objectivesand the possibilityof conflictamong them;
and thisraises the questionof how inflationand policies to preventit
are relatedto thepursuitof the otherobjectivesof economicpolicy.
Ill
The KeynesianAnalysisofInflation
As mentionedin the introductory section of this lecture, there

are two major approaches to inflationto be foundin the postwar
literature; broadlyspeaking,thesecan be said to followone another
in time. The early postwar literature on inflationwas almost
exclusivelyKeynesian,and it has onlybeen towards the latter part
of the period that the quantity theoryapproach has attracteda
substantialnumberof adherents,
The Keynesiantheorywas, as everyoneknows,dismissedby many
of its critics in the 1930s and the early 1940s as simplya theoryof
depression; it was maintained that the Keynesiantheorywas an
ad hoc theorydevelopedto explainthe greatdepressionof the 1930s
and thatits scope was confinedto theexplanationof thatdepression.
But with the successfuluse of the Keynesiananalyticalmethodin
the planningof war finance,thatopinion changed drastically,and
it was recognized that Keynesian theory actually was extremely
adaptable to theanalysisof the problemof inflation* The adaptabi-
lity of the Keynesiananalysisto inflationary problems,in myjudg-
ment,stemmedfromtwo of its major features,thought I do no
want to implythatthose who adapted it to the problemof inflation
werefullyconsciousof thesefeatures.
In the firstplace, the savings-investment equilibrium condition
provided a direct approach to the question of inflationin termsof the
demand forand supplyof goods ; this,of course, is the main attrac-
tion of the Keynesiantheory - it does go rightto what seems fairly
commonsensical and understandable, the aggregatedemandforgoods
and whatdeterminesit. The Keynesiansavings-investment equili-
brium conditionis fairlysimpleto understandand to operatewith,
and it can be convertedveryeasily froman analysisof what deter-
minesthe levelof real outputto an analysisof whatdeterminesthe
level of prices. For underemployment conditions,the Keynesian

OF INFLATION
theorysays that thelevelof outputwill adjust to the level at which

the savingsforthcomingfromthatoutputin real termswill be equal
to the amountof investment goingon. In conditionsof fullemploy-
ment,on the otherhand, the variablewhose adjustmentbringsabout
equilibriumbetweensavings and investment is not the level of real
output or of employment,but the level of money income, more
specificallyof the moneyprice level of fullemploymentoutput. If
the levels of moneyprices or wages can be related by some mecha-
nismto the amountof savingor investment measuredin real terms,
the savings-investmentequilibriumconditionprovides an apparatus
foranalyzingthe effects shocks on the level of wages
of inflationary
and prices.8 This is the firstreason, I think, why the Keynesian
analysisproved so attractiveforthe analysisof inflation; that the
savings-investment equilibriumconditionis simple to understand,
and can be very easily adapted to conditionsin whichmoneyprices
and wages ratherthanreal outputare the variablesthatbringabout
equilibrium.
The second feature,which I thinkis even more important,is
thatthe analysisof the GeneralTheoryrestson the assumptionthat
money wages are determinedëxogenously and are to be taken as
given; it does not includea theoryof what determinesmoneywages.
This treatmentof money wages means thatin applying the theory
to full employment conditions one is at libertyto adopt any treat-
mentof the determination of moneywages one likes. In practice,
thismeant thatwriterson inflationwere freeto use the assumption
thatwages are determinedperiodby periodby negotiationsthat take
into accountpreviouschanges in the cost of living,or theassumption
thatwages are determinedby the interactionof the demand forand
supplyof labour, or the assumptionthat wages are determinedby a
strugglefor shares in the nationalincome. Similarly,they could
assume that pricesare determinedby referenceto past costs, firms
addinga profitmarginto theircosts and raising theirpricesas costs
rise,or thatpricesare determinedby the interactionof demandand
supply,or again thatpricedetermination represents a struggleamong
social groups. In otherwords, since the GeneralTheory did not
8Thesavings-investment
equilibrium condition
canalsobe usedto determine
thedistribution
of incomein a fully-employedcompetitiveeconomy see for
example,NicholasKaldor, "Alternative Theories ";Review
ofDistribution, of
Economic Vol.23,No. 2, 1956,pp.83-100.
Studies,

42 HARRYG. JOHNSON
specifya theoryof moneywages, it was possibleto get a greatdeal

of varietyinto modelsthatused essentiallythe some apparatus.
I have already referredto the wartimedevelopmentof Keyne-
sian inflationtheory, and specificallyto the inflationarygap analysis
that was characteristicof discussionsof war finance,especiallyin the
United States. An importantcontribution to thisline of analysis in
the immediate postwar period was the workof Bent Hensen, the
Danish economist, initially made available to English readers by
Ralph Turveyand Hans Brems.9 Hansen's workconsistedprimarily
of eloborateand essentiallysterileexerciseswiththeformalapparatus
of the Swedishapproach to monetarytheory; but he did, in contrast
to the Keynesian concentrationon thedemandforgoods, introduce
the importantdistinctionbetweenthe goods market and the factor
market and develop an analysisof inflationin termsof the goods
gap and the factorgap. Turveyand Brems provided a dynamic
versionof his analysis.
The most importantwork that was done in the immediatepost-
war period consistedin theconstructionof dynamic models of infla-
tion. Essentiallythis involved constructingfirstor second order
differenceequations suitedto the problem, and analysingthe various
typesof dynamic behaviour such equationscan generate; and the
process derivedits interestmostlyfromthe factthatat thattimefew
economistswereconversantwiththe mathematicsof difference equa-
tions. In order to construct such equations, it was necessary to
convertthe Keynesiantheoryfroma theoryof the determination of
real output to a theoryof the determinationof money national
incomeor prices. The simplestway of doing thiswas to assumethat
the Keynesian propensityto consumeholds for moneyincomeand
consumptionexpenditure,so that a rise in priceswould increasereal
savingfroma givenlevel of real income, yieldingan inflationmodel
based on 'moneyillusion?10 A more sophisticatedapproach was to
work,not in termsof aggregateconsumptionand "investment,"but
in termsof the distribution of income betweenwages and profits,on
the assumption thatthe propensityto save out of profitsis higher
9BentHansen,A Study
intheTheory , London,1951í RalghTurvey
ofInflation
andHansBrems, "TheFactorandGoodsMarkets," , Vol.18,No,69,
Economica
February1951,pp.57-68.
l0Fora pioneeringexample,see Arthur "Behaviorof National
Smithies,
MoneyIncomeUnderInflationary Conditions," Journal
Quarterly ofEconomics
,
Vol.56,No.4, November 1942,pp. 113-29.

OF INFLATION
thenthe propensityto save out of wages.11

In such a model the inflationaryprocess startswith a reductionin
thetotal outputavailable fordivision, or an increasein the share of
outputdemandedby one ofthe participantsin production; the strug-
gle ofeach groupto preserveits absolute sharethenleads to increases
in wages or prices thateither cometo an end at a higherlevel of
pricesor proceedindefinitely,dependingon whetheror not one or
both groups is prepared to accept a reductionof its real income
throughthe inflationary process. A more elaborate and realistic
versionof thismodel introduces a rentiergroup with a fixedmoney
income thatcannot avoid beingrobbed by inflation; in this variant
the inflationaryprocessreaches a limitif the rentiergroup can be
robbed of enough real income to satisfythe other claimants to
income.12 A stillmoreelaboratemodel could be constructed,using
the distinctionbetweenthe goods and the factormarkets and intro-
ducingthe possibilitythatpricesand wages mightbe eitherdemand-
determinedor cost-determined. Such a model was constructedby
Turvey,and used to providea four-foldclassificationof inflations.13
Despite the varietyof theirconstruction, all of thesemodelswere
basically the same. At the formal level they involved a firstor
second order difference equation relating the price level or change
in the price level in one period to the price level or change in the
pricelevel in the previousperiod or two periods, the parametersof
the mathematicalrelationshipincorporatingthe precise behaviour
assumed in the theoreticalmodel. The second-order equation
tendedto be preferred, partly,I suspect,because that equation yields
morecomplexdynamicbehaviourpossibilities,and in particularmay
resultin an oscillatorypath of pricesover time.
As a simple example, consider the inflation model Pf-
abt-x+C, wherePt is the price level at timet and a , b, c are con-
stants,c serving to introducean exogenous disturbanceto startoff
theinflationaryprocess. This model can be arrivedat in a variety
of ways; ab can be a single constant representingthe marginal
nAnexample ofthisapproach D. Holzman,"IncomeDetermina-

is Franklyn
tionin Open Inflation,"
Review of Economics Vol. 32, No. 2,
and Statistics,
May1950,pp. 150-68.
12. See, forexample,C. G. F. Simkin,"Noteson theTheory of Inflation,
ť<ReviewofEconomicStudies pp. 143-51.
, Vol.20,No. 52,1952-53,
13, Ralph Turvey,"Some Aspectsof theTheory in a Closed
of Inflation
Economy," Economic , Vol.61,No. 243,September
Journal 1951,pp. 532-43.
Vol. VIII No, 2, August1963

