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Inflation is about monetary policy

Summary:
I continue to see all sorts of non-monetary theories of inflation. For instance, “demographics” is often cited for the low inflation rate in Japan. There’s a much simpler explanation for inflation—monetary policy. The following graph shows the exchange rate for three European countries, Denmark, Switzerland and Sweden: During this period, the Danish krone (red line) was pegged to the euro.  This meant that the Danish central bank was not able to adopt an independent monetary policy.  The Swiss franc was also pegged to the euro until January 2015, at which time the Swiss National bank sharply revalued the franc upwards, which shows up as a lower SF price of dollars on the graph (blue line).  The Swedish Riksbank pursued a more expansionary monetary policy in order

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I continue to see all sorts of non-monetary theories of inflation. For instance, “demographics” is often cited for the low inflation rate in Japan. There’s a much simpler explanation for inflation—monetary policy.

The following graph shows the exchange rate for three European countries, Denmark, Switzerland and Sweden:

Inflation is about monetary policyDuring this period, the Danish krone (red line) was pegged to the euro.  This meant that the Danish central bank was not able to adopt an independent monetary policy.  The Swiss franc was also pegged to the euro until January 2015, at which time the Swiss National bank sharply revalued the franc upwards, which shows up as a lower SF price of dollars on the graph (blue line).  The Swedish Riksbank pursued a more expansionary monetary policy in order to push inflation up to their 2% target, and hence the Swedish krona (green line) depreciated substantially against the Danish krone (and also against the euro.)

As a result of these diverging monetary policies, Sweden’s price level (red line) rose faster than the Danish price level (blue line), while Switzerland (green line) experienced an even slower rate of increase:

Inflation is about monetary policy

Of course purchasing power parity does not always hold.  But in the long run, a policy that consistently depreciates a currency against another currency will generally leave the depreciating country with higher inflation.

Sweden’s expansionary monetary policy has returned its inflation rate to 2% over the past few of years, while Denmark and Switzerland continue to fall short:

Inflation is about monetary policy

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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