Inflation

Inflation expectations or expected inflation is the rate of inflation that is anticipated for some period of time in the foreseeable future. There are two major approaches to modeling the formation of inflation expectations. Adaptive expectations models them as a weighted average of what was expected one period earlier and the actual rate of inflation that most recently occurred. Rational expectations models them as unbiased, in the sense that the expected inflation rate is not systematically above or systematically below the inflation rate that actually occurs.

A long-standing survey of inflation expectations is the University of Michigan survey.[37]

Inflation expectations affect the economy in several ways. They are more or less built into nominal interest rates, so that a rise (or fall) in the expected inflation rate will typically result in a rise (or fall) in nominal interest rates, giving a smaller effect if any on real interest rates. In addition, higher expected inflation tends to be built into the rate of wage increases, giving a smaller effect if any on the changes in real wages. Moreover, the response of inflationary expectations to monetary policy can influence the division of the effects of policy between inflation and unemployment (see Monetary policy credibility).

Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. For example, if the price of a can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price difference represents inflation. This single price change would not, however, represent general inflation in an overall economy. To measure overall inflation, the price change of a large "basket" of representative goods and services is measured. This is the purpose of a price index, which is the combined price of a "basket" of many goods and services. The combined price is the sum of the weighted prices of items in the "basket". A weighted price is calculated by multiplying the unit price of an item by the number of that item the average consumer purchases. Weighted pricing is a necessary means to measuring the impact of individual unit price changes on the economy's overall inflation. The Consumer Price Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price.[15] While comparing inflation measures for various periods one has to take into consideration the base effect as well.

Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Over time, adjustments are made to the type of goods and services selected to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time to keep pace with the changing marketplace. Different segments of the population may naturally consume different "baskets" of goods and services and may even experience different inflation rates. It is argued that companies have put more innovation into bringing down prices for wealthy families than for poor families.[41]

Inflation numbers are often seasonally adjusted to differentiate expected cyclical cost shifts. For example, home heating costs are expected to rise in colder months, and seasonal adjustments are often used when measuring for inflation to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical techniques to remove statistical noise and volatility of individual prices.

When looking at inflation, economic institutions may focus only on certain kinds of prices, or special indices, such as the core inflation index which is used by central banks to formulate monetary policy.[42]

Most inflation indices are calculated from weighted averages of selected price changes. This necessarily introduces distortion, and can lead to legitimate disputes about what the true inflation rate is. This problem can be overcome by including all available price changes in the calculation, and then choosing the median value.[43] In some other cases, governments may intentionally report false inflation rates; for instance, during the presidency of Cristina Kirchner (2007–2015) the government of Argentina was criticised for manipulating economic data, such as inflation and GDP figures, for political gain and to reduce payments on its inflation-indexed debt.[44][45]

Keynesian economics proposes that changes in the money supply do not directly affect prices in the short run, and that visible inflation is the result of demand pressures in the economy expressing themselves in prices.

There are three major sources of inflation, as part of what Robert J. Gordon calls the "triangle model":[47]

• Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation encourages economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
• Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Another example stems from unexpectedly high insured losses, either legitimate (catastrophes) or fraudulent (which might be particularly prevalent in times of recession). High inflation can prompt employees to demand rapid wage increases, to keep up with consumer prices. In the cost-push theory of inflation, rising wages in turn can help fuel inflation. In the case of collective bargaining, wage growth will be set as a function of inflationary expectations, which will be higher when inflation is high. This can cause a wage spiral.[48] In a sense, inflation begets further inflationary expectations, which beget further inflation.
• Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a feedback loop. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Demand-pull theory states that inflation accelerates when aggregate demand increases beyond the ability of the economy to produce (its potential output). Hence, any factor that increases aggregate demand can cause inflation.[49] However, in the long run, aggregate demand can be held above productive capacity only by increasing the quantity of money in circulation faster than the real growth rate of the economy. Another (although much less common) cause can be a rapid decline in the demand for money, as happened in Europe during the Black Death, or in the Japanese occupied territories just before the defeat of Japan in 1945.

The effect of money on inflation is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively. This sometimes leads to hyperinflation, a condition where prices can double in a month or less. The money supply is also thought to play a major role in determining moderate levels of inflation, although there are differences of opinion on how important it is. For example, monetarist economists believe that the link is very strong; Keynesian economists, by contrast, typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians, the money supply is only one determinant of aggregate demand.

Some Keynesian economists also disagree with the notion that central banks fully control the money supply, arguing that central banks have little control, since the money supply adapts to the demand for bank credit issued by commercial banks. This is known as the theory of endogenous money, and has been advocated strongly by post-Keynesians as far back as the 1960s. This position is not universally accepted – banks create money by making loans, but the aggregate volume of these loans diminishes as real interest rates increase. Thus, central banks can influence the money supply by making money cheaper or more expensive, thus increasing or decreasing its production.