44 HARRYG. JOHNSON
propensityto spend out of moneyincome operatingwith a one-

period lag ; or a can representthe determination of wages in period
t by the cost of livingin period t- 1, and b the fixingof current
pricesby a mark-upon currentwage costs ; or a can representee
determinationof wages in period/ by demand in periodt-l9 and
b the determination of pricesthisperiod by the spending of wages
thisperiod; and so on.
This typeof model is capable of dealingwithtwo questions: the
speed withwhich inflationproceeds, and whetheror not inflation
will automaticallycome to an end at a stable higherlevel of prices.
In the simplemodel just presented,priceswill convergeon an equili-
briumlevel or riseindefinitely accordingas ab is greateror less than
unity; and the speed of at any time wiil dependon the
inflation
lengthof the period and the magnitudeof ab, in the non-converging
case approachingthe limitinflationrate oí ab - I per period. Con-
vergenceof priceson a new equilibriumlevel requiresthat, whatever
the inflationarymechanism is, it does not resultin full compen-
sation of all sectorsof the economyforpast risesin prices; in other
words, it results in a permanentreduction of the absorption of
goods by one or more of the income-receivingsectors of the
economy,via the exploitationof moneyillusionor the redistribution
of real income.
The analyticalessenceof thesemodels is the redistribution of real
income so as to increase real saving, this redistributionresulting
from the inflationaryprocess itself. A major criticismthatcan be
broughtagainst[themis that, to obtaintheir results, theyassume
what is essentiallyarbitrarybehaviour, particularly when Ihey
assume that wages or prices are determinedby previous changesin
the cost of livingor of production accordingto an institutionally-
given constant. Such assumptionsdo not make much economic
sense when applied to a sustained inflationaryprocess in which
people can be assumedto be capable of learningfrom experience
and appreciatingwhat is going on about them. That is, while one
could reasonablyassume that over shortperiods wage earners, for
example,believethat the value of money is stable and demand only
sufficientwage increasesto compensateforpast increasesin the cost
of living,once the inflationary process getsunder way the assump-
tion thatwage and priceadjustmentsrespondonly to past changes
and that the responseis not affectedby changingexpectationsabout

Á sürVey of theořies of inflation 45
the futurebased on understanding of the interactionof wages and

prices becomes increasinglyarbitrary. The models can, however,
be saved from this criticismby assumingthat the coefficients of
reactionto past wage and price changesincorporatea (rathercrude)
process of formationof expectationsabout future developments
frompast experience.
A more fundamentalcriticismis that the relationshipsof the
modelsare assumedto be independentof the monetaryenvironment,
spendingbeingrelatedonly to income; no attention is paid to the
problemof financinga rising level of spending, or to the effects
of a rising moneyincome on the demandformoneyand thus on
interestrates and spending. In other words, the models assume
eitheran unlimitedsupply of idle balances or the continuanceof a
permissivemonetarypolicy. While both assumptions cculd be
defended as reasonable forthe period in whichthe models were
developed, theyare obviously not defensibleas generallyrealistic;
and recognitionof the necessity of one or the other to the analysis
underlinesboth the arbitrarinessof the behaviour assumptionsof
the models, and the extentto whichthe models ignore the influence
of monetaryfactorsand monetarypolicy on inflation.
To conclude the discussionof Keynesianinflationmodels,I should
add thatrelativelylittleattemptat empiricalverificationand testing
of thesemodelswas undertakenuntilthe Americandebate overcost-
push versus demand-pullin thelate 1950s. The mostelaborateearlier
effortof whieh I am aware was a major studyby Dow and Dicks-
Mireauxof the postwarinflationary experienceof the United King-
dom.14 It is obviously easy enoughto set up a cost-pushmodel of
thewage-pricespiral,and use it to analyse the movement of wages
and pricesin an inflationarysequence ; the difficultyis to sort out
14J. C. R. Dow,"Analysis ofthe GenerationofPriceInflation,"OxfordEco-

nomic Papers, Vol.8, No. 3, September 1956,pp.252-301; J.C. R. Dow and
L. A. Dicks- Mireaux, "TheDeterminantsofWageInflation : UnitedKingdom,
1946-56,"Journal of the RoyalStatisticalSociety
, Vol. 132, No. 2, 1959,
pp. 145-74. For further and discussion,
references, see Bronfenbrenner and
Holzman, op. cit.,p. 633. The comments belowrelatetotheearlierphasesof
theseauthors' work; subsequentlytheyshiftedtheiremphasisfrom"cost-push"
towards "demand-pull" ininflation.
factors

46 HARRYG. JOHNSON
fromthe simultaneousupward movementof wages and prices the
causal relationshipsamong movementsof thetwo. Dow and Dicks-
Mireauxfoundthatthe data wereconsistentwiththe causal relation-
shipstheypositedto beginwith: but theymade no seriouseffortto
test their theory against othertheories,and, as I shall argue later,
it is extremelydifficult
to devise any such test; consequently,their
work amounted only to one posible descriptionof the inflationary
processtheyanalysed,
As alreadymentioned,the Keynesiananalysisof inflationconcen-
trates on the redistributionof incomein the inflationary process :
thisprovideson alternativetype of test of the Keynesian models.
For the war period,one can withoutmuchtroubleverifythatthere
were substantialredistributionsof incomeaway fromthose who had
started the period with assets the income on whichwas fixedin
moneyterms; but thisredistribution can be attributedlargelyto the
method of financingthe war throughcheap moneycombinedwith
pricecontrolsand rationing. For the postwarinflationperiod,there
is littleindicationof any substantialredistributionof income attri-
butable to the inflationary process,15 It is possibleto detectsome
redistribution among particulargroups; but forthis type of model
to be proved usefulforthe analysisof inflation,it would be neces-
saryto establishthat the inflationary mechanismworks by redistri-
buting income among major income-receiving groups. This in turn
would requirethatsome of such groups be unable or unwilling to
protect their real incomesfromthe impactof inflation; in fact,on
the contrari,such protectionis available to all groups in a freely
competitivesystem,throughnegotiationof contractsto take account
of expected inflation,and is increasinglyresortedto as the factof
inflationis recognized. Consequently the Keynesianapproach to
inflation in terms of income redistribution seems less satisfactory
thanthe alternativequantitytheoryapproach to whichI now turn,
15G.L. Bachand AlbertAndo; "The Redistributional of Inflation",

Effects
Review ofEconomics , Vol. 39, No. 1, February
and Statistics 1957,pp. 1-13:
seealsoBronfenbrenncrandHolzman,op.cit.,pp 647-649. The latterassert
thatpostwar hasunambigously
inflation erodedthe shoresofinterest, rentand
dividends,though theydo notprovidea specific
referenceandnotewithrespect
thatlowpay-out
to dividends ratiosincreasedcapitalgains,

