3. Law of Economics: Inflation Is Not Made of Money

By Jan Frederik Moos

If you’ve made it this far, you’ve already grasped two crucial insights. First, it’s not workers who price themselves out of employment. And second, the amount the private sector saves each year can be matched by government debt — not only without overheating the economy, but as a way to solve unemployment. Now, we’re entering more technical territory. Let’s look at how mainstream economists think about inflation. If you’ve understood that, you already know more than many economists who build mathematical models in their ivory towers — probably because, unlike them, you participate in the system every day like an ordinary person. To do this, we’ll focus on their basic model.

Think back to Farmer Brown. In this model, if spending rises (demand), his only response is to raise prices. At first it becomes apparent that the tomatoes are sold well before closing time, and the salesman edges towards the new equilibrium by raising prices until the higher equilibrium price is reached. He always produces the same number of tomatoes — the quantity never changes. That’s the mindset I want to prepare you for. Mainstream economists assume that businesses respond to increased demand not by producing more, but by raising prices. In their view, entrepeneurs are price-adjusters — not producers who react flexibly to demand.

But let’s pause and consider reality: aren’t there more cars today than fifty years ago? More computers? More goods of every kind? Clearly, businesses have responded to rising demand — not just with higher prices, but with more production. And that’s one of the fundamental problems in mainstream theory: it treats entrepreneurs as passive agents that only adjust prices, rather than as active producers who expand output when demand increases.

Mainstream theory, as we’ve seen, cannot account for rising production — unlike the approach presented here. And the good news is: you’ll also learn why prices rise. The explanation is intuitive, even obvious — yet economists have largely forgotten it. It’s about costs. But let’s now begin.

“The quantity theory of money, which lies at the heart of the doctrine of monetarism, holds only under the special assumptions that an economy is at full employment and the velocity of circulation of money is stable; otherwise, there will be no direct relation between the quantity of money and the price level.” (Thirlwall, A. P.: 1993).

The third economic law concerns the Quantity Theory of Money. Although the classical quantity theory of money has failed both theoretically and empirically, it continues to dominate textbooks and still shapes the rhetoric of central banks. The European Central Bank, for instance, formally refers to the Quantity Theory in its "two-pillar strategy". In practice, however, the doctrine never guided policy, since—as will become clear—it is neither operationally feasible nor empirically valid.

At the core lies a familiar equation:

M × V = P × Y

where M is the money supply, V the velocity of circulation, P the price level, and Y real GDP. The velocity of money (V) is a technical way to turn a stock of money into a flow of spending. Put simply, it answers the question: how many times is each euro spent in the economy per year? This is no more than an accounting identity: total nominal expenditure (M x V) on the left equals the value of goods and services (P x Y) sold on the right. By itself, the equation tells us nothing new. It is as trivial as noting that every euro spent corresponds to a euro received, or that the word count of a document equals that of its copy.

To transform the identity into a theory, monetarists imposed two key assumptions: that velocity (V) is constant, and that real output (Y) is fixed. Output is treated as fixed because money is assumed to be neutral (Davidson, P. 1994: 15). In this constructed world, the economy cannot expand production (Y) in response to rising spending (M x V). The theory, devised to defend liberal orthodoxy, reduces entrepreneurship to raising prices rather than meeting higher expenditure with higher output.

Under these assumptions, changes in M translate one-for-one into changes in P. As we saw in the previous chapter, the concept of effective demand provides an adequate modelling of the supply side (P x Y): entrepreneurs expand production (Y) when demand increases, and they do so at constant unit costs (P). The prerequisite for this, however, to make it clear once again, is that the economy is not at full employment, so entrepreneurs can increase output by raising capacity utilization and employment. Why prices then rise? That is an excellent question, and one that cannot be answered by the equation alone. It is a matter of costs, and we will come back to this in a moment.

The fundamental error — that money is not neutral — is now clear. Yet we should dig deeper, because the theory also proves useless in practice. It is riddled with deeper structural flaws. And since new variants of monetarism keep emerging, it must be made clear that none of these adjustments can repair the false foundation on which it is built. If you ask a post-Keynesian (a competent economist) what is wrong with it, you will encounter a range of inconsistencies rather than a single mistake. The task now is to uncover these flaws systematically.

First, modern central banks do not attempt to fix the money supply; they pursue interest rate targets. To achieve these, they must supply commercial banks with whatever central bank money is needed in the interbank market at the policy rate. The quantity of central bank money therefore adjusts flexibly, while the rate of interest remains the true operational target. This, dear readers, is highly technical territory. Yet the core idea is simple: the central bank must ensure that banks can respond flexibly to credit demand. Money is therefore the flexible variable, while the interest rate remains relatively stable. If money were not flexible, banks would have to ration credit, and they would do so by changing interest rates. Please note: An increase in central bank money is used for interest rate control and reshapes bank balance sheets; it does not lead to more money (bank deposits) in the economy.

The quantity of central bank money must therefore be flexible in order for the central bank to fulfil its core function. In fact, it is highly flexible and can change rapidly. Even after accounting for this institutional reality, no systematic relationship with inflation can be observed. This becomes evident when looking at a graph of the six largest economies. The shaded areas indicate the amount of central bank money — relative to GDP — that the Chinese, Japanese, European, British, Swiss, and U.S. central banks have provided to the banking sector. The curve shows the development of the inflation rate. In none of the countries can a relationship be identified.

