By Melchor Alcántara
By definition, inflation is the economic process caused by an imbalance between production and demand. This leads to a continuous rise in the prices of most goods and services and a loss of purchasing power, which is reflected in an index whose measurement is one of the most important indicators for national economies. This process is characterized by a demand for goods and services that exceeds the capacity to produce them in a given market.
It is common knowledge that we have been experiencing inflation since the end of 2021. Many forums have debated its causes, consequences, and possible mitigation measures. Regarding the latter, central banks in many countries (and ours has been no exception) have begun combating inflation using their primary tool in these situations: raising interest rates as a way to restrict the money supply.
That said, today I want to focus on those measures and what the best practices have been internationally in this shifting scenario that seeks to balance supply with demand in an economy but which, on many occasions, in seeking the remedy, has generated disastrous recessionary processes that, in the final analysis, make us fear that the medicine may produce worse effects than the disease.
To what extent is curbing the money supply positive? Which sector of demand should we curb? Which products are essential to produce dynamically to maintain a healthy macroeconomic equilibrium during this slowdown? What is better, lowering demand or increasing supply?
We could begin our journey with the once revolutionary ideas of economist John Maynard Keynes. He framed the inflationary phenomenon within a triangular model based on three pillars:
- Increased demand : This occurs when aggregate demand—that is, the sum of government spending, private investment, consumer spending, and the difference between exports and imports—exceeds the available supply in the market, causing a sharp rise in prices. This situation could be due to a rapid increase in the money supply, greater consumer confidence, or a decline in the official exchange rate. The increase in the money supply combined with consumer confidence are currently the primary causes of inflation in the Dominican Republic.
- The increase in production costs : in this case, inflation stems from the rise in prices that businesses charge for their products in response to increased costs; this is done with the aim of passing those costs on to consumers. Currently, fuel and transportation prices have generated increases in production costs worldwide because, in the current neoliberal model, all products contain imported components.
- Structural inflation : when we talk about this type of inflation it is because we have already entered, for whatever reason, a vicious inflationary spiral characterized by an indiscriminate rise in prices from which, from now on, it will be very difficult to break free.
Under this theory, most liberal or neoliberal economies attempt to control or model inflation. Keynes argues that if the goal is to combat inflation, the only available tools are to raise taxes and reduce public spending. This is known as restrictive fiscal policy. Similarly, in financial terms, an increase in interest rates significantly restricts the money supply, leading to a decrease in demand and thus curbing price increases.
Looking back at the Economics Department of the Chicago School, led in its second academic phase in the mid-20th century by Milton Friedman, perhaps a glimpse into the recent past that could still be our future, we notice a significant evolution in the concept of inflation when we analyze the last three of his ten famous propositions, namely:
1- It follows that “inflation is always and everywhere a monetary phenomenon” in the sense that it is and can only be produced by a faster increase in the quantity of money than in production.
2. Government spending may or may not be inflationary. It will be inflationary to the extent that it is financed by creating money, that is, by printing currency or creating bank deposits. Otherwise, it will not be inflationary.
3. Changes in the money supply affect interest rates initially in one direction, but later in the opposite direction. Faster monetary growth at first tends to lower interest rates. But later, as spending increases and fuels inflationary price increases, it also leads to a rise in demand for loans, which tends to raise interest rates. This is why, globally, interest rates are lower in countries that have experienced slower growth rates in the money supply (countries like Switzerland and Germany).
Friedman questions why monetary authorities engage in these monetary excesses. Currently, we are perhaps facing the first instance of induced inflation, due to the measures to increase the money supply proposed by influential economists in the wake of the pandemic. Indeed, after two years of economic boom, we are now experiencing the consequences of this increase in the money supply.
Turning now to the remedy, Friedman is right to point out that "the only way to end inflation is to prevent government spending from growing so rapidly." This is because inflation generally stems from "monetizing the fiscal deficit." This is where the problem of inflation ceases to be a technical issue and becomes a political one.
More recently, this Chicago school has undergone a crucial, and still evolving, evolution that earned Professor Robert Lucas the Nobel Prize for his theory of rational expectations. According to this theory, governments could fine-tune the economy with expansionary monetary policies during times of unemployment and recession, as happened during the pandemic. It was a very simple model that assumed that business owners would not realize that inflation would destroy the nominal increases in the prices of their products, nor that workers would understand that inflation would erase the wage increases they had earned.
Conversely, the rational expectations theory holds that investors and workers may be temporarily surprised by political manipulations, but that they soon learn their lesson and anticipate or discount in advance the changes implemented by the authorities, which in fact neutralizes or cancels the monetary policies of governments.
The lesson is that people, in trying to protect and maximize their interests in the face of changing government policies, are not deceived by the authorities, but on the contrary act in anticipation of those official policies.
The conclusion is that governments achieve nothing positive by printing more money than needed when the economy contracts or by printing less during times of growth.
Professor Lucas's research suggests that central banks, instead of trying to fine-tune and manipulate the economy or intervening in foreign exchange markets, should focus on achieving the truly important and decisive long-term goal of maintaining stable prices, that is, preserving the purchasing power of the currency.
From the consolidation of these theories emerge a few lessons. The confrontation between the notion of reducing the money supply and low economic growth. Although the former tends to cause the latter, the former doesn't always lead to the latter. As Professor Lucas predicted, we were all prepared for the worst from the moment the money printer was switched on to combat the potential recession of the post-pandemic era.
As a consequence, at present, the only tool implemented by the central government to control inflation is limited to raising interest rates—a policy of financial restriction. Nothing is said about the advisable and complementary fiscal policy restrictions, such as reductions in public spending and tax increases. The latter might seem horrendous, but I believe that if the government limits its currency restriction policy to the consumer sector and simultaneously allows attractive interest rates for the national production sector, such as construction, tourism, and industry, we could achieve ideal macroeconomic equilibrium not so much by reducing demand, but rather by sustainably increasing supply.
This would entail, as I've said, fiscal sacrifices. Nations like China and the United States, which are also restricting the money supply by raising interest rates, have decided, paradoxically, to reduce interest rates on loans for real estate purchases. Let's take note and act.
The author is:
Lawyer, with a master's degree in high finance, general coordinator of the National Observatory of the Construction Industry (ONIC).
