Keynesian Inflation Theory

Keynes

John Maynard Keynes
Source: Reproduced with permission of the IMF

Keynes’s cost-push and demand-pull inflation theory

The eminent economist John Maynard Keynes theorised a lot about inflation. He postulated that the money supply had an influence on inflation in a much more complex way than the strict monetarists suggested.
Instead Keynes proposed that inflation was caused in number of different ways:

  • By demand outstripping supply and pulling inflation higher
  • By inflation being built into the system
  • By higher costs pushing inflation higher.

Below are examples of each of these types of causes of inflation.

Examples Keynes inflation

It was also Keynes’s view that inflation expectations were important. They impact the wage settlements that workers seek and affect other inflation agreements that are created. These can have a marked effect on future inflation rates*.

Furthermore Keynes and his followers have argued that governments face a trade-off between unemployment and inflation – i.e. if you want full employment you may need to tolerate higher inflation. Indeed, as Keynes was writing during the Great Depression, he not surprisingly gave great importance to reducing unemployment. This thinking paved the way for post-war governments that were less concerned about creating inflation than their predecessors, as they saw it as a necessary trade-off to create full employment.

It is interesting that the Keynesian theory of inflation has gone out of fashion. This is probably related to the rejection of Keynesian thinking in general which started in the 1970s. However Keynesian ideas have had something of a renaissance following the Great Recession of 2008 as governments seek alternative solutions to the problems we now face.

Evidence for the Keynesian theory

In order to examine the merits of the theory, it is instructive to look at the periods of inflation greater than 4 per cent in the UK since the last war and their probable causes.

Causes inflation since war

This analysis shows that Keynes’s theory does explain the majority of the inflation spikes witnessed in the UK since the 1940s. Some are demand-pull factors e.g. war shortages and increases in the money supply. However cost-push factors have been particularly important i.e. increases in the price of oil, sterling devaluations (which have increased the prices of our imports) and tax rises.

Monetarists might say that the money supply is at the root of most of these factors. For example, it could be argued that the gradual devaluation of the pound against a basket of world currencies over the last century has had much to do with increasing UK money supply. Global money supply increases in the 1970s and following decades could well have significantly contributed to the trend of higher commodity prices—although clearly the short-term spikes in prices were often related to wars restricting supplies.

Note also that this analysis only looks at the spikes in inflation. Inflation has been increasing at low levels almost continuously since the war and the causes of that could be related to the overall steady increase in the money supply, both directly and indirectly.

Keynes’s theory of inflation is therefore useful in explaining more short-term changes in the rate of inflation and probably much more so than Monetarist doctrine. This has implications for central banks, which usually adopt a Monetarist approach in controlling short-term inflation rates with macroeconomic tools such as the money supply and interest rates.

Keynes and current inflation drivers

Although Keynes’s model is useful for describing changes in inflation that we see today, it does not provide any measure of the relative importance of the many factors he describes. Keynes might have argued that he did not do so as they can all be important in different circumstances, and that is probably correct. However, for us in the early 21st Century, some of the above factors do seem to more frequently affect the inflation rate than others. In particular the most important determinants of short-term UK inflation rates currently are governmental policy and commodity prices.

Current inflation causes

Governments control or influence many prices. In the UK this includes everything from energy to education to transport. Moreover they can and do ensure that many of them rise. Governments also set sales taxes and these can have a simple direct effect on inflation rates. This is clearly demonstrated by Japan which used such tax increases in 2014 to help foster inflation.

Commodity prices, including oil and foodstuffs, are also particularly important in affecting short-term inflation rates, as the spikes in UK inflation since 1940 clearly illustrates (see chart previously). This is because there are still many items in cost of living indices that are closely linked to these raw commodities e.g. petrol prices and crude oil prices. For example in 2014, oil prices declined by a half in a matter of months and this led to inflation rates in many countries declining towards near-zero levels.

* Much research has been done on the subject of inflation expectations by economists and it shows that they are primarily influenced by observations of past inflation together with perceptions of likely future inflation proposed by experts e.g. in the media.

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