Question

[9 marks] “Inflation is always and everywhere a monetary phenomenon”. Provide an economic explanation for that statement. Is the statement more likely to be true in the long-run, in the short-run, or in both? Explain.

Answer 1

Economics Nobel laureate Milton Friedman said inflation is always, and everywhere, a monetary phenomenon.Time and again he has been proved wrong. For the last decade, central bankers in the US, the eurozone, Japan and China have been pumping their economies with money without inciting inflation.Economists have long assumed that a trade-off exists between unemployment and inflation. It is not possible to attain full employment, they argue, without risking high inflation. Likewise, economies cannot hope to bring down prices without inflicting unemployment.

This inverse relationship (also knownas the Phillips Curve, named after economist A W Phillips) appears to be breaking. Unemployment in the US has reached the lowest since 2000. But inflation continues to remain close to 2%. The eurozone had a core inflation (excluding food and energy) of less than 1%. Even as the eurozone economies perked up in 2017, the core inflation rate declined further.

Have economists been wrong all along, or has something changed in the economy that has weakened the expected link between inflation and unemployment? Perhaps they have been wrong all along. Who knows? It is, after all, not an exact science. You cannot test economic theories in labs in a controlled environment.

We must look for non-monetary explanations. In recent years, three aspects of the new economy technology, globalisation, and demographic trends have created strong deflationary pressures. Technological progress is often deflationary. But it is difficult to measure its impact as new products have better quality and new features than the ones being replaced.

The prices of personal computers, television sets and cell phones have been falling even as quality improved.

Online retail stores have imposed deflationary pressures on the brick and-mortar economy. They have the advantage of locating in areas with the lowest land prices as well as labour costs. The mantra of the online retailers (Amazon, Alibaba, Flipkart, etc) is low margins combined with enormous sales.

Appy Economy Technology has also resulted in what is called the sharing economy, where individuals can rent assets owned by others for short periods. Airbnb, now the largest provider of short-term residential accommodation, is an example.

Airbnb has over three million lodging listings in 65,000 cities and 191 countries, many times the size of any major hotel and motel chain anywhere in the world. Prices at Airbnb are fixed by the owners and have been much lower than hotel and motel prices. Further, AirBnB’s vast capacity has tamed the rest of the hotel and motel industry from raising rents.

Uber, the largest private taxi service in the world, is another example of the sharing economy. Uber’s mantra is also scale with low margins: it operates in 84 countries and 737 cities.It has created a model in which individuals use their personal cars to provide taxi service. In most cities, Uber fares are often half the private taxi fares. With competition from Uber, private taxi companies are not able to execute routine increases in fares as they did in the pre-Uber world. Competition from other app-linked taxi companies like Sewa, Ola, Uno, Lyft and Gett has further checked fares from rising.Globalisation has inflationary as well as deflationary effects. By bringing prosperity in emerging economies, globalisation increased demand and inflation. Indeed, inflation in the 2000s was partly an outcome of rising commodity demand from China and other fast-growing developing countries.
But there are other aspects of globalisation that are deflationary. Freer trade and tariff reductions lower inflation. Outsourcing of labour-intensive operations to countries with cheap labour is also deflationary.

Synergies of production across rich and developing countries that globalisation has created have moderated wage growth across rich countries.

Whoever thought demography would have anything to do with inflation? But recent demographic trends have also created deflationary pressures.
In ageing economies across Europe, the population pyramids are bulging at the top and becoming narrower at the bottom. The share of older people in the population is rising and of younger people declining.
Because old people are net savers and young people net borrowers, many ageing societies are in what economists call a saving glut, resulting in low interest rates. Old people buy less, reducing gross demand and inflation.

Immigration, a key source of labour supply in most of Europe and the US, is yet another factor. While its impact is modest compared to the impact of technology and globalisation, immigration also lowers wages and wage growth.

Inflated Worries Price expectations are an important cause of low inflation. It is the most common explanation put forward by central bankers.Price expectations are driven by past trends. The current low-inflation expectations are driven by low inflation of the last decade. Once prices begin to rise, the expectation will change and inflation will pick up further.
But then, you might ask, what is so bad with low inflation? Why are central bankers waiting for inflation to reach its target with bated breath? Two main reasons: one, deflation limits the ability of central bankers to provide monetary stimulus in the next recession.Two, low interest rates drive money to stocks, further feeding into asset price bubbles.