Inflation Is A Nominal Phenomenon

In my previous post, I discussed how Milton Friedman was right about 4 key issues during the 1960s and 1970s. He argued that interest rates are not a good indicator of the stance of monetary policy. He argued that the long run Phillips Curve was vertical, which means no long run tradeoff between inflation and unemployment. He argued that fiscal policy was not an effective way to control inflation. And he suggested that wage/price controls would not work.

grey mountain pass road


But why was he able to see what other top economists failed to see? What do these four cases have in common? Perhaps conventional economists were putting too little emphasis on the distinction between real and nominal variables. Friedman saw that persistent inflation is a nominal problem, and it has nominal causes.

Edward Nelson (vol. 2, pp. 155-56) quotes Friedman in 1977, looking back on his 1967 Presidential address:

The essence of my argument in that paper was that the monetary authorities had a monetary instrument with which they could ultimately control only monetary variables, such as the price level and nominal income; that it is not possible to use monetary instruments to achieve a real target, whether that real target be the real interest rate or real output or unemployment rate.

When analyzing inflation, Keynesians were explicitly or implicitly focused on 4 real variables:

1. real interest rates
2. unemployment
3. the velocity of money
4. price mark-ups (in percentage terms)

1. In the 1960s, Keynesian wrongly assumed that rising nominal interest rates represented rising real interest rates, and hence “tight money”. There are actually two problems here. The obvious problem is that nominal interest rates might be rising due to inflation (the Fisher effect.) The less obvious problem is that although tight money often does temporarily increase real interest rates, it is not true that rising real interest rates imply tight money. Real interest rates move around for many different reasons. And finally, for any given money supply, higher nominal interest rates are actually inflationary, as they boost velocity.

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