Figure 1: Central Bank Money to GDP (left) and Inflation (right)

Second, the velocity of money is not constant. It fluctuates with the cyclical state of the economy, with central bank policies such as asset purchase programs, and with distributional trends. Increasing inequality, for instance, has contributed to a long-term decline in velocity, as a growing share of wealth is being parked in financial assets rather than spent on goods and services.

Third, entrepreneurs are not passive price setters in the face of higher expenditure. Before full employment is reached, they expand output and employment to meet rising demand. Money is not neutral, and treating it as such ignores the mechanisms through which capitalist economies actually adjust. Put simply: if Farmer Brown sees a line forming at his shop, he will supply more tomatoes.

This last point is decisive. (You now know that I belong to the fundamentalist strand of post-Keynesianism; the institutional post-Keynesians would probably have told you that the first two points are the decisive ones.) Post-Keynesian theory emphasises that entrepeneurs react to demand. Until full employment is reached, they expand production by hiring more workers and using idle capacity. Under conditions of constant labour productivity—an empirical regularity of advanced capitalist economies—additional employment does not reduce productivity and does not push prices upward. Simply put, the business sector produces more output (Y) at constant costs (P).

In addition, entrepreneurs do not simply raise prices to boost profits. The wage share is relatively stable, even if it tends to decline somewhat over time. This implies that entrepreneurs only increase prices when their costs actually rise. Instead, they respond by producing a larger number of units, at constant costs and with a constant profit margin. We will return to this point later, but for now, let us once again walk through what this really means.

Starting instead from rising expenditure (M × V) rather than from an increase in the money supply — and therefore correcting for the error of assuming a constant velocity of circulation — the conditions of constant unit costs and a stable wage share imply that higher output (Y) is produced at constant costs (P). When the wage share is constant, the profit mark-up remains constant as well. Combined with constant unit costs, this means that higher demand simply leads entrepreneurs to expand production at unchanged prices — no upward pressure on prices arises. This renders any new reconstructions of monetarism equally meaningless, and the explanation of price developments must be sought elsewhere.

Post-Keynesian analysis starts from a different premise: prices are determined by costs, and the key cost in any economy is labour. After all, in national income accounting, the only costs that actually flow into income in absolute terms are wages — a point Sydney Weintraub strongly emphasised. National income is divided into wages and profits, but wages account for around two-thirds of the total and are the main determinant of costs. Dividing the aggregate wage bill by real output yields unit labour costs, the decisive factor in cost and therefore price dynamics. Rising nominal wages are inflationary; rising productivity is deflationary, since the same wage is spread across more units of output. Long-run inflation is therefore governed by the path of unit labour costs, not by the quantity of money. To clarify: From a microeconomic perspective, there are, of course, other sources of cost. But at the macroeconomic level the picture is clear: money never flows to machines or raw materials; it flows only to people. Labour is therefore the sole cost factor.

The logic is straightforward. Every price paid is a flow of money to workers or to entrepeneurs. As productivity rises, more output is produced with the same input of labor (national wagebill), reducing costs per unit. When wages rise faster than productivity, unit costs increase and inflationary pressure builds. Put simply, inflation can be seen as wage growth minus productivity growth. At the heart of this lies the distributive struggle over national income: unions push for a larger share to flow into wages, while entrepeneurs seek to pass on as much as possible in higher prices without undermining sales. Stabilizing prices therefore depends on the outcome of this conflict over income shares, not on attempts to control the money supply.

Let’s return to a simple example. Imagine Farmer Brown, who faces an increase in demand for tomatoes. To meet this demand, he hires additional workers and expands production. He does not raise the price per tomato unless his labor costs rise. What really matters here is the wage cost per tomato. For instance, if his workers produce 10% more tomatoes while also receiving 10% higher wages, then the price per tomato stays exactly the same. In absolute terms, Farmer Brown increases his profit by selling more tomatoes, while in relative terms he keeps the markup per unit constant. If he were simply to raise prices, other tomato sellers would quickly undercut him and push him out of the market.

To conclude, let’s briefly look at some empirical evidence, using data provided by the ECB. The green line shows the inflation rate, measured here by the so-called GDP deflator, while the blue line represents unit labour costs. On the left-hand side you can see the Eurozone; on the right-hand side, the data for the United States. The clear correlation is obvious — and by now, you also understand the causal link behind it.

Figure 1: Inflation (green) and Unit Labour Costs (blue)

Let us restate the key point: the quantity theory of money was never valid. It rests on assumptions that do not hold in reality — the money supply is not controlled (1), the velocity of circulation is not constant (2), and even if all these errors were corrected, the money supply would still have no systematic influence on prices (3).

What truly matters are wage negotiations — wages are the most important price in the economy. Workers and entrepreneurs are engaged in a continuous tug of war over national income: when wages increase, a larger share goes to employees; when prices rise, a larger share flows to entrepreneurs; and then the process repeats.

It is this conflict that drives the dynamics of a capitalist economy. Within this framework, there is no trade-off between full employment and price stability — both can be achieved at the same time, provided that all parties act responsibly. The long-term trend, however, tells a different story: over the past decades, it has not been “greedy workers” but rather the entrepreneurial sector that has claimed an ever larger share of national income. The result has been a falling wage share (see Chapter 1).

Those wishing to explore inflation in more detail should turn to Stephanie Kelton’s The Deficit Myth, including the appendix. The book offers a genuinely macroeconomic perspective, which is particularly valuable when one keeps in mind that overheated sectors can also strengthen wage bargaining in other parts of the economy.

If you are interested in working with me as an editor or guest lecturer, interview guest or if you have any questions, please feel free to get in touch: mmtmitjan@gmx.de

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