Inflation Is A Nominal Phenomenon

4. The same argument applies to price controls. Let’s say that firms have some monopoly power and that price controls are able to reduce price mark-ups by 2%. That merely produces a one-time 2% fall in the price level, relative to where it would otherwise have been. Go much further with price controls and you end up with severe shortages. But if the Fed is simultaneously boosting money growth from 5%/year to 10%/year, the disinflation effects of the price controls will be overwhelmed by the effects of faster money growth.  That’s the story of the 1970s.

To summarize, Keynesians were treating inflation like it was a microeconomic problem, which could be addressed by influencing real variables. It’s true that if you want to lower the relative price of a single good in the economy, you need policies that impact real variables. But inflation is a nominal phenomenon, and it requires nominal solutions. You need to reduce the growth rate of the nominal money supply.

In some respects the Keynesian mistake was understandable. Between 1879 and 1968, the price of gold was fixed, except during 1933-34 when it rose from $20.67/oz. to $35/oz. During much of that long period, people tended to think in terms of high and low price levels, not high or low rates of persistent inflation. In a world where price levels bounce up and down and inflation is not persistent, the four Keynesian fallacies discussed above are much less of a problem. Real and nominal interest rates are similar, the Phillips Curve is more stable, tax increases can slightly reduce the price level during a period of high prices, and price controls can have a modest effect during a temporary price level surge.

But if the inflation rate rises from 2% to 8%/year, and the high inflation persists for a long period, then real theories of inflation become almost worthless. It’s a monetarist world, and Milton Friedman was the master of that world.

PS.  Some of these arguments are less applicable to a world of zero interest rates.  But Friedman was winning his arguments with the Keynesians at a time when nominal interest rates were far above zero.

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