Inflation is a general sustained rise in the price level. Differing theories have been suggested of the causes of inflation.

Monetarists argue that inflation is caused by excessive increases in the money supply. This view can be demonstrated with the Fisher equation MV=PT. Monetarists argue that, if V and T are constants, a rise in M, the money supply, will result in an increase in P, the price level. V, the velocity of the circulation of money, was determined by institutional constants, such as the sophistication of the banking system. T was dependent upon the level of national income. Therefore, the money supply could only grow without producing inflation if it were matched by real growth in national income.

Keynesians also argue that there is a link between increases in prices and increases in the supply of money. However, they do not believe that the government can fully control the supply of money. Two basic ideas have been put forward by Keynesians to explain inflation. Some believe that it is caused by excess demand in the economy, whilst others believe that it results from increases in costs.

The theory of demand-pull inflation argues that prices in general will rise if aggregate demand in the economy is greater than aggregate supply. This is sometimes explained as too much money chasing Too few goods in the economy. A rise in aggregate demand when the economy is at less than full employment will result in a rise in both prices and output. if the economy is at full employment, increases in aggregate demand simply lead to increases in inflation.

Demand-pull inflation can result from a number of factors. High government spending leads to pressure in the economy if it is funded by borrowing because it amounts to an injection into the economy. Spending funded by taxation will not increase pressure on prices significantly, as it does not add new money to the economy. The money that the government spends would be spent anyway.

Optimism about the future might lead to demand-pull inflation. People will borrow more money if they are optimistic about the future. This will increase the amount of money in the economy, and will lead to an increase in spending. High borrowing in the late 1980s consumer boom led to high levels of inflation. Wage increases that are linked to productivity do not lead to inflation, as there is a parallel between the increase in the amount of goods that are available and the goods that consumers can afford to buy.

Demand-pull inflation might arise because of a reduction in the price of exports, and hence a fall in the value of the pound. If exports become cheaper, there will be greater demand for them. This will put pressure on the economy for prices to rise. AD = C + I + G + X - M. Therefore, if X rises, AD will rise.

The magnitude of any rise in inflation will depend on how near to full capacity the economy is. If total demand in the economy rises in a period of recession, the level of inflation may not be effected because firms will have spare capacity. Furthermore, extra workers can easily be recruited. If demand rises when a firm is operating at full capacity, the only way to increase output is to expand the scale of production. To attract extra workers, higher wages must be paid. This leads to an increase in costs, and therefore a rise in price. As the economy gets closer to full capacity, a rise in demand leads to a greater rise in price. At low capacity, extra workers can be employed and output can be increased without costs increasing significantly. As we get closer to full capacity, shortages, or ‘bottlenecks’ appear. There may be a shortage of skilled labour or of raw materials. When the LRAS curve becomes vertical, no more can be produced. An increase in demand will only lead to an increase in price, with no increase in output.

The second strand of Keynesian thought has been that inflation is caused by increases in the costs of production. There are a number of sources of increased costs.

Increases in wages are normally the single most important cause of increases in the costs of production. When wages go up faster than output per capita, firms will face rising costs, and will have to put up prices to reflect this. Rising wages result from powerful trade unions. The real wages of ununionised workers could fall as a result. Cost-push inflation can result in a wage price spiral.

Trade unions are particularly powerful when there is low unemployment. This is because workers cannot be replaced as easily, on a period of expansion and growth, firms do not want to lose out on expanding markets as a result of industrial disputes, and because of low consumer spending, an increase in costs cannot easily be passed onto consumers. It follows that wage increases are more difficult to negotiate in periods of high unemployment.

The relationship between wage rises and unemployment levels is shown by the Phillips curve.

Cost-push inflation could also result from an increase in the price of imports. This is sometimes known as imported inflation. If imported raw materials and components rise in price, costs become higher, and this results in inflation. An example of imported inflation is the 1970 oil price shock when oil prices quadrupled, leading to an inflation rate of 27%. Changes in the exchange rate can also cause inflation. If the value of sterling drops, exports become cheaper, and imports become dearer.

Taxes can also affect the costs of production. The government could raise indirect taxes, or reduce subsidies, therefore increasing prices.

