before we get to the books, could you define what inflation is because I think a lot of people are wrong about it? also, maybe it could explain why it seems to be increasing now.
Inflation is simply 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 more or less expensive goods are today than they were in the past or whether goods are more or less expensive in the future than they are today. Now, there are different ways of defining inflation. In the UK, inflation tends to be defined by the CPI, which is an index of the consumer basket. that helps us understand how the price of the goods people consume changes over time. We can also look at the producer price index, which analyzes inflation from the point of view of companies: what is the price that companies charge for their goods and services. then there is core inflation, which does not take energy prices into account: energy prices, especially oil, are much more volatile and subject to international shocks. therefore, there is no single definition of inflation, there are many definitions of inflation, and we view the aggregate in different ways.
You are reading: Best books on inflation
Why do we care about inflation? In a sense, inflation is just a change in prices. Arguably, if goods are more expensive today than in the past, we shouldn’t worry too much, because price is just the way goods are measured. we measure the value of goods in units of money, but we could measure them by some other measure, such as a standard good. for example, we could use wool units, as we did in the past. At first glance, that shouldn’t matter any more than whether you measure a distance in meters or yards. is the same distance.
But inflation is important because, as economists, we think it has some effect on the real sector of the economy. if inflation rises too high, it may have some feedback effect on output or unemployment, or on the country’s financial stability. if that weren’t the case, we wouldn’t worry about inflation.
why is inflation rising now? there are different theories. Some say that inflation increases because there is a drop in aggregate supply. If we think in terms of demand and supply, the price level could rise if demand increases or if supply decreases. some academics think that what you’re looking at now is that since the covid crisis there’s been a problem with the supply chains and there’s some problems with the supply of oil and that for this reason companies haven’t been producing what enough. so there has been a drop in the supply side of the economy.
The most optimistic people see that prices increase 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 one we’ve experienced, although I think most people are inclined to believe the negative supply shock story, that there’s not enough supply of goods in the economy and this means we’re now experiencing an increase in prices and we will see more of that in the future.
let’s go to the books. The first 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 I would suggest mainly for people starting a Ph.D. it is very technical. it talks about monetary economics and inflation in a very technical way, but of the books of that type it is 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 mathematics. he helps you understand how inflation is created in a mathematical model in the first place, but more importantly why we care.
“There is no single definition of inflation”
jordi says that, in a sense, we care about inflation because of this feedback effect on output: employment and inflation are strictly linked to each other. A key element of the model economy in the book is sticky prices, companies do not adjust prices immediately. now, if firms do not adjust prices, if they experience a rise or fall in the general price level, then they need to adjust output in the short run. so if you have higher inflation, it will have some effect on output through this mechanism. the book describes this mechanism and then describes the optimal monetary policy.
The book looks at 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 production and employment, in the short term, are exactly the same. this result is known as the “divine coincidence”.
turning to the monetary history of the united states, 1867-1960 by milton friedman and anna j. schwartz.
The next few 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 math, because you don’t want to do a Ph.D. these are the books for you. they are interconnected: one is a kind of updated version of the other.
friedman and schwartz is the first book that tried to connect monetary aggregates, which is the amount of money in circulation, and inflation with the real sector. that’s why it’s important. they established a connection between the stabilization of prices and the stabilization of the real economy. the book covers the period from the second half of the 19th century to the 1960s.
For most of this period, the gold standard was in place. the gold standard meant that dollars could be exchanged for gold at a fixed rate. under this regime, the only function of the central bank is to defend the exchange rate of the dollar with gold, so the money supply was closely related to 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 cases. 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 to achieve these goals. A striking episode is the handling of the depression after 1929, which the authors called “the great contraction”. during this period, a contraction in the money supply aggravated the output recession and generated deflation.
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This book is very old, so some of its methods are no longer up to date. First of all, this book is mainly about money action. friedman and schwartz care about the central bank’s balance sheet, whereas we now care much more about interest rates and central bank communications. there are also many parts of modern economics, such as expectations, that are completely missing from the book. however, I think it is an important book because it is the first attempt to link inflation and output. in a sense, it is the basis for many of the books that have been written since then on inflation, monetary policy, and the real side of economics.
Moving to Inflation Targeting: Lessons from International Experience by Ben Bernanke, Thomas Laubach, Frederic Mishkin, and Adam Posen.
The authors of this book start from Friedman and Schwartz’s book, and there are many references to it in the first few chapters. They argue that what is missing from Friedman and Schwartz’s book are expectations.
They ask why we are trying to stabilize the price level. The answer is that we want to stabilize prices because we realize that there is a trade-off between output and the price level. however, it is very difficult for the central bank to understand how to stabilize the price level.
The main reason for the book is to defend the inflation target. In the book, the authors argue that the goal should not be a hard and fast rule. it should be more like a framework in which the central bank operates to stabilize inflation. it is not important to stabilize inflation at a narrow target: 2%, trying to ensure that it does not reach 2.1%, or whatever. The important thing is to avoid large episodes of inflation, because this could be very disruptive for the economy.
“why is inflation rising now? there are different theories”
provide many examples from different countries. Interestingly, this book was written just before the United States adopted inflation targeting. They speak first of Germany and Switzerland, which had never adopted inflation targeting at the time but were very cautious in handling inflation. Then they look at New Zealand, the first country to adopt inflation targeting. they then look at several other countries that have adopted inflation targeting. Finally, they ask if countries should apply the inflation targeting rule, if it is something important, and argue that we should, but more as a framework than as a strict rule.
and, when bernanke ran the fed, he made sure there was this flexibility, without hard targets.
turning 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 the fiscal side.” so they look at the history of many 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 argue that it is the joint conduct of fiscal and monetary policy that causes inflation to take off, that it is the mismanagement of both that causes the large fluctuations.