OF INFLATION
of inflationon wealth
an approach whichconcentrateson the effects
on
ratherthan real incomeand its distribution.
IV. The QuantityTheoryApproach to Inflation
The quantitytheoryapproach to inflationdiffersessentiallyfrom

thatof the Keynesianmodelsjust discussed in the basic assumptions
fromwhichit starts: insteadof assumingthatwage changesprovoke
pricechangesand converselythroughinstitutionally given(and there-
fore arbitrary)reaction coefflcients, it assumesthat in an inflation
the economy becomes accustomed to theexpectationof continued
inflation,so thatthe processesof determining woges and prices are
fundamentallyreal processesand not arbitraryprocessesdetermined
exogenously. The basic postulateof the quantity theorymodels of
inflationis thatthereis a stable demandfunctionformoneym real
terms,into whichthe rate of inflationenters as a cost of holding
real balances, whichcost influencesthequantityof real balancesheld.
Given this function,the rate of increaseof the nominalstockof
moneydeterminesthe rate of inflation,the public eventuallycoming
to expect that rate of inflationand adjusting its stock of real
balances (or ratio of real balances to real income)to it. In order
to maintainits real balances constantin the face of inflation,the
public must accumulate moneybalances at a rate equal to the rate
ofinflation; thisaccumulationof moneybalances in orderto preserve
real balances is achieved at the cost of sacrificing
theconsumptionof
currentreal income in order to maintainreal balances intact,the
releaseof currentreal incomeconstitutingthe equivalentof a "tax"
on the holders of real balances ; the tax on real balances, in turn¿
accruesas revenueto the beneficiariesof the inflationaryincrease
in the money supply.16
16M.Friedman,ed., StudiesintheQuantity TheoryofMoney, Chicago,1956;

M Friedman."The Quantity
especiãlly Theoryof Money- A Restatement,"
andPhilipJ Cagan. "The Monetary Dynamics of HyperinflationMartin J.
Bailey,"TheWelfare Costof InflationaryFinance/'Journalof PoliticalEco-
nomy, Vol.64, No. 2, April1956,pp.93-110;R. A. KesselandA. A, Alchian,
ofInflation,"
"Effects ofPoliticalEconomy
Journal , Vol.70, No. 6, December
1962,pp.521-37.

48 harry g. Johnson
The basic analytical apparatus of this approach to inflationis

in the accompanyingdiagram (Figure 1), in whichthe
represented
Figure1
rate of inflationis measured on the verticalaxis, and the ratio of

moneystockto moneyincome (or of real balances to real income)is
measuredon the horizontalaxis, the demandfor real balances as a
functionof the (actual and expected) rate of inflationbeing repre-
sentedby the demand-for-money curveDD Withprice stability,the
ratio of real balances to real income is OD' . With the rate of
inflationestablishedand expectedto continueat OP , the demandfor
real balances relativeto incomefalls to OM> the cost of holding real
balancesunderinflationary conditionsreducingthe quantitydemand-
ed by MD' The area OPP'M representsthe proportionof real
income that holdersof real balances are obliged by the inflationto
accumulatein the formof moneybalances in orderto keep theirreal

A SURVEYOF THEORIES
OF INFLATION 49
balances intact- the inflationtax expressedas a proportionof real
income.
The quantitytheoryapproach to inflation,which views inflation
as imposinga tax on holding of real balances, has some definite
implicationsthatare in contrastwiththoseof theKeynesianapproach
discussed in the previous section. In the firstplace, the redistri-
butionof incomeinvolvedin inflationis not primarilya redistribution
among income groups, but a redistributionfrom the holders of
cash balances to, in thefirstinstanceat least,the controllersof the
money supply; in other words it is a redistributionfrom the
communityat large in its capacity as a holderand user of moneyto
the monetary authority,not fromone group of participantsin the
distributionof the nationalincometo another. In the second place,
the rate of inflationis determined, once inflationbecomesestablished
by the rate of increase of the money supply rather than by the
institutionalfactors governingthe responses of wages and prices
to one another- the institutionalfactorsare assumed,or predicted,
to adapt themselvesto the rate of inflation. In the initial phase of
inflation,however, the rateof inflationis likelyto be less than the
rate of increaseof the money supply owing to the persistenceof
belief in the stabilityof prices, and thereafter fora periodthe rate
of inflationis likelyto exceed the rate of increase of the money
supply owing to the eflectsof growingbeliefin the continuanceof
inflationin reducingthe demandforreal balances.
Jn the thirdplace, the cost of inflationappears,not as a socially
undesirableredistribution of income- since the owners of wealth,
once they become accustomedto the factof inflation, will incorpo-
ratethe rate of inflationin the moneyrate of intereston loans fixed
in moneyterms - but as the waste of resourcesinvolvedin the effort
of the publicto economizeon the use of moneyby substituting real
resourcesforit. Such substitution, whichmay take such formsas
shorteningthe intervalsbetween wage payments,holdingstocksof
goods instead of money, and so forth,will be carriedto the point
wherethe alternativerate of returnon the real resources substituted
for the use of moneyis equal to the rate of inflation. In Figure1,
the cost of inflationto the economyis measurableby thearea P'MD'
and can be approximatedby the formula whereP is
yP~yw,
Vol. VIII No. 2, August1963.

50 HARRYG. JOHNSON
M
the rate of inflation, is the ratioof moneyto incomeheld at the
y-
givenrate of inflation,and ymis the inflation-elasticity
of the ratio
of money to income. (In a more elaborateanalysis,it would be
necessaryto recognizethatthe factthat interestis not paid on cash
balances impliesa social loss from the substitutionof real resources
formoneyin the absence of inflation,a loss aggravatedby the effect
of inflationin discouragingthe use of money.) Finally, the notion
of inflationas a tax, and of thecost of inflationas a sortof ^collec-
tioncost" of this tax, implies certain analogies between inflation
and the more explicittaxes levied by the government,including the
concept of the optimumrate of inflationfromthe point of viewof
thegovernment, that is, the rate of inflationthat maximizes the
proportion of national income put at the government'sdisposal by
by inflation ; these analogies have been developed by Martin
J. Bailey in an importantarticle on the welfarecost of inflationary
finance.17
The quantitytheoryapproach to the theoryof inflationhas been
subjected to a substantial amountof testing,both in A. J. Brown's
studyof The Great Inflation , 1939-51, and by members of the
Universityof Chicago Money and BankingWorkshop. The most
strikingevidencein its favouris Philip Cagan's studyof seven hyper-
inflations,which discovered a remarkablestable demand function
formoneyof the typedepictedin Figure 1 underlyingthe behaviour
of the seven economies undergoinghyper-inflation.Brown's study,
which assembles a great deal of informationwithoutanalysingit
withthe some rigouras Cagan, confirms thequantitytheoryapproach
in a numberof ways ; forexample,Brown findsno clear evidenceof
of the wage lag of World War I popular beliefand manyof the
Keynesianmodels,and shows that inflationsdo not necessarilytend
to "gallop away," countrieshaving experiencedinflationsof up to
one hundred per cent per annumand more withoutthe inflation
acceleratinginto hyper-inflation.
So foras substantialinflationsare concerned,the evidence there-
fore seemed to favour the quantity theory approach over the
Keynesian approach. For the mildtypeof inflationtypical of the
UnitedStatesand otheradvanced countriesin recentyears, however,
the approach has not proved nearlyso useful. The theory implies
17. Martin
J.Bailey,op. cit.