A fundamental concept in inflation analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and employment. Therefore, some level of inflation could be considered desirable to minimize unemployment. The Phillips curve model described the U.S. experience well in the 1960s but failed to describe the stagflation experienced in the 1970s. Thus, modern macroeconomics describes inflation using a Phillips curve that is able to shift due to such matters as supply shocks and structural inflation. The former refers to such events like the 1973 oil crisis, while the latter refers to the price/wage spiral and inflationary expectations implying that inflation is the new normal. Thus, the Phillips curve represents only the demand-pull component of the triangle model.

Another concept of note is the potential output (sometimes called the "natural gross domestic product"), a level of GDP, where the economy is at its optimal level of production given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.[50]

However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under British Prime Minister Margaret Thatcher might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed, unable to find jobs that fit their skills. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.

A connection between inflation and unemployment has been drawn since the emergence of large scale unemployment in the 19th century, and connections continue to be drawn today. However, the unemployment rate generally only affects inflation in the short-term but not the long-term.[51] In the long term, the velocity of money is far more predictive of inflation than low unemployment.[52]

In Marxian economics, the unemployed serve as a reserve army of labor, which restrain wage inflation. In the 20th century, similar concepts in Keynesian economics include the NAIRU (Non-Accelerating Inflation Rate of Unemployment) and the Phillips curve.

Inflation and the growth of money supply (M2)

Monetarists believe the most significant factor influencing inflation or deflation is how fast the money supply grows or shrinks. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation.[53] The monetarist economist Milton Friedman famously stated, "Inflation is always and everywhere a monetary phenomenon."[54]

Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that any change in the amount of money in a system will change the price level. This theory begins with the equation of exchange:

${\displaystyle MV=PQ}$

where

${\displaystyle M}$ is the nominal quantity of money;

${\displaystyle V}$ is the velocity of money in final expenditures;

${\displaystyle P}$ is the general price level;

${\displaystyle Q}$ is an index of the real value of final expenditures;

In this formula, the general price level is related to the level of real economic activity (Q), the quantity of money (M) and the velocity of money (V). The formula is an identity because the velocity of money (V) is defined to be the ratio of final nominal expenditure (${\displaystyle PQ}$) to the quantity of money (M).

Monetarists assume that the velocity of money is unaffected by monetary policy (at least in the long run), and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With exogenous velocity (that is, velocity being determined externally and not being influenced by monetary policy), the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not exogenous in the short run, and so the formula does not necessarily imply a stable short-run relationship between the money supply and nominal output. However, in the long run, changes in velocity are assumed to be determined by the evolution of the payments mechanism. If velocity is relatively unaffected by monetary policy, the long-run rate of increase in prices (the inflation rate) is equal to the long-run growth rate of the money supply plus the exogenous long-run rate of velocity growth minus the long run growth rate of real output.[10]

If economic growth matches the growth of the money supply, inflation should not occur when all else is equal.[55] A large variety of factors can affect the rate of both. For example, investment in market production, infrastructure, education, and preventive health care can all grow an economy in greater amounts than the investment spending.[56][57]

Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.

A core assertion of rational expectations theory is that actors will seek to "head off" central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or economic actors will make bets that the central bank will expand the money supply rapidly enough to prevent recession, even at the expense of exacerbating inflation. Thus, if a central bank has a reputation as being "soft" on inflation, when it announces a new policy of fighting inflation with restrictive monetary growth economic agents will not believe that the policy will persist; their inflationary expectations will remain high, and so will inflation. On the other hand, if the central bank has a reputation of being "tough" on inflation, then such a policy announcement will be believed and inflationary expectations will come down rapidly, thus allowing inflation itself to come down rapidly with minimal economic disruption.

There are also other theories about inflation that are no longer accepted by mainstream economists.

The Austrian School stresses that inflation is not uniform over all assets, goods, and services. Inflation depends on differences in markets and on where newly created money and credit enter the economy. Ludwig von Mises said that inflation should refer to an increase in the quantity of money that is not offset by a corresponding increase in the need for money, and that price inflation will necessarily follow.[58][59]

The real bills doctrine asserts that banks should issue their money in exchange for short-term real bills of adequate value. As long as banks only issue a dollar in exchange for assets worth at least a dollar, the issuing bank's assets will naturally move in step with its issuance of money, and the money will hold its value. Should the bank fail to get or maintain assets of adequate value, then the bank's money will lose value, just as any financial security will lose value if its asset backing diminishes. The real bills doctrine (also known as the backing theory) thus asserts that inflation results when money outruns its issuer's assets. The quantity theory of money, in contrast, claims that inflation results when money outruns the economy's production of goods.

Currency and banking schools of economics argue the RBD, that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the 19th century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as currency boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of the Federal Reserve going so far as to say it had been "completely discredited."

The debate between currency, or quantity theory, and the banking schools during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century, the banking schools had greater influence in policy in the United States and Great Britain, while the currency schools had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.

