Publications   On the Stability

Excerpts from

Robert W. Clower

The Genesis and Control of Inflation

in Oldrich Kyn and Wolfram Schrettl (eds)
On the Stability of Contemporary Economic Systems,
Vandenhoeck & Ruprecht, Goettingen, 1979.

I. A Review of Theories

It is generally acknowledged that inflation is a monetary phenomenon in the literal sense that it manifests itself in a continuing rise in all or most money prices. …., it can be argued that inflation must be a monetary pheno­menon in a much deeper sense as well for if all money prices are rising, this means that the rate of exchange between two "composite commodities“, namely “goods“ and “money“, is falling…

Outward simplicity may… cloak inward complexity. First there is the question: What is money? Second there is the question: What determines its quantity and rate of change? Third there is the question: How much money would be just enough? Fourth there is the question: Supposing we know what inflation is, what do we do about it…

The closest approximation to a common theoretical framework is provided by general competitive analysis, but its value for other than academic purposes is severely limited. … general competitive analysis is open to just two possible interpretations: it is des­criptive either of an ongoing economy in a state of full equilibrium or of a virtual exchange economy in which production, consumption and trading plans are never executed except in a state of full equilibrium. On either interpretation the theory is quite unsuited to deal explicitly with disequilibrium adjustment pro­cesses in a world where economic plans are at least partially executed in virtually any and all circumstances…

Two other so-called theories have acquired a certain following among pro­fessional economists, namely, income-expenditure theories suggested by Keynes‘ General Theory and „modern“ quantity theories suggested by Friedman‘s influential writings…

Income-expenditure theorists start with the trivial proposition that an economy cannot be in equilibrium unless aggregate income is equal to planned aggregate expenditure. From there they proceed in an ad hoc and largely arbitrary fashion to discuss the determinants of planned expenditure …. income-expenditure theories are incompletely specified variants of general competitive analysis…

As for modem quantity theorists, they start with the trivial proposition that an economy cannot be in equilibrium unless prices are such that the quantity of means of payment that economic agents wish to hold is equal to the quantity actually in existence… quantity theorists then discuss the determinants of the stock of money on the presumption that prices must move to bring the real value of this stock into equality with the real demand for money. Again, we have to deal with theories that are incompletely specified variants of general competitive analysis. ….

…none of the theories subjected to criticism above is logically inva­lid; each is simply incomplete, hopelessly ambiguous, or lacking in empirical relevance. … all of them may well be seen to offer useful insights into the problem of inflation. …

II. Towards a More General Theory

… we must first dispense with the notion that individual economic activi­ties are coordinated by a fictitious “auctioneer“ or … by vaguely specified “forces of supply and demand.“ …. In every economy, and in all markets, …, we find that the day-to-day coordination of economic activities is carried out by highly visible exchange intermediaries — economic agents who act in a specialized capacity as brokers and auction agents or as outright dealers in various commodities …. Thus the performance characteristics of an economy, although dependent in the final analysis upon the actions of individual producers and consumers, are determined in the first instance by the actions of exchange intermediaries. For it is these intermediaries who set and vary prices and who maintain buffer stocks of commodities so that trades can be executed routinely by other agents …

… The essential function of intermediaries is to reduce search and bargaining costs to prospective customer by providing a ready market for goods at prices that, on average, are better for both buyers and sellers than could be obtained in quick trades by direct barter. To perform that function effectively, intermediaries must at all times hold inventories of both money and goods and must stand ready to buy or sell at stated prices in such quantities as prospective customers might desire. To pay expenses and earn a profit, intermediaries must of course charge a brokerage fee on each transaction or maintain a differential between buying and selling prices.

… prices set by intermediaries must be varied from time to time to maintain control of trade inventories. …., trade volume over short intervals of time cannot signi­ficantly affect pricing decisions. Prices will tend to vary discontinuously and discretely in response to perceived gaps between desired and actual holdings of goods and money as determined by the average volume of purchases and sales over more or less extended intervals of time. It is worth remarking, in particular, that conventional concepts of market demand and supply play no direct role in price adjustment: indeed, …The opera­tive forces governing price movements are notional excess stock demands as seen by intermediaries, …

… an intermediary economy is unlikely to respond to changing conditions of production or consumption except with lags that appear outwardly to be both long and variable. No single intermediary sees anything more than a small part of the economy, and even that small part is seen only indistinctly because each intermediary typically will be competing for customers with many others. On first thought, then, one might suppose that an intermediary economy would be inherently unstable. … we should be inclined to regard a system with long and variable lags as potentially very unstable. In general process analysis, however, price and quantity adjustments are explicitly associated with conscious and purposeful decisions of individual economic agents. Market performance characteristics are therefore to be regarded not as preordained consequences of technical and structural factors but rather as the end product of a complicated evolutionary process that permanently eliminates certain organizational arrangements because they do not work and provisionally tolerates the survival of other arrangements because they have worked. On this view unstable economic systems, although theoretically conceivable, are not likely to be observed since they do not have survival value. Systems that survive over long intervals of calendar time effectively declare themselves to be “of stable type…

Under what conditions can stationary equilibrium occur in an intermediary economy? Evidently we require that preferences and technology be given or at least constant in a stochastic sense, … If the economy is one in which the quantity of the money commodity is determined exogenously … constancy of this quantity would also be required as an essential background condition. …we should then have to add various other requirements. Specifically, prices set by intermediaries would have to be uniform for any single good (abstracting from transport costs); rates of return on trade inventories would have to be equal to comparable rates of return on production capital; prices would have to be such that the quantity produced and sold of each good was equal, on average, to the quantity demanded for purchase and consumed; each individual intermediary‘s average inventory of money and goods would have to be constant; and the general level of money prices would have to be such that the total existing stock of money was just equal to the amount demanded to hold for trade purposes.