As in the book by Bernanke and co-authors, they analyze different countries. what’s nice is that in each chapter you have an economist, an expert on that country, writing the story and they give you a lot of facts 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 can be improved about the chapter. it is easy to read and very interesting and facilitates comparisons between countries.
It is important to look at Latin America if we want to understand inflation. In fact, in the United States and Europe, inflation has been stable from the 1990s 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 the United States. therefore, if we want to understand more about inflation, we must look at the experience of these countries. paradoxically, in europe and the united states, we have spent a lot of time looking for inflation, and really worrying that we might be facing deflation, especially after 2008. therefore, the central banks went to great lengths to design expansionary monetary policies, being Get creative with new tools like Quantitative Easing (QE) and Advance 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 an inflation rate of 1%. We weren’t scared then, but now we have 5% and we’re a little scared.
the last book is by thomas j. sargent: the conquest of american inflation. What story does this book tell us about inflation?
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This book offers a very good insight into the conquest of American inflation. it’s a narrative, and if you’re an economist and really interested in its innovative reasoning, you’ll enjoy it. but you can’t read this book with just a cup of coffee. it requires a lot of understanding, it is a difficult read.
The main story is that we left the gold standard and then central banks had to learn how to control inflation and why it was important to do so. At one point in the 1960s, Paul Samuelson and Robert Solow convincingly argued that there was a trade-off between unemployment and inflation. therefore, whenever you allow an increase in inflation, you will cause a decrease in unemployment. this compensation is the idea behind the phillips curve. Robert Lucas then pointed out that even though this correlation existed, if he tried to exploit it for political purposes, the correlation would disappear because people will internalize the idea and will no longer be able to exploit it.
Furthermore, scholars tend to accept the idea that there is an unemployment rate towards which the economy converges that does not depend on inflation. This level of unemployment depends on the fundamentals that support the economy. therefore, inflation may have transitory effects, but not permanent effects on unemployment. In the end, if you are going to implement expansionary policies many times, you will end up with the same level of unemployment, but higher inflation, and that is not desirable.
“It is important to look at Latin America if we want to understand inflation”
Conventional wisdom is that in the 1970s, people began to accept this criticism of Lucas. Then, in the 1980s, Paul Volker, as Fed Chairman, cracked down very hard on inflation. so the fed started to implement this disinflationary policy and the fed understood that using the phillips curve was bad. Again, a conventional wisdom among scholars is that the Fed understood that there is this natural rate of unemployment. therefore, the fed realized that the trade-off between inflation and unemployment can no longer be exploited. Most scholars agreed that after the tumble the economy was in a new regime. this is ‘the conquest of American inflation’. The United States managed to keep inflation stable because the legislators understood that they could not play with inflation too much and that the Phillips curve is a good relationship, but we should not move inflation like crazy because we cannot move unemployment.
That’s a positive story. we understood how it all happened. legislators realized they were doing something wrong and now they’re not doing it anymore.
sargent comes with a second story. this is the hard one. he argues that the same observation for inflation may have occurred in the absence of regime change. In the alternate history proposed by Sargent, there has been no change in policy making. politicians operate, as they did before, according to their beliefs. more importantly, however, we must assume a small departure from rationality in that the policymaker must learn about the workings of the economy, and learns over time. How does this learning process work? Politicians have some background on how the economy works. they play their politics and update their antecedents according to empirical observations. this is not what would happen under rational expectations, where 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 onward. And Sargent argues that the main reason for believing that is that if you look at their forecasts and the way they make decisions, you’ll see that policymakers are still estimating the Phillips curve. why do they do that if they don’t care?
It is important to understand that unemployment and inflation move for two reasons: as a result of policy and as a result of shocks. Suppose we are in a belief system where politicians think it is very expensive to reduce inflation. therefore, they never play a disinflationary policy. now, there was a lucky combination of shocks that reduced both unemployment and inflation.
Then these shocks trigger a change in belief among policymakers about the past. they observe a fall in inflation and a fall in unemployment. then 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. therefore, they change their beliefs about the phillips curve. they give it weight, but they don’t think the phillips curve is exactly the same as the one used before.
learn from this new process. After these shocks, policymakers start implementing policies that they weren’t ready to implement before because they were so scared about rising unemployment and they see that these policies reduce inflation, without hurting unemployment.
In this second narrative, Sargent argues that it was a lucky sequence of shocks that changed the beliefs of policymakers. however, we are in exactly the same regime as before. it may happen that an unfortunate sequence of shocks changes the beliefs of policymakers again.
compares the two narratives and argues that the united states did not beat inflation due to a change in policy making. he is inclined to think that what happened was just a change of beliefs. and it could be that we’re going to go back to a regime where we’re going to have high inflation again because politicians still care about the phillips curve and still give it a lot of importance.
It’s a good book, but it has a lot of criticism. many scholars think that the conventional narrative is not wrong. however, I think it is an interesting exercise. it’s innovative thinking because most people think that the reason that from the 1980s to 2008 we had this great period where there was stabilization of inflation is because of the fact that monetary policy was very successful . he claims no, it’s just a coincidence. it’s interesting, but it’s hard to read.
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