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The best books on Inflation

recommended by Federica Romei

Inflation has been under control in the developed world for decades now. Many assumed we had it beaten, but it has picked up recently and is once again a major policy concern. Here, Oxford economist Federica Romei chooses five books to help you understand inflation from a historical and theoretical perspective, and when, if and why you should worry about it.

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Before we get to the books, could you define what inflation is because I think lots of people get that wrong? Also, perhaps you could explain why it seems to be picking up now?

Inflation is just the growth in the aggregate level of prices. Or you can think of inflation as aggregate prices in the future divided by aggregate prices today. Inflation tells us by how much goods are more or less expensive today with respect to the past or whether goods are more or less expensive in the future with respect to today. Now, there are different ways of defining inflation. In the UK inflation tends to be defined by the CPI, that is a consumption-basket index. That helps us to understand how the price of goods people are consuming are changing over time. We can also look at the Producer Price Index, which looks at inflation from the point of view of firms—what are the price that firms charge for their goods and services. Then there is core inflation, which does not take into account energy prices—energy prices, especially oil, are much more volatile and subject to international shocks. So there is no unique definition of inflation, there are many definitions of inflation, and we look at the aggregate in different ways.

Why do we care about inflation? In some sense, inflation is just a change in prices. Arguably, if goods are more expensive today with respect to the past, we shouldn’t worry too much, because price is just the way in which you measure goods. We measure goods’ value in units of money, but we could measure them by some other measure such as a standard good. For example, we could use units of wool, like we did in the past. On the face of it, that shouldn’t matter any more than whether you measure a distance in meters or yards. It’s the same distance.

But inflation is important because, as economists, we think that it has some effect on the real sector of the economy. If inflation increases too much, then it can have some feedback effect on output or unemployment, or on the financial stability of the country. If that weren’t the case, we wouldn’t care about inflation.

Why is inflation increasing now? There are different theories. There are some people who say that inflation is increasing because there is a drop in aggregate supply. If we think in terms of demand and supply, the price level could increase if demand is increasing, or if supply is decreasing. Some scholars think what you’re observing now is that, since the COVID crisis, there has been a problem with the supply chains and there are some problems with the oil supply and that, for this reason, firms have not been producing enough. So there has been a drop in the supply side of the economy.

People who are more optimistic see prices increasing because there is an increase in demand. The problem is that if you have a negative supply shock, you should do one thing, but if you have a positive demand shock, you should do something different. And it’s not clear which we have experienced, although I think most people are inclined to believe the negative supply shock story, that there is not a sufficient supply of goods in the economy and this means that we are experiencing increasing prices now and will see more of that in the future.

Let’s go to the books. First up is Jordi Gali’s book, Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework and Its Applications.

This is a book that I would suggest mostly for people starting a PhD. It’s very technical. It talks about monetary economics and inflation in a very technical way, but of the books of that kind it’s the easiest and gives you an overview of the vision of the so-called New Keynesian model. Jordi is an amazing writer. There is a lot of intuition, despite the use of a lot of maths. It helps you to understand, first of all, how inflation is created in a mathematical model but, most importantly, why we care about it.

“There is no unique definition of inflation”

Jordi says that, in some sense, we care about inflation because of this feedback effect on output—employment and inflation are strictly linked together. A key element of the model economy in the book is price rigidity, firms do not immediately adjust prices. Now, if firms do not adjust prices, if they experience an increase or a decrease in the overall price level, then they need to adjust production in the short run. So if you have higher inflation, then you’re going to have some effect on the output through this mechanism. The book describes this mechanism, and then it describes the optimal monetary policy.

The book discusses the connection between inflation and the real side of the economy, and why the central bank should care about inflation. Jordi also explains the conditions under which stabilizing inflation and stabilizing output and employment, in the short run, is exactly the same. This result is known as the ‘divine coincidence.’

Let’s go on to A Monetary History of the United States, 1867-1960 by Milton Friedman and Anna J. Schwartz.

The next books go together and are more for a general audience. Imagine that you want to know something about inflation and you don’t want to go through a lot of maths, because you don’t want to do a PhD. These are the books for you. They’re interconnected: one is sort of an updated version of the other.

Friedman and Schwartz is the first book that tried to connect the monetary aggregates—which is the amount of money in circulation—and inflation with the real sector. That’s why it is important. They established a connection between stabilizing prices and stabilizing the real economy. The book covers the period from the second half of the 19th century to the 1960s.