Á SURVEYOF THEORIES
OF INFLATION 51
the existence of a stable demand functionformoneyin whichthe

expectedrate of inflationappears as one of the arguments ; but
while many researchers have established the existence of satis-
factorilystable demand functionsformoneyfor such countries,the
expectedrate of price change has not appeared as a significant
determinantof the quantity of moneydemanded. This mightbe
accounted for on the hypothesis that the public only becomes
sensitiveto inflationaftera certainthresholdrate of price increase
has been passed, or that recognitionthat the situationhas been
characteristicallyinflationarycomes only with a very long lag.
Whatever the reason, the theory has not succeeded in providing
as convincingan explanationand methodof analysis of mild as of
strong inflations. Neither the Keynesian nor the quantitytheory
approach to inflation,of course, is very well adapted to dealing
withthe problemsof suppressed inflation.
Cost-PushversusDemand-PullInflation
As mentionedin the briefhistoricalsketchof inflationaryexperi-

ence provided in an earliersection, the issue of whetherinflationis
theconsequenceof the upward push of costs or the upward pull of
demand on prices became a lively issue in the late 1950s in the
UnitedStates as a consequenceof the co-existenceof an apparent
upwardtrendof priceswitha higheraverage level of unemployment
than had characterizedthe immediatelypreceding period. It is
necessary,however,to resistthe temptationto thinkof this problem
as a specificallyAmericanproblem developedin that period, forthe
issue began to be debated in the United Kingdom and other
European countriesverysoon afterthe War.
The importanceof the debate stemslargelyfromthe difference
betweenthe recommendations for anti-inflationarypolicy to which
the two views of thecause of inflationlead, the demand-pullexpla-
nation leading to the recommendationof monetaryrestraintand
fiscalorthodoxyand the cost-pushexplanationleadingto therejection
of macro-economic measuresof this sortin favourof policiesdirected,
at the processes of priceformationand wage determination. The
differencein policy recommendationsis not entirelya difference

52 HARRYG. JOHNSON
betweenright-wing conservativeand left-wing radical solutions,since

fiscalpolicycan be directedto radical objectives, whileon the other
hand the alterativepoliciesrecommendedhave covereda very wide
range. In fact, these recommendationshave ranged fromdirect
wage and price fixing,or the establishmentof nationalwage or
income policies to be implementedby voluntaryco-operationof
bnsinessand labour with"guide lines" laid down by government,
throughtrust-busting or union-bustingpolicies,to policies designed
generally improve the mobilityof labour and the efficiency
to of
competition in the economy, such as were recommendedby the
American Commission on Money and Credit.18 Nevertheless,the
two schools of thoughtdid differfundamentally over policy,the one
school recommendingmeasures involving a higher volume of
unemploymentin order to stop inflation,the other preferring
measures that sought to restrain inflationwithoutsacrificing un-
employment (both schools were united in the belief that inflation
oughtto be stopped,a convictionthat became increasinglystrongin
the United States in that period). In the debate, the economic
issuesbecame so closelybound up withthe political issues that for
some writersat least it is difficult
to determinewhetherthe economic
analysispreceded the policyrecommendation or vice versa.
The issue of cost-push versus demand-pullwas in myjudgment
largelya spuriousone, forthreereasons. The first,which I have
already developed in criticismof the Keynesianinflationmodels,
relatesto the failureof the disputantsto investigate the monetary
assumptionson which the rivaltheorieswerebased. Neithercost-
push nor demand-pull inflationmodels can generate a sustained
inflationunlessit is assumedeitherthatthe demand for money can
compressed indefinitelywithout adverse effectson demand and
employment, whichrunscontraryto the theoryand factof monetary
behaviour, thatthe monetaryauthoritypermissivelyprovides the
or
additional moneyrequiredto circulate the nationalincomeat ever-
increasingprices,in whichcase the behaviourof the monetaryautho-
ritybecomes the crucial factor in the inflation(and, in addition,
the questionarisesforthecost-pushtheoryas to what determines the
pace of inflation).The two theoriesare therefore not independentand
self-contained theoriesof inflation,but rathertheoriesconcerningthe
: Theirlufluence
18. MoneyandCredit onJobs
, Pricesand Growth
, Report
ofTheCommissionon MoneyandCredit,Englewood 1961.
Cliffs,

A SURVEYOF THEORIES
OF INFLATION 53
mechanismof inflationin a monetaryenvironment that permitsit.

The real issue betweenthem, therefore,was an issue of policy;
whetherinflationcould be stopped by attacking the mechanismof
cost and price determinationor whetherit could onlybe stoppedby
attackingaggregatedemand.
In the second place, the argumentwas in large part based on dif-
ferencesbetweenthe two theoriesin theirdefinitions of fullemploy-
ment. To elaborateon this,considerthe curveshownin FigureII,
Figure2
whichexpressestheproposition thatthe rate of pricechange in the

economyis a functionof the percentageof unemployment,prices
being stable at the unemploymentrate B. Now if "full employ-
ment"is defined as existing whenthe demand for goods is just suf-
ficientto preventprices fromeitherrisingor falling-thatis, defined
Vol, VÏII No. 2, August1963

54 HARRYG. JOHNSON
by thepointB- it followsas a meretautology thatinflationmustbe

associatedwith excess demand forgoods and labour or "over-full"
employment. If, on the other hand, full employmentis defined
independently,by reference to the level of unemploymentat which
unfilledvacancieswould just equal the numberof men seekingwork,
or some equivalent conceptof whatpercentageof unemployment is
technicallynecessaryto the efficient functioning ofthe labour market,
or is identifiedwiththe percentageof unemploymentregarded as
normalin some past period or as politicallydesirablein the present,
the resultis extremelylikelyto be a conceptcorresponding to some
such point as A. BetweenpointsA aud B inflationcan co-existwith
less than fullemploymenton thisdefinition,and such inflationcan
only be explained by referenceto forces thatpush pricesup in spite
of the absence of excessdemand as reflected in "over-full"employ-
ment. Again the real issue betweenthe two theories appears as a
policyissue, in thiscontext the issue of whetherthe actual levelof
unemployment is to be regardedas too greator too small,theformer
descriptionimplyingthe need foranti-inflationary policiesotherthan
policiesentailing a further increasein unemployment.
In the thirdplace, it is extremelydifficultif not impossibleto
devise a testcapable of determiningwhethera particularinflationis
of the demand-pullor cost-pushvariety. Much of the case forthe
cost-pushinterpretation of the U. S. inflationof the late 1950,rested
on a very casual contrastof the period with the earlier postwar
period whenunemployment was substantially lowerand bottlenecks
wereapparentin importantsectorsof the economy,and a verynaive
view of the time-perspective and otherelementsinvolvedin increases
in the pricesof the productsof heavily-capitalizedsectorsof the
economy; and muchof the empiricalevidence advanced in its sup-
port was of an extremelysuperficialsort. The major difficulty of
devisingan empirical testhas been referredto earlier - the difficulty
of sortingout causal relationshipsfromthe interactionof wages and
prices in the inflationary process. In principle, a good empiricai
testof the relativevalidityof the two theorieswould be to determine
whetherthe rate of priceor wage increase decreasesas the demand
for commoditiesor labour decreases, as the demand-pull theory
implies, or whetherit is relativelyunaffectedby decreasingdemand.
(The answeris not as obvious as it mightappear at firstsight; the
sourceof the disputewas the observationof inflationcoupled with

A SURVEYOF THEORIESOF INFLATION 55
rising unemployment). The problemis to choose a point in the

inflationary episode from whichto starty and to determinewhethera
price or wage increaseoccurringat a particularpointis a responseto
a previous increasein demand whichmay have disappeared, or an
autonomouschangeoccurringat thatpoint. Clearlyany procedure
for doing thiscan be questioned as depending on judgment and
arblitary selectionof evidence. The most fruitfulline of attackis
through a statisticalcross-sectionstudyof a numberof labour or
commoditymarkets,thoughthismethodalso raisesdifficult problems
of interpretation ; incidentally,the studiesconductedon theselines
have tendedto come out with results contraryto the cost-push
hypothesis.19
Beforeleavingthecost-pushversusdemand-pulldebate,itis appro-
priateto comment brieflyon the alternativetheoryof inflationthat
was put forwardat the timeand enjoyedwidespread but briefpopu-
larity, the 'sectoral-demand-shifť theoryof inflationpropoundedby
Charles L. Schultze.20 This theory soughtto reconcilethe appa-
rentlyobserved absence of generalexcess demand withthe demand-
pull explanationwhile rejectingthe cost push theory, by introducing
the notion thatin a dynamic economy progressinvolves continual
shiftsof demand fromsectorto sector,and the propositionthat such
shiftsraise prices in the sectorstowards which demandshifts,but
do not lead to price reductions in the sectorsfrom whichdemand
shiftsaway owing to the downward rigidityof wages and pricesin a
modernindustrialsociety,so thaton balance priceswould displayan
upwardtrend despitethe absence of generalexcessdemand. This
theory- aside fromthe factthatempiricalevidencefailedto confirm
the propositionthatsectoralpriceincreasesare explainedby upward
shiftsof demand- sufferedfromthe same defects as the two rival
theories it soughtto challenge- failureto investigatethe monetary
preconditions for inflation,and imprecisionrespectingthe definitions
of fullemploymentand generalexcessdemand.
While the debate over cost-push versus demand-pull was
ragingin the United States,a new and very interestingapproach to
19For
a survey ofthequantitativetestsofinflation
modelsandsomediscussion
ofthedifficulties,
seeBronfenbrennerand Holzman, op. cit.partII, pp.630-39.
L. Schultze,
2oCharles ReceniInflation
in theUnited States,StudyPaperNo. 1
forJoint
Economic Committee, StudyofEmployment , Growth , andPriceLevels
,
Washington,1959; forcriticaldiscussion and references, seejBronfenbrennçr
andHolzman, pp. 612-13.
Vol. Vjii No. 2, August1963

