Theories of Inflation

Definition: Inflation refers to a situation that advocates a persistent rise in the general price level of goods and services over a period of time.

Theories of Inflation

The theories of inflation try to explain the causes of inflation and can be studied from the perspective of:

  1. Monetarist Theory of Inflation
  2. Modern Theories of Inflation

The history of inflation theory can be traced back to the period where the classical theorists sought the cause of inflation through the quantity theory of money. According to them, the general price level rises due to the proportionate increase in the supply of money, output remaining the same. Thus, the classical economists laid emphasis on the role of money and had ignored the non-monetary factors that might cause inflation. As a result, the inflation theory considered to be one-sided and incomplete.

Then came the Keynesian theory, which posits that the inflation is caused due to the excessive aggregate demand at a full employment level or the potential output level. This excess aggregate demand is called the Inflationary Gap. Keynes emphasized on the non-monetary factors, i.e. aggregate demand in real terms and ignored the effect of monetary expansion, i.e., the supply of money on the price level. Thus, his theory was also inadequate to explain the phenomena of inflation.

The modern monetarist led by Milton Friedman tried to revive the classical economist’s concept of monetarism, i.e. the change in the economy depends on the changes in the money supply.  Thus, emphasizing the role of money vis-a-vis inflation. While the modern theories of inflation laid emphasis on the role of both the demand-side and supply-side factors on the price level.

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