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During most of this period, the gold standard was in operation. The gold standard meant that dollars were exchangeable for gold at a fixed rate. Under this regime, the sole role of the central bank is to defend the exchange rate of the dollar with gold so the money supply was closely connected with the amount of gold held by the government. There are two main facts presented by the authors that I found particularly interesting. First, the gold standard was weakened in several instances. When this happened, the central bank had to learn how to conduct monetary policy to achieve price and financial stability. Second, the authors show the struggle of the central bank in achieving these objectives. A striking episode is the management of the Depression after 1929, which the authors called ‘the Great Contraction.’ During this period, a contraction of the money supply worsened the output recession and generated deflation.

This book is very old, therefore some of its methods are no longer up to date. First, this book is mostly about the monetary stock. Friedman and Schwartz care about the balance sheet of the central bank, whereas now we care much more about interest rates and the communications of the central bank. There are also many parts of modern economics, like expectations, that are completely missing from the book. However, I think it is an important book because it is the first attempt to link together inflation and output. In some sense, it is the basis for many of the books that have been written since about inflation, monetary policy and the real side of the economy.

Let’s move on to Inflation Targeting: Lessons from the International Experience by Ben Bernanke, Thomas Laubach, Frederic Mishkin and Adam Posen.

The authors of this book start from the Friedman and Schwartz book, and there are a lot of references to it in the early chapters. They argue that what is lacking in the Friedman and Schwartz book are expectations.

They ask why we’re trying to stabilize the price level. The answer is that we want to stabilize prices because we realise that there is a trade-off between the output and the price level. However, it is very difficult for the central bank to understand how to stabilize the price level.

The main motive of the book is to make the case for inflation targeting. In the book, the authors argue the target shouldn’t be a strict rule. It should be more like a framework in which the central bank operates in order to stabilize inflation. It’s not important to stabilize inflation to some narrow target—2%, trying to ensure it doesn’t reach 2.1%, or whatever. What is important is to avoid big episodes of inflation, because this could be very disruptive for the economy.

“Why is inflation increasing now? There are different theories”

They provide a lot of examples from different countries. Interestingly, this book was written just before the US adopted an inflation-targeting regime. They talk first about Germany and Switzerland, who had never adopted inflation targeting at the time but were very cautious in managing inflation. Then they look at New Zealand, the first country to adopt inflation targeting. Then they analyse several other countries that adopted inflation targeting. Finally, they wonder whether countries should apply the inflation targeting rule, whether it’s something important, and they argue that we should, but more as a framework rather than as a strict rule.

And, when Bernanke was running the Fed, he ensured there was this flexibility, with no strict target.

Let’s move on to A Monetary and Fiscal History of Latin America, 1960-2017 by Timothy Jerome Kehoe and Juan Pablo Nicolini.

They also start with Friedman and Schwartz and say, ‘Okay, Friedman and Schwartz did a great job, given the state of knowledge at the time. However, if we care about inflation, we should not only look at the monetary side, but also at the fiscal side.’ So they look at the history of a lot of South American countries where inflation has been very high. Inflation there has been disruptive. They try to connect these fluctuations in inflation with output and they argue that it is the joint conduct of fiscal and monetary policy that makes inflation take off, that it is the mismanagement of both that make for big fluctuations.

As in the Bernanke and co-authors book, they look at different countries. What is nice is that in every chapter you have an economist, an expert on that country, writing the story and they give you a lot of data about each specific country. Then, at the end of each chapter, there are discussions with other economists, saying what they think is good and what they think is improvable about the chapter. It’s easy to read and very interesting and it makes comparisons between countries easy.

It is important to look at Latin America if we want to understand inflation. Indeed, in the USA and Europe inflation has been stable from the ’90s to 2008. After 2008, these countries witnessed a prolonged period of low inflation. But inflation in Latin America has been consistently higher than in Europe and in the USA. Therefore, if we want to understand more about inflation, we should look at the experience of such countries. Paradoxically, in Europe and in the USA, we have spent a lot of time looking for inflation, and actually worrying that we might be facing deflation, especially after 2008. So, central banks tried their best to engineer expansionary monetary policies, being creative with new tools like quantitative easing—QE—and forward guidance. Despite this, inflation was below target for many years.

Now, finally, we have a little bit of inflation again, but we have this after spending 10 years with a 1% inflation rate. We were not scared then, but now we have 5% and we are freaking out a little bit.

The last book is Thomas J. Sargent: The Conquest of American Inflation. What story does this book tell us about inflation?

This book offers a very nice idea about the conquest of American inflation. It’s a narrative and, if you’re an economist and you’re really interested in his out-of-the-box reasoning, then you’ll enjoy it. But you cannot read this book just with a coffee. It requires a lot of understanding, it’s a difficult read.

