Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Pointing the finger at policy makers for inflation

Milton Friedman, one of the great economists of the twentieth century, famously said, ‘inflation is always and everywhere a monetary phenomenon’. To see exactly what he meant, we rearrange the quantity equation by dividing both sides by output (Y), which yields:

This expression reiterates that the price level can only increase for one of three reasons:


An increase in the amount of money in the economy (M)


An increase in the velocity with which money circulates (V)


A fall in the total amount of output (Y)

In the long run (a period of more than a few years), economists think that government policy has little impact on V or Y:

V is either relatively stable or, if it does change, it’s not something that policy makers can easily control. For example, the introduction of credit and debit cards as well as online banking increased V because it made

spending/transferring money easier.


In the long run, output (Y) grows mainly due to technological progress – basically the economy becomes better at transforming factors of production such as capital and labour into output. Again, this isn’t directly in the control of policy makers, although, of course, badly managed economies (for example, where corruption is rife and law and order weak) tend to do worse than well-managed ones. But when an economy is reasonably well managed, policy makers have difficulty boosting the long-run growth rate of output.

What policy makers do have a lot of control over is the amount of money in the economy (M), because the central bank has a monopoly over the creation of money in the economy. Therefore, policy makers can effectively choose M directly. (The full story is slightly more complicated, because the financial system has the ability to ‘multiply’ the amount of money through fractional reserve banking; see Chapter 14 for details.)

Thus, Friedman is really saying to policy makers: if your country is experiencing very high levels of inflation, it’s your fault! It must be because you’re increasing the money supply excessively. Furthermore, if you want to reduce the amount of inflation, you have to do one simple thing: stop printing so much money!

Although economists agree that in the long run growth in the money supply causes inflation, in the short run other things can cause inflation (see Chapter 9 for details).