How do central banks control inflation? A guide for the perplexed

Central banks are tasked with managing the money supply, which in turn should affect their currency’s value and inflation. To expand the money supply, most advanced countries buy their own bonds and give the seller currency, and to reduce the money supply, they sell their bonds and pull currency out of circulation. Interest rates can also be adjust

The sum total of the contribution of both these schools of thought is the consensus taught in undergraduate macroeconomics courses across the world: that the central bank should be in the business of expanding the money supply at a controlled pace, to encourage people to spend more and thus keep the unemployment level sufficiently low. Should a cen

Saint Milton Friedman taught us that inflation is always and everywhere a monetary phenomenon. A central bank, by printing too much money, can bring about inflation and destroy a currency, all things being equal. But that is the tricky part of that equation, because not all things are equal.

Monetarists generally oppose Keynesian efforts to spend money to eliminate unemployment, arguing that in the long run, the effect on unemployment will be eliminated while causing inflation. Instead, Monetarists prefer tax cuts to stimulate the economy, because they argue that the free market will better allocate resources than government spending.

Inflation is caused by a sustained increase in the supply of money. When people have more money, they spend it, and without an increase in the supply of goods, prices must rise. As Nobel laureate Milton Friedman once wrote: “Inflation is always and everywhere a monetary phenomenon.”

The claims of monetarists, and especially of the “rational expectations” theorists, that government is helpless to influence employment levels by using the standard Keynesian tools of monetary and fiscal policy and that attempts to reduce unemployment can only cause inflation, are based on the assumption that public responses to these measures will

Furthermore, in the nature of things, credit contraction is severely limited—it cannot progress beyond the extent of the preceding inflation.14 Credit expansion faces no such limit.

Early on across the world, as already noted, the main device for defaulting on government obligations was that of debasing the content of the coinage. Modern currency presses are just a technologically advanced and more efficient approach to achieving the same end. As a consequence, a clear inflationary bias throughout history emerges.