The main story is that we abandoned the gold standard and then central banks had to learn how to control inflation and why it was important to do so. At a certain point in the 1960s, Paul Samuelson and Robert Solow convincingly argued that there was a trade-off between unemployment and inflation. Thus, whenever you allow an increase in inflation, you will bring about a decrease in unemployment. This trade-off is the idea behind the Phillips Curve. Then Robert Lucas pointed out that although there was this correlation, if you were to try to exploit it for policy purposes, the correlation would disappear because people will internalize the idea and you wouldn’t be able to exploit it anymore.

Moreover, scholars tend to accept the idea that there is a rate of unemployment towards which the economy converges that does not depend on inflation. This level of unemployment depends on the fundamentals underlying the economy. Thus, inflation can have transitory effects, but not permanent effects on unemployment. In the end, if you’re going to implement expansionary policies many times over, you will end up with the same level of unemployment, but higher inflation and that is undesirable.

“It is important to look at Latin America if we want to understand inflation”

The conventional wisdom is that in the ’70s, people began to accept this Lucas critique. Then, in the ’80s, Paul Volker, as chairman of the Fed, took very strong action against inflation. So the Fed started to implement this disinflationary policy and the Fed understood that using the Phillips Curve was bad. Again, a conventional idea among scholars is that the Fed understood that there is this natural rate of unemployment. Thus the Fed realized that the tradeoff between inflation and unemployment cannot be exploited anymore. Most of the scholars agreed that after Volcker the economy was in a new regime. This is ‘the conquest of American inflation’. The US managed to keep inflation stable because policymakers understood that they could not game inflation much and that the Phillips Curve is a nice relationship, but we shouldn’t move inflation like crazy because we cannot move unemployment.

That is a positive story. We understood how it all happened. Policymakers learned that they were doing something wrong, now they’re not doing that anymore.

Sargent comes with a second story. This is the difficult one. He argues that the same observation for inflation may have occurred in the absence of the change in regime. In the alternative story proposed by Sargent, there has been no change in policymaking. Policymakers operate, as they were before, according to their beliefs. Crucially, however, we must assume a small departure from rationality in the sense that the policymaker should learn about the functioning of the economy, and they learn over time. How does this process of learning work? Policymakers have some priors about the functioning of the economy. They play their policy and they update their priors according to the empirical observations. This is not what would happen under rational expectations, where the policymakers would know exactly how the economy responds to policy.

In the second narrative, policymakers did not change their ideas about the Phillips curve from the 1970s onwards. And Sargent argues the main reason for believing that is that, if you look at their forecasts, and the way they take decisions, you’ll see that policymakers are still estimating the Phillips curve. Why are they doing that if they don’t care about it?

It is important to understand that unemployment and inflation move for two reasons: as a result of policy and as a result of shocks. Assume that we are in a system of belief where policymakers think that it is very costly to decrease inflation. Thus, they never play any disinflationary policy. Now, there was a lucky combination of shocks that brought both unemployment and inflation down.

Then these shocks trigger a change in belief among policymakers about the past. They observe a dropoff in inflation and a drop of unemployment. So they think that maybe their beliefs were wrong. They no longer believe that if they lower inflation, they will cause a huge increase in unemployment. Thus, they change their beliefs about the Phillips Curve. They give it weight, but they don’t think that the Phillips Curve is exactly like the one that was used before.

They learn from this new process. After these shocks, policymakers start to implement policies that they were not prepared to implement before because they were very scared about increasing unemployment and they observe that these policies bring inflation down, without harming unemployment.

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In this second narrative, Sargent argues that it was a lucky sequence of shocks that changed policymakers’ beliefs. However, we are exactly in the same regime as before. It may happen that an unlucky sequence of shocks may change policymakers’ beliefs again.

He compares the two narratives and he argues the USA did not conquer inflation because of a shift in policymaking. He is inclined to think that what happened was just a change of beliefs. And it could be that we are going to go back to a regime in which we are going to have high inflation again because the policymaker does still care about the Phillips Curve and still puts a lot of weight on that.

It’s a nice book, but it has a lot of critics. Many scholars think that the conventional narrative is not wrong. However, I think it’s an interesting exercise. It’s out-of-the-box thinking because most people think that the reason why, from the 1980s to 2008, we had this big period in which there was inflation stabilisation is due to the fact that monetary policy was very successful. He claims that, no, it’s just a coincidence. It’s interesting, but it is difficult to read.

April 8, 2022

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Federica Romei

Federica Romei

Federica Romei is a Fellow at Hertford College, Oxford and Associate Professor in Economics at Oxford University. Previously she has taught at the Stockholm School of Economics. She has also worked at the Centre for Economic Policy Research and the Banco de Espana.

Federica Romei

Federica Romei

Federica Romei is a Fellow at Hertford College, Oxford and Associate Professor in Economics at Oxford University. Previously she has taught at the Stockholm School of Economics. She has also worked at the Centre for Economic Policy Research and the Banco de Espana.