A Critical Account of the Neoclassical Theory of Inflation

Friedman’s demand for money theory stated that a change in the supply of money in to the economy will cause a change in inflation rates, assuming the demand for money is constant. Dm = f(P, rb, re, 1/p x dP/dt, Yp, W) Interest rates are set by the Bank’s Monetary Policy Committee. The MPC sets an interest rate it judges will enable the inflation target to be met. This is the current policy on setting and controlling inflation in the economy, In the first three months of 2009, the UK economy shrank more than it did in the whole of the 1990's recession. Adding to the misery was the fall in asset prices.(rbs.com) The price of assets, and in this case the price of stocks and shares, and of the homes we live in, matter because they are directly related to wealth, and changes in personal wealth affect the spending and saving decisions of individuals and companies. With lower interest rates there is less of a reason for individuals and companies to save, this in turn increase the general willingness to spend with in the economy thus increase the money supply which will, according to Freidman’s theory will increase inflation and help the economy grow. Another contributor for the UK leaving the recession is quantitative easing. However is the money just being printed and if so how is that any different to the 1920’s Germany and Zimbabwe, in short is isn’t, the short term effects are similar, this is said to be a short term cure to the recession but a 0.1% growth in the final quarter of 2009 was less than convincing, in theory when the uk has fully recovered the government will sell the bond it has bought and destroy the cash it receives meaning no new cash has entered the economy. The monetary policy seems to the answer to the recession the control of money supply directly is impossible but via interest rate changes and inflation a certain amount of control can be put upon the uk economy, the only other answer is the use qualitative easing more aggressively ‘print more money’ however this is not a financially sound decision nor is it a quick fix as first believed.