What causes inflation?
One might think that this issue is fairly resolved in modern macroeconomics, but it is not. There are largely two competing visions of inflation circulating, the New Keynesian view and the Monetarist (Old and New) view.
The New Keynesian View
The basic New Keynesian model can be represented by the following three equations:
where y is the output gap, R is the nominal interest rate, is the inflation rate, E is the mathematical expectations operator, , , and are stochastic shocks with mean zero and finite variance, and a, b, , are parameters. The first equation is the dynamic IS equation, the second is the New Keynesian Phillips curve, and the final equation is the Taylor Rule that governs monetary policy.
Within the New Keynesian framework, the central bank is an inflation fighter. What I mean by this is that the central bank adjusts the short term nominal interest rate, R, in response to realized inflation. The higher the value of , the greater the responsiveness of the central bank. Inflation, within this framework, is pinned down by the Taylor principle (). To illustrate this suppose that there is some cost-push shock in the economy ( is positive). The cost-push shock causes an increase in realized inflation. However, if the central bank adheres to the Taylor principle, the central bank will raise the short term interest rate by more than the increase in inflation. With sticky prices, this leads to an increase in the real rate of interest and therefore a reduction in “aggregate demand” and thereby the output gap. The reduction in the output gap reduces inflation (see the New Keynesian Phillips curve).
So what determines inflation in the New Keynesian model? In short, inflation is determined by the central bank target of inflation. Deviations from this target are caused by shocks to supply () and demand (). The demand shock is (given the derivation of the model) a household preference shock (e.g. households wake up one morning and decide that they prefer current to future consumption). The supply shock is a shock to marginal costs, which causes firms to increase their prices. So long as the central bank adheres to the Taylor principle, the inflation rate can be uniquely determined.
A separate, but related question is what causes inflation in the New Keynesian model? Conceivably, it is the shocks to supply and demand. The central bank doesn’t create inflation, it prevents it through the Taylor principle.
The Monetarist View
The New Keynesian View is in stark contrast to the Monetarist View. In the Monetarist View, the central bank is not an inflation fighter, but rather an inflation creator. To understand why, let’s consider this from a New Monetarist perspective.
The New Monetarist framework is interested in examining money, monetary arrangements, intermediation, monetary policy, etc. from a perspective in which (*gasp*) money is actually important. You will note that in the New Keynesian framework above, money was never mentioned. This is because money is inconsequential for analysis within the NK model. The main reason why money is unimportant in NK models, however, is by assumption. Money, if it is introduced, is done through reduced form methods like putting money in the utility function or requiring that individuals must buy goods with money. These reduced form approaches, however, fail to capture the characteristics of money that make it important and therefore it is not surprising that they fail to identify that money isn’t important.
New Monetarist economics, in contrast, concerns itself with environments in which money is essential. It is therefore not surprising that one gets substantially different results. In NM models, the goods price of money is an endogenous determined. Put differently, the value of money is determined within the model rather assumed. If the goods price of money is zero, this means that money has no value and therefore a monetary equilibrium doesn’t exist (money is not simply assumed to be unimportant).
In equilibrium the goods price of money is determined as follows:
where is the goods price of money, is the quantity of real money balances demanded given the quantity of consumption , and is the aggregate supply of money. If we think of the goods price of money as the inverse of the price level, this implies that the price level is determined by the following equilibrium condition:
In other words, the price level is pinned down by the ratio of the money supply and money demand. It is deviations between the money supply and money demand that cause fluctuations in the price level. It follows that the central bank in this type of framework is an inflation creator. Money growth causes inflation.
So why does this distinction matter?
It matters because it is an often overlooked aspect of inflation targeting. When forecasts are being conducted on inflation, care needs to be taken as to how inflation should be forecast. The NK approach would have inflation forecasts based on the NK Phillips curve. The NM approach would have inflation forecasts based on money growth.
Unfortunately, simply taking these models to the data doesn’t resolve this issue. For example, NK advocates would argue that money growth doesn’t do a good job predicting inflation and therefore the NK approach is better. However, the empirical evidence upon which these claims are made rely on simple sum measures of the money supply, which are severely flawed (more on this later). In addition, from the NM side, one could easily point to the failure of the NK Phillips curve in fitting the data. While New Keynesians like to point out that the fit improves by incorporating lagged terms of inflation, it also undercuts the notion of microfounded macroeconomic models and suggests a circularity between fitted the data to the model and the model to the data.
In short, the differences between the New Keynesian view on inflation and Monetarist view on inflation are stark. In the NK view, the central bank acts as an inflation fighter using the nominal interest rate to mitigate and control inflationary pressures. In the NM view, the central bank is an inflation creator. The price level is determined by the relationship between the money supply and money demand. This distinction is not minor.
(Note: The inflation fighter vs. inflation creator terminology comes from the work of Robert Hetzel.)