James d. Gwartney

Video:
Milton Friedman on Inflation
Countries with high rates of inflation frequently also have wide fluctuations in the
inflation rate. Variable rates of inflation make it even harder than consistent high rates to plan
for the future, undermining prosperity. When prices increase 20 percent one year, 50 percent
the next year, 15 percent the year after that, and so on, individuals and businesses are unable to
develop sensible long-term plans. This uncertainty makes the planning and implementation of
capital investment projects risky and less attractive. Unexpected changes in the inflation rate
can quickly turn an otherwise profitable project into an economic disaster. Rather than dealing
with these uncertainties, many decision-makers will simply forgo capital investments and other
transactions involving long-term commitments. Some will even move their business and
investment activities to countries with a more stable environment. As a result, potential gains

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from trade, business activities, and capital formation will be lost.
Moreover, when governments pursue inflationary policies, people will spend less time
producing and more time trying to protect their wealth. Because failure to accurately anticipate
the rate of inflation can devastate one’s wealth, individuals will shift scarce resources away
from the production of goods and services and toward actions designed to hedge against
inflation. The ability of business decision-makers to forecast changes in prices becomes more
valuable than their ability to manage and organize production. When the inflation rate is
uncertain, businesses will shy away from entering into long-term contracts, place many
investment projects on hold, and divert resources and time into less productive activities.
Funds will flow into the purchase of gold, silver, and art objects, in the hope that their prices
will rise with inflation, rather than into more productive investments such as buildings,
machines, and technological research. As resources move from more productive to less
productive activities, economic progress slows.
Economic progress will also be undermined when monetary policymakers are
constantly shifting between monetary expansion and contraction. When the monetary
authorities expand the money supply rapidly, initially the more expansionary monetary
policy
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will generally push interest rates downward, stimulating current investment and
creating an artificial economic boom. However, the boom will not be sustainable. If the
expansionary monetary policy continues, it will generate inflation, which will cause monetary
policymakers to shift toward a more restrictive policy. As they do so, interest rates will rise,
which will impede private investment
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and throw the economy into a recession. Thus,
monetary shifts between expansion and restriction will generate economic instability, jerking
the economy back and forth between booms and busts. This pattern of monetary policy will
also create uncertainty, slow private investment, and reduce the rate of economic growth.
Why might those in control of the supply of money (the monetary authorities) shift
between expansionary and contractionary regimes? Note that there is likely to be an
unsustainable boom following a rapid expansion of the money supply. If the monetary
authorities are subject to control by or influence from political leaders, the interests of these
leaders may be to create just such a boom prior to elections in the hope that they will be re-
elected before the inevitable recession arrives.

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While these political business cycles
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can be seen in much of the world, there has
been a different relationship in transition economies. As always, policy stability is important to
create business confidence and, therefore, investment and expansion. Post-communist
countries had to decide between different paths of reform
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to a market economy. Some
countries were consistent and early reformers (such as Estonia), while the leadership in others
was dominated by ex-communists (Uzbekistan). Countries, therefore, followed different
speeds and types of reforms, some better than others. In all of them, however, economic actors
could rely on consistent policies and plan for the future under these policies. By contrast, in
countries that followed inconsistent and changing paths, switching back and forth between
reform and delay (such as Bulgaria and Ukraine) increased uncertainty prior to elections when
it was not clear who would form the new government. The political business cycle was
reversed, with slow growth leading up to elections because of policy uncertainty leading to low
investment.
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