The Theory of Inflation

THE TRADITIONAL explanation of inflation runs largely in terms of changes in the money supply, the gold stock, and the cost of money (interest). While doubtless helpful in explaining inflation, these stock concepts are theoretically inconclusive and practically inadequate. Even the concept of “liquid assets” (e.g., accumulated savings out of past incomes) is incomplete, though admittedly important. The quantity-theory type of explanation has been greatly improved by the income-expenditure approach to inflation, such as developed by Keynes during World War II. By functionally relating expected expenditures to disposal income (national income after taxes) in relation to the value of available output at base prices, Keynes originated the concept of the “inflationary gap”—not only to emphasize the strategic significance of the flow of money incomes in influencing the general price level but to show the primary importance of fiscal measures (e.g., tax and borrowing) for wiping out the “inflationary gap,” ¹ This gap concept is our starting point.