56 HARRYG. JOHNSON
the problem of inflationand anti-inflationary policy was developed
by A. W. Phillips21. This approach by-passed the argumentover
the causes of inflation,and insteadconcentratedon the dynamics of
the market for labour. The Keynesian literature on the policy
problems of inflationhad long includedthe generalnotionthatthe
rateof wage increaseis in part at least a functionof the rate of
unemployment,such that wages (and therefore prices)tend to rise
fasterthe lowerthe rate of unemployment. Phillips' contribution
was to develop an empiricalrelationship, apparentlystable over a
long period of British economic history,incorporatingthe idea, in
the form of a functionalrelationshipbetweenthe rate of wage in-
crease and the percentageof unemployment - what has since come
to be called "the Phillipscurve." Such a relationshipis not at first
sightapparentin the statistics,which seem to suggest that at low
levels of unemployment the rate of wage increaseis highand varies
erratically, whereas at higher levels of unemploymentthe rate of
wage increase is low but does not verymuchwiththe levelof un-
employment (some criticsof the Phillips curve still maintain, with
some justification,that this is reallyall the figuresshow). Phillips
was able to explainthe data forboth high and low unemployment
ratesby a singlerelationship,however,by assumingthatthe relation-
ship is curvilinear - similarto that shown in Figure II - ratherthan
linear. From this relationship,and an assumptionabout the rate
of increaseof productivity, it is possible to determinethe level of
unemploymentnecessary to achieve price stability - a level which
Phillipsputs at about 2-1/2per cent for the United Kingdom and
7 to 8 per centforthe United States22.
The central contributionof Phillips'approach is to substitute
an empirical relationshipbetween the rate of inflationand the
percentageof unemployment forthe vague literaryand judgmental
arguments about how much reductionin employmentwould be
necessary to halt inflationthathad previouslydominatedthe debate
about economicpolicy- a methodof determiningrelevant factsthat
allowed one side to continue to imply that a trivialréductionin
employment, or a verytemporarylargerreduction,would completely
21. A. W. Phillips,"The RelationBetweenUnemployment and theRate of
Change of Money Wage Ratesin the UnitedKingdom,1862-1957,"
Economica, Vol.25,No. 100,November 1958,pp 283-99.
22. A.W.Phillips,Employment, Growth
Inflation, " Economica,
Vol 29,No.
113,February 1962,pp. 1-17.

A SURVEYOF THEORIES
OF INFLATION 57
stop inflation,and the other side to continue to assert that an

intolerablyhigh level of unemployment would be necessaryeven to
make a dentin the inflation. As againstthis,thereare some serious
doubts about the applicability of Phillipscurveto the formulation
of economicpolicy. On the one hand,the curve representsonly a
statistical descriptionof the mechanicsof adjustmentin thelabour
market,restingon a simplemodel of economic dynamics with little
general and well-testedmonetaryand value theorybehindit. On
the otherhand, it describesthe behaviourof thelabour market*in a
combination of periods of economic fluctuationand varyingrates
of inflation,conditionswhich presumablyinfluencedthe behaviour
of the labour market itself, so that it may rersonablybe doubted
whetherthe curvewould continue to hold its shape if an attempt
were made by economic policy to pin the economy down to a
point on it.
The Phillipscurvehas been elaboratedon subsequently,parti-
cularly as a result of the research done for the Commissionon
Money and Credit, through the developmentof the concept of
"trade-offs" among policy objectives. Earlier I referredto the
lengtheningof the listof economicpolicyobjectivesin recentyears,
and the consequent possibility of conflicts among objectives.
Conflictamong objectives means thatthe economicpolicy- makers
mustsacrificeor "trade-off " a lesser achievementof one
objective
against a greater attainmentof another. The Phillips curve
expressed empiricallythe termson whichunemployment and price
stabilitycan be tradedoff against one another. It is an obvious
extension of the Phillips curve approach to attemptto determine
statisticallythe trade-offs
betweentheseobjectivesand, say, the rate
of economicgrowth; such a studywas conductedfortheCommission
on Money and Creditby LawrenceKlein and Ronald Bodhen, and
in a less rigorous fashion by the Scitovskys.23So far,the Phillips
curveappears to be the most reliable of such relationships,and
23. L. R. Klein and R. Bodhen,"EmpiricalAspectsof Trade-Offs among

ThreeGoals: High-LevelEmployment, PriceStability,and Economic
Growth", andTiborandAnneScitovsky, "WelfareAspectsof Economic
Growth, HighLevelEmployment andPriceStability",
to be publishedby
the Commission on Moneyand Credit.For discussion ofthesepapers,
see MartinBrcnfenbrenner, "A SampleSurveyof the Commission on
MoneyandCreditResearch Papers",andHarry G. Johnson, ^Objectives,
MonetaryStandards, and Potentialities"'.
Review ofEconomicsandStati-
sties,Vol.45,No. 1,Part2, Supplement
, February1963,pp. 111-28and
137-46.

58 HARRYG. JOHNSON
even the existence of that relationship has been doubted by

researchersworkingon the U. S. data.24 The question of policy
objectives and potential conflictamong them is dealt withfurther
in the finalsection.
VI
Some EmpiricalFindingson Inflation
This section is devoted to a brief discussion of empirical

findingson inflationthathave a bearingon currentargumentsabout
inflation. The argumentsI referto are not so much arguments
among economists as argumentsthat one finds brought against
inflationin the speeches of politicians, the pronouncementsof
centralbanks- which are a way of conducting politics by other
means- and newspaper editorials. For brevity,the discussionis
framed in the form of answers to a series of questions about
inflation.
(i) Does inflationnecessarilyaccelerateinto hyper-inflation?
The ans.weris no. There is a fairlyclose relationship,at least
in some inflations, betweenthe rate of increaseof the moneysupply
and the rate of increase of prices. The acceleration into hyper-
inflationonlyoccursif the expansionof themoneysupplyaccelerates,
and thatdoes not necessarilyhappen. Nor is there a low critical
limit to the rate of inflation,beyondwhichthe economysoars into
hyper-inflation : Brown's evidence, as well as other evidence on
Latin-Americaninflations,showsthat variouscountrieshave experi-
enced reallysubstantialrates of inflationwithoutthe inflationgetting
out of hand.25
(ii) Does inflationnecessarilylead to monetarycollapse ?
The answeris no, providedthatthepricesystemis uncontrolled
and prices are allowed to rise freely. The strongestevidenceon
thispointcomes from the Chinese postwar hyper-inflation, during
which money continuedto circulatedespitethe extremelyrapid rise
and theRate ofChangein

24. For example,R. J. Bhatia,"Unemployment
, Vol 28,
MoneyEarningsinthe UnitedStates,1900-1958."Economica
No. Ill, August1961,pp.285-96.
25. A. J Brown, op. cit.,chap.8.

