In the near future, I plan on publishing a policy paper explaining how a country like the United States can use its spending, regulatory, and taxing power to increase fiscal space and prevent inflation. In the meantime, please enjoy this brief primer on what causes inflation, from a Post-Keynesian and MMT perspective. I begin by describing how inflation results in changes in bargaining power, and in the second section, I explain how government policies can mitigate inflation by improving bargaining power for buyers.
What Inflation is and Where it Comes From
Inflation is the sustained increase in the general price level, which is a function of prices set by the government and of the the bargaining power of both every buyer and every seller of every goods, services, and financial assets (these three will subsequently be referred to as "products") in the economy. The bargaining power of the seller of any product decreases when the product is numerous, widely distributed, replaceable, easy to produce, and in low demand. Similarly, the bargaining power of the seller of any product increases when the item is rare, narrowly distributed, unique, hard to produce, and in high demand. For the purpose of this article, I will never refer to inflation as the increase in the overall supply of money.
It is also important to understand what inflation is not. Because inflation is a sustained process, one-time adjustments are not inflation. If the government raises the minimum wage, there may be a one-time adjustment in the price level due to the raise, but raising the minimum wage once does not cause sustained increases over an extended period. Because inflation affects the general price level, increases in the price of individual goods are not inflation. Increases in the price of individual goods can occur in economies where there is technically zero inflation because price decreases in some goods can offset price increases in other goods. For example, if the price of apples goes up by 10%, it does not mean that inflation is 10%. If the price of TVs goes down by 10%, it might be the case that inflation is technically 0%. This is because the consumer price index - the most commonly cited measurement of inflation - is determined by assigning weights to the prices of hundreds of individual items.
Prices for any given item go up when sellers have more bargaining power than buyers. Because every aspect of the economy is heterogeneously connected with many other parts of the economy, the price of one product can affect the price of other products. Certain products impact the overall price level more strongly because they are used in the creation or distribution of other products. The prices of energy, raw materials, and labor greatly affect the price of intermediate and final goods. Conversely, the price of final goods has a smaller impact on the price of labor, raw materials, and energy. To illustrate, an increase in the price of wood should directly and significantly increase the price of homes, but an increase in the price of homes may only indirectly and insignificantly increase the price of wood.
Inflation is often divided into two types, demand-pull inflation and cost-push inflation. Demand-pull inflation occurs when buyers drive up the cost of products by bidding against each other because they have more money than they desire to save and, consequently, they choose to spend it. Post-Keynesians believe that demand-pull inflation from “excess money” is rarely - if ever - the primary cause of inflation in consumer prices because the mere existence of additional money has only a limited effect on the complex web of bargaining power positions that contribute to pricing decisions. For more discussion on this topic, see my article on Why the Quantity Theory of Money is Wrong.
On the other hand, cost-push inflation is when sellers raise prices because their own business costs have increased. When the general price level greatly increases in a short time, it is usually driven by shortages of a handful of important products. As climate change intensifies and droughts become more common, food scarcity occurs more frequently. During crises in the Middle East, the price of oil increases, and during pandemics, labor becomes more scarce. These types of scarcity increase the prices of almost every other product.
When the general price level moderately increases over a long period, it is usually due to a systemic failure to invest in and sustain supply and productive capacity as well as a gradual concentration of market power by sellers. For example, in the US during the 21st century, growth in the supply in housing units and primary care physicians slowed. Pharmaceutical companies merged, concentrating market share, and Amazon used its massive size to coerce price increases. These events increased the bargaining power of sellers of shelter, medical care, and general consumer goods, leading to higher prices.
In addition to the mark-up over costs, inflation may come directly from the profit motive. Because firms are incentivized to raise prices to increase profits and because workers are incentivized to request greater compensation, there may be “forces inherent in our economy” which lead to “gradual and persistent inflation” even in the “total absence of demand pressures.” (C.E. Ferguson 1962)
Finally, the prices of financial assets, including stocks, corporate bonds, derivatives, and other securities increase when there is undue enthusiasm about the future value of revolutionary technology and when regulators allow the originators of volatile financial assets to externalize risk. The popularization of the internet, which lowered the barrier of entry and communication costs for many enterprises, made it easier for businesspeople to create firms with a small initial investment that had the potential to become worth hundreds of millions of dollars. This potential for massive gains enticed investors in the late 1990s to speculate on any company with a strong internet presence, leading to high stock prices during the Dot-com bubble. Similarly, in the 2010s and 2020s, technology stocks led a bull market, partially due to exuberance about the potential of artificial intelligence. During the American housing market bubble of the 2000s, lax regulations allowed banks and other financial institutions to package risky financial assets - including subprime mortgages - and sell them. After several iterations of this process, known as securitization, the risk profile of the package of assets becomes impossible to determine. This allows the originators of these assets (for example, the bank who first extends a mortgage loan) to create unsound financial products with high potential returns because the risk of default can be externalized to the eventual buyers of the assets.