Keynesian economists have argued that a cost push spiral can develop which results in a long term cycle of inflation. An initial rise is costs will lead to a chain of wage increases which will feed back as an increase in costs. This cycle is sometimes known as a wage price spiral.

Economists disagree over the causes of inflation. If, as monetarists believe, inflation is caused by excessive increases in the money supply, then it can only be curbed by reducing the rate of growth of the money supply through monetary policy. A restrictive monetary policy will result in a fall in the supply of money relative to the demand for money. Households and firms will react by trying to increase their holdings of money. They will sell some of their non-money financial assets or borrow money. They may also reduce their expenditure on goods and services. Sales of financial assets and increasing demand for borrowed funds will force up the rate of interest which will result in a reduction in both consumption and investment. Both directly, and via the interest rate mechanism, restrictive monetary policy will moderate the growth of aggregate demand or even reduce it and hence cause a fall in inflation. The government may choose to attempt o restrict the money supply by raising interest rates, as the UK government did in the late 1980s. High interest rates will lead to a fall in consumption and investment and a fall in inflation.

Monetarists would argue that he reason that governments tend not to pursue such a policy to reduce inflation is that they lack the political will. A restrictive monetary policy would lead to a fall in output and a rise in unemployment. These are electorally unpopular, and governments often act based not upon what is good for the economy in the long run, but upon short term electoral considerations. Moreover, governments can actually gain short term electoral popularity by increasing the rate of growth of the money supply, by cutting taxes and by raising public spending, and creating an artificial boom. This is one argument put forward for the case of independent control of interest rates by the Bank of England. An independent central bank is free to pursue counter-inflationary monetary policy without the need to worry about short term political pressures.

Keynesians are sceptical about the effectiveness of monetary policy. They argue that the government is unable to control the growth of the money supply directly. Moreover, they say that there is no precise relationship between the money supply and inflation. Although raising interest rates may be an effective way of reducing aggregate demand, it is inefficient. It disproportionately affects he demand for durable goods traditionally bought on credit, and those with large mortgages. High interest rates also reduce investment. Keynesians argue that raising income tax will spread the burden across far more individuals and far more sectors of the economy, and also works far quicker. They would also question the priority given to control of inflation. It is not obvious that creating mass unemployment in the short run is “ a price worth paying for low inflation.” Furthermore, high interest rates can actually increase inflation in the short term. Mortgage repayment are included as part of the RPI. Higher repayments are also likely to lead to higher wage claims.

Keynesian believe that inflation can only be controlled through manipulation of real variables within the economy. Aggregate demand can be manipulated via fiscal policy. If inflation is demand-pull in nature, then reducing the level of aggregate demand will reduce inflationary pressures. The key variable that the government can manipulate is the PSBR. If the government reduces the level of borrowing it will cut aggregate demand. Governments can also influence wage-push spirals by artificially manipulating indirect tax rates. In a wage-push spiral, workers press for wage increase which are equal to a real increase plus the rate of inflation. Governments can reduce the expected rate of inflation by not raising indirect taxes in money terms. Monetarists see all such measures as futile.

In an open economy, exchange rate policy can be important in the control of inflation. Maintaining a stable exchange rate is likely to help in the fight against inflation. Some Keynesians believe that the government should intervene in the currency markets directly, by buying and selling on the foreign exchange markets. Some monetarists say that a rise in interest rates will attract inflows of financial capital from abroad which will increase the exchange rate. This will help to reduce inflation because the price of imports will fall, and domestic producers will also have to cut costs if they wish to stay in the market because a high exchange rate makes their goods less competitive against imported goods.

Keynesians advocate the use of prices and incomes policy to reduce the impact of supply side shocks. Such policy is designed to limit the growth of prices and incomes directly. However, it is inappropriate to use prices and incomes policy to control inflation caused by excess demand in the economy.

Inflation is very difficult to control. This is due, in part, to disagreement between economists as to the causes of inflation. It is often difficult to identify the true cause of inflation at any given time. Another problem that governments face is electoral popularity. It is unfortunate that governments are unlikely to act in the long term interest of the economy because it may bring about short term electoral unpopularity.