A SURVEYOF THEORIES
OF INFLATION 59
in prices.28 Cagan's evidencesuggeststhe same conclusion. Where
monetarybreakdownsdo occur is whererapid inflationis combined
with general price control, so that moneyceases to be usable for
making transactionsbecause the nominal value fixed by price
controlscomes to be far above the real value determinedby the
plethora of money and the shortageof goods. This is the expla-
nation, for example, of the breakdown of the German currency
after World War II and the adoption of the use of cigarettesas a
medium of exchange. If prices are free to rise money remains
usable because its real value is adjustedto the inflation.
(iii) Does inflationredistributeincomeaway fromthe savers,
the middleclass, etc., on a sociallyintolerablescale ?
The answer again is no. Most of the evidencewe have on
mild inflationsindicatesthat it is difficult
to detect such large-scale
redistributionsof income over any substantial period.27 Over a
short period, when an inflationhas occurredthatwas not expected
(as typicallyhappens in war), theremay be substantialredistribution
of incomeand wealthaway fromthosegroupsthathave made their
occupational choices and their saving and investment decisionsin
the expectationof the continuance of stable prices. But in the
longer run,whenthe expectationof inflationbecomesbuiltinto the
economy'sbehaviourpatterns,the nominalrewardforsaving(money
interestrates) comes to contain an allowance forexpectedfuture
inflation,and employmentcontractsand wage and salary relativities
are readjusted to conformwiththe underlying demand and supply
situation. For example,school and college teachers in the United
States were for a long time sufferersfrom inflation; but their
salaries have now been forthe most part adjusted to the growing
scarcity of teachers. It can be argued on the contrarythat once
inflationhas come to be expected,it is the terminationof inflation
by monetaryrestriction thatwill cause sociallyintolerableredistribu-
tionsof incomeand wealth, because borrowerswho borrowed at
high interestrateson the expectationthatrisingpriceswould make
thereal interestrate substantiallyless than the nominal interestrate
26. Colin D. Campbelland GordonC. Tullock,"HyperinflationinChina,

1937-49",Journalof PoliticalEconomy
, Vol. 62, No. 3. June1954,
pp.236-45.
27. SeeBronfenbrenner
and Holzman,op, cit, PartVI, forreferencesand
discussion.
Vol VIII No. 2, August1963

60 HARRYG. JOHNSON
will thenfindthemselvesobliged to pay higherreal ratesof interest
than theyhad countedon. (This was one of Keynes' main argu-
ments against Britain'sreturnto the gold standardat the old parity
afterWorld War I.)28
(iv) Does inflationcause economicinefficiency ?
Not too much work has been done on thisquestion; but the
evidenceseem to indicatethat inflationdoes not reduce economic
efficiency,at least when the inflationis mild and reasonablysteady
and pricesand wages are not controlled.29In fact,a good case can
be made out, and supportedby some empiricalevidenceproduced
in the U. S. and the U. K., that inflationof this kind tends to
increase efficiencyby increasing the mobilityof labour fromlow-
productivityto high-productivity regions and occupations.30 On
the otherhand,inflationthatproceedserratically, therateof inflation
varyingsharply from one year to the next,and that is accompanied
by policies of price control over importantconsumptiongoods and
services designed to shield the real consumptionof some groups of
the populationfromthe effectsof inflation - in other words, the
type of inflationcharacteristicof the underdevelopedcountries -
indubitablycauses serious inefficiencies of allocation of current
resourcesand of investment.31
(v) Does inflationhampereconomicgrowth?
This is a difficultquestion, because both cross-sectional
differencesamong countries and historical differencesin a given
countrywith respect to the rate of inflationare usuallyassociated
withotherdifferences of circumstances,so thatan observed relation
between inflationand slow growth is not sufficient to establishan
adversecausal connectionbetween inflationand slow growth. In
fact, there is frequent evidence (especially for underdeveloped
28. J.M Keynes, TheEconomic Consequencesof Mr.Churchill , London,1925.
29. See HaroldWolozin,"Inflation and the Price Mechanism," Journal of
PoliticalEconomy , Vol 67,No. 5,October1959,pp. 463-75,forevidence
thatinflation does not appeartoreducetheefficiency ofthepricesystem
as reflectedinrelative priceadjustments.
30. Forexample, itis shownbyDonaldDewey,"LabourTurnover as an Index
of Unemployment in the UnitedStates, 119-58,"Journal of Industrial
Economics , Vol. 8, No. 3,June1960,pp. 265-87, thatturnover (a measure
ofmobility) variesinversely withunemployment. Unpublished workby
R. G. LipseyfortheU. K. alsosupports thestatementinthetext.
31. This pointhas been frequently madewithreference toLatin- American
inflations. See forexample Tom E. Davis"EightDecadts ofInflation in
Chile,1879-1959 : A PoliticalInterpretation," ofPoliticalEconomy
Journal ,
Vol.71,No. 4, August1963,pp.389-97.
IndianEconomicReview '

OF INFLATION
countries)thatthe causal connectionrunsthe otherway, from slow

growthto inflationary policies. For what such evidenceis worth,it
tendsto show that if the inflationis mild (betweenzero and six per
cent, according to the findingsof the Commissionon Money and
Credit),32the rate of inflationdoes not affectthe rate of growth,but
that either rapid inflationor deflationis associated with slower
rates of growth. This evidence, thought frequently interpreted
by central banks as an argument for price stability,seems to
argue for mild inflationas the best environmentfor economic
growth.33
In summary,forcountrieswith an advanced economic struc-
ture, high incomes, and a fairly free and competitiveeconomic
system,mostof the assertions usually made in policy arguments
about inflationturn out not to be confirmed by the empirical
evidence. It is necessary to point out, however,that this is not
necessarilytrueof underdevelopedcountriesthat rely on sharply
inflationarypolicies to promotedevelopment,coupled with policies
of pricecontrol designedto protect the real consumptionstandards
of the labouringor the urban classes. In other words, it seems
necessaryin theanalysisof inflationto distinguish betweenadvanced
and underdevelopedcountries, between mild and fierce inflations,
and betweencompetitiveand controlledeconomies.
VII
PolicyIssues Concerning
Inflation
This finalsectiondiscussessome recentpolicyissues respecting

inflation. Policy to deal withinflationis a subject on whicha great
deal has been writtenand argued by eminent authoritieswithout
adding substantiallyto knowledge and in some cases subtracting
fromit. I have alreadydescribedhow the objectives of economic
policy have been broadened from the simple objective of price
stabilitycharacteristicof the 1920sto a listthatincludes in addition
high employment, balance-of-payments equilibrium,and economic
growth. The of
presence balance-of-payments equilibrium on the
listreflectsthe inadequacy of the present internationalmonetary
32. op.cit.,p. 44.

op.cit.,forthispoint.
33. See HarryG. Johnson,

62 HARRYG. JOHNSON
system. The inclusionof economicgrowthin the list- at least in

theeconomists'list- reflectsin my judgment an unfortunatepro-
pensityof thoseconcernedwithpolitical economynot to thinkvery
hard about things before they write or speak about them. The
growthobjective,unliketheothers,is a very difficultone to render
preciseenoughforanalysis- not onlyis the rate of growtha statistic
whose significance economicsciencelacks adequate tools to evaluate,
but our knowledgeof the sourcesof growthand the policies required
to promoteit is only in its infantstage, and riddledwithconfusions.
In any case, the notion of "growth" as an objectiveof policy is
used in an extremelyloose fashion. In North America, at least,
whenpeople referto the desirabilityof economic growthfrequently
what they really mean is thattheyare in favourof less unemploy-
ment,thispreferenceinvolvinggrowthonly in the sense thatin the
processof movingup to a higherlevel of employmentthe economy's
measuredrate of growth will be transitionllyhigher than if the
unemploymentpercentage remainedconstant; whereasifgrowthis
to be an objectivedistinctfromhighemployment,the rate of growth
should be defined in relation to a normallevelof unemployment
and the argumentforgrowthshould relate to policiesforachieving
a higherrateof growthwiththatnormallevel of unemployment.
For brevity,it is mostconvenientto presentrecentpolicyissues
concerninginflationin termsof an "orthodoxview" and its limita-
tions, the orthodoxviewrepresenting what is to be foundin official
and centralbank pronouncements and such documentsas the Report
of the Commission on Money and Credit. This orthodoxview,
which has been asserted particularlystronglyby centralbankers,
is that thereis no inconsistencybetween the objectives of policy,
and that in fact price stability is the keyto the otherobjectives.
Price stability,it is alleged,will ensurehigh employmentby promot-
ing confidence; in the same way it will promoteeconomicgrowth,
and it is evenarguedthatonlypricestabilitywillpermit"sustainable"
economic growth; price stabilitywill ensurecompetitiveness in the
internationaleconomy and hence preserve balance-of-payments
equilibrium.
I findthis collectionof assertionsextremely questionable,both
theoreticallyand empirically. In particular, the assertion that
price stabilitywill take care of the balance of paymentsseems to me
to be absolutenonsense: a country producesa particular collection