How the Government Can Mitigate Inflation
Recall from the previous section that the price level is a function of the bargaining power of every buyer of every product in the economy and the bargaining power of every seller of every product in the economy. If the government intends to prevent inflation, it should enact policies which increase the bargaining power of buyers of products and decrease the bargaining power of sellers of products. Those policies should increase supply, decrease concentration, make replacements available, make production easier, or decrease demand.
Certain markets have inherent inefficiencies that prevent adequate production and just distribution. A market for a product is efficient if, among other things, it is not dominated by a monopolist, demand is certain, supply is certain and not dependent on outside markets, demand is not induced by the supplier, risks are certain, the customer can test the product before consuming, information symmetry exists between buyers and sellers, and consumers can predict the results of their consumption decisions. In many markets which do not meet these conditions, profit-driven behavior by reasonably well-informed actors can lead to adverse outcomes, and government interventions can improve efficiency to increase overall consumer satisfaction by working with consumer preferences rather than trying to change them. For more information, please read my article on Why and How to Enact Consumer Responsive Industrial Policy.
Because there are a few key industries that drive inflation (energy, housing, transportation, education, and food), a comprehensive anti-inflationary industrial policy should target these industries first with the expectation that cost-control measures will spill over into downstream industries. The list below contains many ways that the government can use targeted spending and regulation to make certain products less expensive. This list is not exhaustive, and there is some overlap between solutions. Note that these are all proposals to prevent inflation that can be implemented before or in conjunction with spending bills; there is no need to wait for inflation to occur and then try to push it back down. Most importantly, although taxation is one tool the government has, by no means is it the only or the best way to prevent or reduce inflation.
The government can make products more numerous by directly providing them at a price it deems affordable.
The government can make products more widely distributed by enforcing laws against anti-competitive practices to prevent the formation of monopolies.
The government can make certain expensive products replaceable by funding research and development that improves inexpensive products, so they can compete with or reduce the need for certain expensive products.
The government can make products easier to produce by directly subsidizing their manufacture and sale.
The government can reduce demand for products by exercising its role as price setter by refusing to pay increased prices for goods and services in government programs; it can also strictly regulate products or outright ban them.
To prevent financial speculation leading to asset price inflation, the government can regulate credit conditions by mandating higher lending standards, and it can ban risk-externalizing financial activities that serve no public purpose. The sale of credit default insurance and the packaging and sale of loans are examples of practices which allow banks to externalize risk because they encourage the originators of loans to care less about the borrower’s ability to pay. For this reason, an MMT-informed government would restrict these practices.
The government can also reduce spending, but this is not guaranteed to reduce inflation, as outlined in my working paper, Inflation and Productive Capacity: An Empirical Risk-Reduction Model. It also is not always the most effective way to reduce inflation because decreased government spending can harm producers whose business models and supply chains depend on sales to the government, resulting in fewer goods and services and increasing inflationary pressure. Raising taxes on the rich is another option, but because the rich spend most of their excess money on financial products, increasing taxes on the wealthy - while helpful - is not always sufficient to reduce inflationary pressure on non-financial products such as food and energy. A comprehensive government plan to reduce and prevent inflation would include a combination of spending, regulation, and taxation. I will publish an example of such a plan, complete with specific budget estimates, in the coming months.
The Government's Role as Price Setter and Monopoly Issuer of the Currency
Now that I've explained how prices drift from their previous level, it's important to add where the initial price level comes from. Because the government is the monopoly supplier of the currency, it has the power to legislate the prices it pays and the prices it charges independent of the normal bargaining process outlined in the sections above. If the government sets minimum wage at a certain level by statute or sets the price of stamps at a certain level by regulation, it establishes the "absolute value" of unskilled labor and standard postal services. Because the government has no risk of insolvency in its own currency, the price of products identical to products with regulated prices cannot stray far from the regulated price. For a detailed model explaining this phenomenon, see Sam Levey's working paper Modeling Monopoly Money: Government as the Source of the Price Level and Unemployment. The prices of other products in the economy, such as skilled labor and overnight postal services, reflect the "relative value" of those products, compared to the absolute value of the prices the government mandates. Effective management of the price level requires influencing both absolute and relative values in the economy.