Understand Inflation 2022

Jia Han
Jun 16, 2022
4 min read

Jia L (John) Han

Great economist Milton Friedman said, “Inflation is caused by too much money chasing after too few goods.” This statement is deceptively simple. If so simple, why cannot the government act to save the day? The government of a capitalist economy does not control the economy directly. It establishes laws and regulations. In addition, the government manages the growth rate of the economy by controlling the interests and money supply. The interests here mainly refer to the lending rates to corporations and consumers.

From a different, more fundamental viewpoint, managing the economic activities of hundreds of millions of citizens is very difficult, to say the least. Unlike natural sciences, there are no laws that are always correct and universally applicable in economics. (Refer to [P1-P4] and think about the implications carefully.) Economics had been studied since ancient Greece. Both Plato and Aristotle had written about economics. At that time economics was part of philosophy. Modern economics was born when Adam Smith published The Wealth of Nations.

One might ask why Adam Smith’s work is so important? I would like to point to the classical textbook Intro to Economics by Samuelson and Nordhaus [1]. At the very end of [1], it says that ordinary citizens in modern nations now live better lives than princes centuries ago. [1] attributes to two events: America’s Declaration of Independence and Adam Smith’s The Wealth of Nations. That is correct, i.e., liberal democracy and capitalist economy have made modern nations rich. I realized the essence of Adam Smith’s work and wrote a short article about it [2]. Later I saw a video on Adam Smith and realized I discovered what Adam Smith already knew centuries ago [3]. The economic development of the last two hundred plus years has proved Adam Smith’s hypothesis is correct. Further work needs to examine the philosophical and theological foundations of Adam Smith’s work. Adam Smith’s philosophy is reviewed in [4].

Although Adam Smith’s theory works, it has several practical problems. One is the economic cycle, periodically high and low. However, cycles here are really misnomer (see [1] for more explanation). In order to improve stability, the US established a central bank, Federal Reserve. In the late 1920s and 1930s, the American economy fell into a deep recession. The severity and longevity made it known as Geat Depression. British economist John Maynard Keynes proposed methods to save the economy. His proposal primarily is to increase government expenditure. However, Keynes’ economics could go only so far. By the 1970s, the economies of many Western nations became stagnated and inflation was high. Although Keyen’s economics was widely adopted, many economists still did not give up classical economics. Among them are Friedrich Hayek and Milton Friedman. Hayek mainly worked on the philosophical aspect while Friedman mainly worked on finance theory. Friedman argued that the 1930s Great Depression mainly was Fed Reserve’s fault. If Fed Reserve adopted the right policy, Great Depression would not happen. In the 1970s, Milton Friedman also pointed out that stagflation then was due to government monetary policy mistakes.

Milton Friedman’s monetary theory was put into stress tests during the GFC. Read [5] for some details. In short, his theory works. More recently the pandemic shock put Friedman’s monetary theory to another test, although it was not as a severe test as GFC. Part of the reason is that it had been applied both in the US and Europe earlier and proved that it worked. Part of the reason is that the shock this time perhaps was not severe.

Friedman’s monetary theory should be used with care. If not enough money is put into the system, it would not mitigate the external shock sufficiently. However, if too much money is put into the system, it will cause inflation. That is the cause of 2022 inflation. See [6-10] for more information.

Once inflation sets in, it will take some time to get rid of it (i.e. reduce it to a 2-3% level). Watch the links for more links. It will take 3-6 months for the market to regain the confidence of the Fed.

References:

Paul A. Samuelson and William D. Nordhaus, "Economics", McGraw-Hill, Irwin, c2005 18th ed
韩家亮：了解经济学的另一角度：多体问题的优化和研究的范式 http://my.cnd.org/modules/wfsection/article.php?articleid=34676
The Real Adam Smith: Ideas That Changed The World - Full Video

https://www.youtube.com/watch?v=8ruiUOQRnw