A SURVEYOF THEORIES
OF INFLATION 63
of goods forexportand exchanges this collectionforanothercollec-

tion it imports,and thereis no reason in economic theory or expe-
rience for believingthat stabilityof the priceof one batch of goods
in termsof anotheror of moneywill preserveequilibrium in a chang-
ing world. The movementof a country's price level required to
maintain balance-of-paymentsequilibriumat fixed exchangerates
depends on both the real trends in the world economyand on
monetarydevelopmentsin othercountries. For example, if the rest
of the world is inflating,a particularcountrycan onlystabilizeits
price level by deflatingas the restof the worldinflates,and running
a larger and larger trade surplus; conversely,if the restof the
world is deflating,maintenanceof price stabilitywill make the
country less and less internationallycompetitiveand obligeit to
inflate and run on increasingly large tradedeficit. Thus the use of
the need to keep the balance of paymentsin balance as an argument
for price stabilityseems to me purelya propaganda argumentfor
accordingpriorityto price stabilityover otherobjectivesof policy.
So faras the argumentfromprice stabilityto high employment
is concerned, the argumentof the preceding section is highly
relevant. Given the existenceof the Philips curve (or at least of a
relationshipof some kind between unemploymentpercentage and
rate of wage increase), and the empirical tradeoffbetweenprice
stabilityand unemployment, it is of course always possibleto define
fullemployment as thatlevel of unemploymentwhich is consistent
withprice stability,and so to conclude that full employmentand
price stabilityare not at all inconsistent. But thereis nothing
sacredor comniandinglydesirableabout the percentage of unemp-
loymentat whichpricesare stable,unlessone starts fromthepostu-
late that price stabilityhas crash priorityover otherobjectives-
especiallyif is recognizedthat the choice betweenmorerapidlyrising
pricesand higherunemplomentis a choice respecting the distribution
of economic welfare between owners of monetaryand financial
assets and owners of human labour,the formergroup losingsome-
thing(thoughit may onlybe psychic satisfaction)by inflationand
the latterdemonstrably losingsubstantiallyfromunemployment.
So far as the argumentfromprice stabilityto economicgrowth
is concerned,thisis initiallybeset by the confusions alreadynoted
concerningthe meaningof "growth." The empirical evidencedoes
not indicate that price stabilityis the key to rapid economic

64 HARRYG. JOHNSON
growth-different countrieshave succeeded in growingrapidlywith

rising,falling or stable pricesat differentperiodsof time. Nor does
theory suggest that price stability maximizes growth: rather it
suggeststhatthe trendof prices willwithinlimitshave littleinfluence
on growth,sincethe economywill becomeaccustomed to and expect
the continuance of any established trend. What may impede
growth,however,are unanticipatedchanges in the rate of change
of prices, associated with changes in economic policy ; but such
changes include both inflationary and deflationary policychanges.
In oppositionto theorthodox view on price stabilityand the
objectivesof economic policy just discussed,manyeconomistshave
advanced argumentson behalfof inflationas a means of achieving
a greaterdegreeof fulfilment of the otherobjectivesof policy. The
argumentforinflationas a meansof securingfull employmentis an
obvious one, though such a policywould soon encounterbalance
of paymentsproblemsin a countryon a fixedexchance rate, and it
mightbe ineffective in a countrywherelabour is relativelyimmobile.
Anotherargumentwithconsiderablevalidityis thata strongdemand
forlabour increasesmobilityand therefore theefficiencyof resource
allocationand indirectly the rate of growth. Some otherarguments
forinflationas a means of increasing the rate of economic growth
are much less convincing,because they rely on the questionable
assumptionthatone groupin the economy is capable of realizing
that inflationis going on while other groupsare not. I referin
particularto the argument,expounded by Nicholas Kaldor among
others, that inflationis good for growth because it increasesthe
real rate of returnon investment.34This argumentassumes that the
rate of interestat whichentrepreneurs can borrowis unaffectedby
theexpectation of inflation,implying that though borrowersare
aware of inflationlenders are not. (Equally inconsistentis the
counter-argument, put forwardby adherentsof the orthodox view,
that inflationimpedes growth because savers are deterred from
saving by the expectation that inflationwill rob them of their
savings- and this argumentis doublyinconsistent, because the ex-
of
pectation robberyby inflation might lead savers to save more
34. NicholasKoldar, "EconomicGrowthand the Problemof Inflation,"

, Vol.26,Nos.103and104,August
Economica andNovember
1959,pp.212-26
and287-98.

A SURVEYOF THEORIESOF ÍNFLATIOR 65
ratherthan less.35) If the argumentis formulatedcorrectlyin terms

of the inflationtax approach, it appears that whetherinflation
promotes growth depends on how the proceedsof the inflationtax
are spent: if theyare spenton investment growth will probably be
promoted, whereas if they are spent on consumptiongrowthwill
probably be retarded.
I concludewithsome commentson the general issues involved
in the contemporary discussionof the objectives of policy and the
possibility of conflictsamongthem. The mostimportantdifficulties
in the discussionstemfromthe complexityof economic growth as
an objective of policy. The otherobjectivesare capable of quantifi-
cation in a meaningful way, and of evaluation in terms of accepted
techniques of analysis. The rate of growth is not susceptibleof
comparabletreatmentbecause it is not a magnitudebut the rate of
change of a magnitude,and economicshas barelybegunto develop
theoriesconcerningthe determinantsand the welfare implications
of ratesof changeof economicvariables. It is, forexample,a simple
matterto show that a lowerpercentageof unemploymentnormally
impliesa higherlevel of outputand a higherabsolutelevel of saving.
But it does notnecessarilyfollowthatthe increase in saving will be
sufficientto yield a higherrate of growth,because the increasein
outputthatis responsibleforit also raises the denominatorof the
growthrate; in fact, an analysison the lines of the Harrod-Domar
equationtendsto resultin the conclusionthat the growth rate will
fallratherthan rise,whilean analysison neo-classical lines leads to
the conclusion thatin the long runthe growthratewill be determin-
ed by the exogenousinfluencesof the rate of technical change and
the rateof population growth.36
For the same reason,it is very difficultto formulatesatisfac-
torily the problem of choosingthe policycombinationyieldingthe
optimummixtureof growth,price stability,and employment : the
to
rate of growth is not a conceptcomparable the rate of inflation
and the rate of unemployment, so that it is difficultto pin down
what is involvedin tradingoff growthagainstotherobjectives. For
intelligentpolicy-making, in principleit is necessaryfirstto be able
35. HowardEllis is reportedto be a strongexponentof ths viewof the
ofinflation,
consequences thoughI havebeenunableto finda convenient
recentreference.
36. HarryG. Johnson, op. cit.; J. E. Meade,A New-ClassicalTheory
of
EconomicGrowth, London,1961.