… In the model considered here, each producer and consumer will hold inventories of goods and money to avoid prohibitively heavy transaction costs associated with frequent trading in small lots. These inventories must be maintained at constant levels, on average, if equilibrium is to occur. In addition, all the usual marginal conditions must hold, at least in a stochastic sense, since otherwise the realized trade volume of some intermediaries would vary over time. In the present context, however, it hardly makes sense to talk about “efficiency“ or “optimality“, even in equilibrium, for we are dealing with a system in which possibly very large quantities of resources are devoted to trade and this fact, plus the essentially social character of prevailing market arrange­ments, makes it impossible to establish any definite benchmark of optimality or efficiency. Equilibrium is efficient in a practical sense if it generally permits individuals to carry out production and consumption plans as scheduled and so serves effectively to ensure the coordination of economic activities.‘ In particu­lar, equilibrium does not necessarily involve full employment of labor or other resources in any absolute sense …

III.      Inflation: A General Process Perspective

The account of general process analysis set out above is thoroughly traditional. It is compatible not only with Marshall‘s ideas .. but also with those of his classical predecessors …. It includes general competitive analysis as a limiting case that is approximately valid for analyzing full equilibrium states of a general process model. …

Now, consider a moderately generalized version of a pure commodity-money model in which we continue to suppose that all trading is spot but in which we also allow for fractional-reserve private banking so that “money“ now includes bank deposits as well as cash. Let us further suppose that the cash commodity … serves no purpose in the economy except as a means of payment and store of value…. in full equilibrium income will equal aggregate expenditure, and existing demands for money (cash and deposits) will be equal, on average, to the existing stock. Starting from this kind of situation, how might a sustained rise in the money prices of all commo­dities be generated  …? Only two possible sources of inflation make any sense at all in these circumstan­ces, and one of them makes too little sense to merit more than passing mention. The uninteresting possibility is that there might be a general retrogression in technology or a progressively increasing reluctance to work that produces a sustained and general decrease in the output of goods. …

The more relevant possibility, of course, is a change in initial conditions that leads to a sustained positive rate of increase in the stock of money. This might come from two main sources: a change in technology that makes gold substan­tially cheaper to … debasement of the coinage by government. Both possibilities are of some interest, if only for historical reasons.

The second, however, is of special concern because it corres­ponds exactly to modem situations in which the cash base consists of fiat money rather than gold….. As for a steady increase in government spending financed either by taxes or by borrowing (with no change in the cash base), we can affirm categorically that this might produce a temporary increase in some or even most prices but it could not in any circumstances produce a continuing rise in the general level of money prices.

So we return to the case of a debasement of the coinage: i.e., governmentally generated increases in the cash base. Suppose that the government (or monetary authority) proceeds to increase the cash base at a steady rate. It will matter very little whether this occurs through government purchases of private or public debt or through government pur­chases of goods and services. In either case, the first impact will be felt by intermediaries (bond brokers or merchants) whose inventories of commodities will decline and whose inventories of cash will rise. To replenish their commodity inventories, these intermediaries will turn to other intermediaries or to primary agents, or both, and within a short time prices paid by intermediaries will increase (i.e., market rates of interest will fall and prices of goods will rise). As the stock of cash continues to rise, bank loans and deposits will expand, trade generally will appear to be picking up, and so the effect of the increasing money stock gradually will spread through the economy — but certainly not at an even pace. There will be long lags in the adjustment of some prices, delayed shifts in the mix of outputs produced by primary agents, changes in consumption patterns because of different individual price and wealth elasticities of demand, and so forth. Eventually, however, the economy will settle down to a steady rate of inflation …

One can then imagine various explanations being offered for the rise in prices that is actually being observed. One school will point out that prices are governed by the relation between expenditure and income and will note, correctly, that government deficits continue to keep pace with the rise in prices,

Another school will point more directly to the source of the problem by drawing attention to the rise in the aggregate money stock.

