1 The Causes of Inflation

The problem of inflation has been of central concern to American policymakers since the mid 1960s. Of particular concern has been the rise in the core, or sustained, inflation rate from below the 2 percent level in the early 1960s to near the double-digit level by the late 1970s. Since 1981 a rapid disinflation has occurred, bringing the current inflation rate down to below 5 percent. The recent decline in inflation has not been achieved without substantial costs: In 1982, unemployment reached the highest level in the postwar period, peaking at 10.7 percent and is currently still above the 7 percent level. At the present time we are at a crucial juncture: The inflationary fire has abated, but there remains a persistent worry that it might reignite. What should be the stance of policymakers, and in particular the monetary authorities, in the current economic environment? This paper attempts to provide some answers to this question by exploring why sustained inflations occur and the role of monetary policy in the inflation process.' The conclusion reached in this paper is that in the last ten years there has been a convergence of views in the economics profession on the causes of inflation. As long as inflation is appropriately defined to be a sustained inflation, macroeconomic analysis, whether of the monetarist or Keynesian persuasion, leads to agreement with Milton Friedman's famous dictum, "Inflation is always and everywhere a monetary phenomen~n."~,However, the conclusion that inflation is a monetary phenomenon does not settle the issue of what causes inflation because we also need to