66 HARRYG. JOHNSON
to quantifythe Phillipscurverelationamong objectives,and second
to be able to attach weights or values to the numbersalong the
axes. For the trade-off betweenunemploymentand price stability
this can be done, though so farthe only attemptto do it is to be
foundin a studyconductedby G.L. Reuber forthe Canadian Royal
Commission on Banking and Finance.37 That studyestimatesthe
value of the outputlost throughunemployment, and uses theinflation
tax approach to estimate the resource waste entailed in inflation,
arrivingat a combination of inflation and unemploymentthat
minimizesthe loss to the economyfromincompletefulfilmentof its
objectives. But non-fulfilment of these objectives entails in each
case a loss of currentreal income,which can be compared, whereas
the growth objective cannot be readilyreducedto measurementin
termsof currentreal income. Unless one believes that growth is
costless,evaluationof the differencein economicgain or loss between
differentgrowthrates involves comparing the future benefitsof
faster growth with the additional present sacrifice required to
achieve it- and in thisarea the tools available to the economistare
notoriouslyweak and difficult to manage.
37. G. E. Reuber,The Objectives Policy,Staffstudy.Royal

of Monetary
on Banking
Commission andFinance,Toronto,
1962,mimeographed.

APPENDIX
Notes on theDiscussion
1. A question was asked concerningthe consistencyof the

argumentthat a reduction in the rate of unemploymenttends to
increasethe rate of inflationwiththe observationthat in manyLatin
Americancountriesdevaluationled to both a sharp increasein prices
and a sharp increase in unemployment.The reply was thatthere
was no inconsistency. The increasein internalprices is the result
of the linkage of internaland external pricesthroughforeigntrade
and constitutesa non-inflationary price increase of the typedis-
cussed in the firstsection of the lecture. The increase in unemploy-
mentcould be the result of a redistributionof income towardspro-
fitsresultingfromthe increasedpricesof internationalgoods, of an
increaseddemandformoneydue to the expectationof price stability
in place of inflation,or of a reduced supply of money due to the
monetaryrestriction thatusuallyaccompaniesa planned devaluation.
2. A commentwas solicited on the monetarist-structuralist
controversy. The reply was that thisis a controversydifficult to
penetrateforone not skilledin Spanish, but thatlike the cost-push
versusdemand-pullcontroversy it seemedto be an argumentabout
desirable economicpolicy rather than about theoreticalapproach
or the natureof economicreality. Inflation in Latin Americacan
be (and has been) interpretedas the most acceptable solution to
politicaldivisionsoverthe distributionof real income. The struct-
uralistsaccept this solutionand recommendthe pursuitof policies
intendedto resolvethe underlying conflictby increasingtotal income
whereas the monetaristssee inflationand the policies associated
withit as the major obstacleto the growthof real income.
3. ProfessorSmithies presentedan alternativeapproach to
the theoryof inflation,whichhe describedas more Keynesian, in
termsof an excessof real demandover real supply; on thisappro-
ach the monetaryauthorityplays a merelypermissiverolein inflation.
He arguedthat the monetarist-structuralist controversy is an argu-
mentover the remedyfor inflation,the monetaristtaking supply
as givenand recommendinga contractionof demand,the structu-
ralistinsteadtakingdemand as givenand recommending an increase
in supplyto meetdemand,this increaseto be achievedby increasing
67

68 APPENDIX
productivity. In his opinion neither position was satisfactory: a

contractionof demand would not produce increased supply, and
increasingproductivitywould not stop inflationin the contextof an
inflationary increasein demand. A satisfactory policyin his opinion
would involve consideringboth the demand and the supply sides
of the picture and combiningrestraintson demand withpolicies to
increaseproductivity.
In reply,it was argued thatthe Smithiesexcess demand model
did not explain how the excess demands are reconciledwith the
existing suppliesin the inflationary process, the model relying on
people being cheated out of real income by unexpectedincreasesin
prices even though they could expect inflationto continue. The
inflationtax model, on the other hand, explained thereconciliation
in termsof intentionalforegoingof consumptionin orderto preserve
real balances from erosion by inflation. It was also argued that
the Smithies analysis and its recommendationof policies forin-
creasingproductivity as a meansof overcominginflationcould not
appropriatelybe described as Keynesian, since the essence of the
Keynesian revolutionis that income (output) is the source of ex-
penditureand expenditurethe source of income(output) whereas
the Smithies approach assertsthat output and expenditurecan be
discussed in isolation from onç another. Increasingproductivity
would not solve the inflationproblem unlessthe increase in income
associated withthe increasein productivityresultedin an increase
in saving(a net reductionin excess demand).
4. A member of the audience took up the remark of the
lecturerthatthe argumentfor price stabilityas a meansof balancing
the balance of paymentswas propaganda, and maintained that in
Argentinathe balance-of-payments argument forprice stabilityhad
been used as an excuse fora monetarypolicy designedto createa
greatdeal of unemployment. The reply was that an increasein
unemploymentmight well be the result of monetaryrestriction,
but that it was not fairto describethis as the intended objectiveof
the policy : the intentionwas to balance the balance of payments
by restrictingaggregate demand,but whetherit resulted in unem-
ploymentwas a question of how the economy responded to mone-
taryrestriction. In the United Kingdom, for example, the main
effectof monetaryrestrictionwas to direct production from the
home marketto exports. The questioner was reallyarguing thatin

APPENDIX 69
the Argentineeconomy resourceswere relativelyimmobile,so that
the main effectof monetaryrestraintwas to create unemployment
In addition,one could not expectan economy accustomed to sus-
tained inflationto adjust rapidly to the termination of inflation.
Those who recommend monetaryrestraintto stop inflationare
inclinedto take an optimisticview of the speed with whichthe
ecconomywill adjust to the ending of the inflation;alternatively,
theytend to have a longer time-horizon than their opponents.
This line of thoughtsuggeststhat the differencebetweenstructura-
listsand monetaristsis a differenceof time-perspective : if one is
not prepared to tolerate a disturbanceto output and employment
of more than a fewmonthsone is likelyto be a structuralist,
whereas
if one regardsan adjustment period of several years as transitory
one is apt to be a monetarist.
Vol.. VIJINo. 2, August1963


Survey of Inflation

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Survey of Inflation

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Department of Economics, Delhi School of Economics, University of Delhi

A SURVEY OF THEORIES OF INFLATION

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This article presentsa survey of recent workon the theoryof

*Basedonthesecondoftwosurvey lecturesdeliveredto la Reuniónde

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A second problemarises when one begins to considerwhat prices

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productsuntilaftertheyhave become mass-produced, so that the

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common that they attemptto defineinflationin termsof what is

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A BriefHistoricalSketchof InflationProblemsand Theory

In understanding currentargumentsabout and views on inflation,

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risingprices,risingwages,and rising rates of interest. One of the

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All of theseideas about inflation,which were derived from the

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solutionof the urgentproblemof mass underemployment.

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the physicalcontrolswould preventcheap money from leading to

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policyproblemshave been concernedwiththe relativeimportanceof

As mentionedin the introductory section of this lecture, there

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theorysays that thelevelof outputwill adjust to the level at which

Vol. VIII No. 2, August1963

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specifya theoryof moneywages, it was possibleto get a greatdeal

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thenthe propensityto save out of wages.11

nAnexample ofthisapproach D. Holzman,"IncomeDetermina-

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propensityto spend out of moneyincome operatingwith a one-

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the futurebased on understanding of the interactionof wages and

14J. C. R. Dow,"Analysis ofthe GenerationofPriceInflation,"OxfordEco-

Vol. VIII No. 2, August1963

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15G.L. Bachand AlbertAndo; "The Redistributional of Inflation",

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IV. The QuantityTheoryApproach to Inflation

The quantitytheoryapproach to inflationdiffersessentiallyfrom

16M.Friedman,ed., StudiesintheQuantity TheoryofMoney, Chicago,1956;

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The basic analytical apparatus of this approach to inflationis

rate of inflationis measured on the verticalaxis, and the ratio of

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Vol. VIII No. 2, August1963.

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the existence of a stable demand functionformoneyin whichthe

As mentionedin the briefhistoricalsketchof inflationaryexperi-

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betweenright-wing conservativeand left-wing radical solutions,since

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mechanismof inflationin a monetaryenvironment that permitsit.

whichexpressestheproposition thatthe rate of pricechange in the

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by thepointB- it followsas a meretautology thatinflationmustbe