A third school, however, will see something quite different, namely, that prices are rising because costs are rising. This view will be applauded by intermediaries, who will naturally view price increases by themselves not as a means of making higher profits but rather as a way to avoid serious losses— which requires that they increase sale prices in step with the prices they have to pay for new supplies… Actual inflations — even sustained and rapid ones — always proceed by fits and starts. Because of this the operations of intermediaries as coordinators of economic activity are thrown into a more or less constant state of turmoil. Inventories of goods are always either too low or too high Price increases are introduced at some times in anticipation of increased demands that do not materialize, while at other times price increases are delayed and sudden shortages then occur because demands suddenly increase. No outside observer can make sense of price movements. Depending on prevailing levels of inventories in relation to desired holdings, prices can rise even when stocks are increasing … and remain constant or decline even when stocks are declining …. The velocity of money undergoes odd and erratic movements; the ratio of deposits to cash reserves also behaves unpredictably. Money movements appear to be generated by changes in real activity rather than the other way around. Search activity increases as price rela­tionships become ever more chaotic. Resources are unemployed because owners do not wish to commit them too quickly in one direction lest commitment in another direction should shortly turn out to be more desirable.

In short, economic “laws“ appear to break down. In fact, what breaks down is the capacity of intermediaries effectively to coordinate economic activities. It is one thing to operate in the face of mere ignorance this is the usual situation of any intermediary. …But when ignorance is compounded with Knightian uncertainty and the past becomes an essentially worthless guide to the future, intermediaries cannot follow conventional rules and stay in business. The behavior of intermediaries then appears to become and may in fact be — both erratic and unpredictable, and their ability to serve effectively as coordinators of economic activity is diminished accordingly.

… I should like to remark that I see no serious division of opinion among economists over the issue of the genesis of inflationary processes. The general public may be confused in this regard, but no reasonably competent economist doubts that inflations actually experienced in modern times are attributable to government dictated or government tolerated increases in the cash base. …

IV. Inflation: The Problem of Control

The problem of bringing an ongoing inflation under control without seriously disrupting existing patterns of economic activity would evidently be fairly difficult even in a spot economy of the kind considered in the preceding discussion. … Still, it seems clear that a policy of gradually reducing the rate of increase of the cash base, if it were firmly adhered to, would work out reasonably well in a world of spot exchange.

It is an altogether different question whether the same type of policy would work well in an economy where a major part of current activity is concerned with the production and use of long-used capital goods. In this case, even moderate reductions in the rate of increase in the cash base might trigger large declines in production and employment and so set in motion processes of contraction that would seriously disrupt the normal working of the economic system. The main danger here is that the reduction in employment might be followed by a reduc­tion in household holdings of liquid assets to a level where large numbers of families were unable to express an effective money demand for food and clothing and other necessities of life…

In my view, the only way to guard against the dangers just mentioned is to broaden significantly the coverage of typical unemployment insurance pro­grams. … Provided that adequate provision Is made to ensure that no large segment of the population is ever left completely without resources (a proviso that most definitely was not satisfied in the U.S. during the early 1930‘s), I see no reason to suppose that a policy of gradual re­duction in the rate of increase in the cash base would produce sustained disruption of any economy.

But of course there is a hitch even here. In the wake of the Keynesian Revolu­tion, most governments in the world have taken upon themselves responsibi­lity for maintaining full employment. The one thing that cannot be avoided in any policy that aims at bringing inflation under control is shifts in demand and consequent increases … in levels of unem­ployment. As a practical matter, therefore, it may well be doubted whether any policy that aims simultaneously at full or even high employment and the gradual elimination of an ongoing inflation can be carried out successfully. One goal or the other simply must be sacrificed.

To me it seems clear which goal ought to go. Those who argue that full employ­ment must take precedence over any and all other considerations seem to me to place too much weight on the value of human sweat for its own sake. By all means we should ensure that those who can‘t find work should continue to eat and even enjoy a certain amount of fun and leisure; but to guarantee everyone continual work as well as continual pay is an act of utter folly, for it inevitably carries with it a threat of direct and piecemeal intervention in economic affairs that can only work to inhibit the transition of the economy from a state of rapid to a state of moderate or zero inflation.

V.        A Concluding Comment

… I think it will be generally acknowledged that the only way to avoid inflation is to avoid any but moderate and steady increases in the cash base. As for the problem of inflation control, that remains a disputed issue — and rightly So: for in truth economists stand together here only in being generally unable to say anything definite about the probable short-run effects of any specific set of policy actions.



Clower, R. W., “Reflections on the Keynesian Perplex,“ Zeitschrift fúr Nationalökonomie, July 1975, 1—24.

Hahn, F. H., “Foundations of Monetary Theory,“ Essays on Modern economics, M. Parkin (ed.), London: Longmans, 1973, 230—242.

Hicks, J.R., Critical Essays in Monetary Theory, Oxford: Clarendon, 1967.

Howitt. P. W., “Stability and the Quantity Theory,“ Journal of Political/ Economy, 82, Jan/Feb. 1974, 133—140.

Johnson, H. G., “The Problem of Inflation.“ in On economics and Society, Selected Essays, Chicago and London: U. of Chicago Press, 1975.

Leijonhufvud, A., “Effective Demand Failures,“ Swedish Economic Journal, 73, 1973,


Marshall, A., economics of Industry, London: Macmillan, 1913.

—‚Industry and Trade, London: Macmillan, 1919.

Ostroy, J. ‚ “ The Informational Efficiency of Monetary Exchange,“ American Economic Review, 63. September 1973, 597—610.

    and Starr, R. M., “Money and the Decentralization of Exchange,“ Econometrica, 42, November

















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