In 2019 monetary historians Thomas M. Humphrey and Richard H. Timberlake published "Gold, the Real Bills Doctrine, and the Fed: Sources of Monetary Disorder 1922-1938".[60]

Inflation is the decrease in the purchasing power of a currency. That is, when the general level of prices rise, each monetary unit can buy fewer goods and services in aggregate. The impact of inflation differs on different sectors of the economy, with some sectors being adversely impacted while others benefitting. For example, with inflation, those segments in society which own physical assets, such as property, stock etc., benefit from the price/value of their holdings going up, when those who seek to acquire them will need to pay more for them. Their ability to do so will depend on the degree to which their income is fixed. For example, increases in payments to workers and pensioners often lag behind inflation, and for some people income is fixed. Also, individuals or institutions with cash assets will experience a decline in the purchasing power of the cash. Increases in the price level (inflation) erode the real value of money (the functional currency) and other items with an underlying monetary nature.

Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the inflation rate. The formula R = N-I approximates the correct answer as long as both the nominal interest rate and the inflation rate are small. The correct equation is r = n/i where r, n and i are expressed as ratios (e.g. 1.2 for +20%, 0.8 for −20%). As an example, when the inflation rate is 3%, a loan with a nominal interest rate of 5% would have a real interest rate of approximately 2% (in fact, it's 1.94%). Any unexpected increase in the inflation rate would decrease the real interest rate. Banks and other lenders adjust for this inflation risk either by including an inflation risk premium to fixed interest rate loans, or lending at an adjustable rate.

High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services to focus on profit and losses from currency inflation.[15] Uncertainty about the future purchasing power of money discourages investment and saving.[61] Inflation can also impose hidden tax increases. For instance, inflated earnings push taxpayers into higher income tax rates unless the tax brackets are indexed to inflation.

With high inflation, purchasing power is redistributed from those on fixed nominal incomes, such as some pensioners whose pensions are not indexed to the price level, towards those with variable incomes whose earnings may better keep pace with the inflation.[15] This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, higher inflation in one economy than another will cause the first economy's exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.

Hoarding

People buy durable and/or non-perishable commodities and other goods as stores of wealth, to avoid the losses expected from the declining purchasing power of money, creating shortages of the hoarded goods.

Social unrest and revolts

Inflation can lead to massive demonstrations and revolutions. For example, inflation and in particular food inflation is considered as one of the main reasons that caused the 2010–11 Tunisian revolution[62] and the 2011 Egyptian revolution,[63] according to many observers including Robert Zoellick,[64] president of the World Bank. Tunisian president Zine El Abidine Ben Ali was ousted, Egyptian President Hosni Mubarak was also ousted after only 18 days of demonstrations, and protests soon spread in many countries of North Africa and Middle East.

Hyperinflation

If inflation becomes too high, it can cause people to severely curtail their use of the currency, leading to an acceleration in the inflation rate. High and accelerating inflation grossly interferes with the normal workings of the economy, hurting its ability to supply goods. Hyperinflation can lead to the abandonment of the use of the country's currency (for example as in North Korea) leading to the adoption of an external currency (dollarization).[65]

Allocative efficiency

A change in the supply or demand for a good will normally cause its relative price to change, signaling the buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, price changes due to genuine relative price signals are difficult to distinguish from price changes due to general inflation, so agents are slow to respond to them. The result is a loss of allocative efficiency.

Shoe leather cost

High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed to carry out transactions this means that more "trips to the bank" are necessary to make withdrawals, proverbially wearing out the "shoe leather" with each trip.

Menu costs

With high inflation, firms must change their prices often to keep up with economy-wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly, as with the extra time and effort needed to change prices constantly.

Labour-market adjustments

Nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation allows real wages to fall even if nominal wages are kept constant, moderate inflation enables labor markets to reach equilibrium faster.[66]

Room to maneuver

The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations, which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) to stimulate the economy – this situation is known as a liquidity trap.

Mundell–Tobin effect

The Nobel laureate Robert Mundell noted that moderate inflation would induce savers to substitute lending for some money holding as a means to finance future spending. That substitution would cause market clearing real interest rates to fall.[67] The lower real rate of interest would induce more borrowing to finance investment. In a similar vein, Nobel laureate James Tobin noted that such inflation would cause businesses to substitute investment in physical capital (plant, equipment, and inventories) for money balances in their asset portfolios. That substitution would mean choosing the making of investments with lower rates of real return. (The rates of return are lower because the investments with higher rates of return were already being made before.)[68] The two related effects are known as the Mundell–Tobin effect. Unless the economy is already overinvesting according to models of economic growth theory, that extra investment resulting from the effect would be seen as positive.

Instability with deflation

Economist S.C. Tsiang noted that once substantial deflation is expected, two important effects will appear; both a result of money holding substituting for lending as a vehicle for saving.[69] The first was that continually falling prices and the resulting incentive to hoard money will cause instability resulting from the likely increasing fear, while money hoards grow in value, that the value of those hoards are at risk, as people realize that a movement to trade those money hoards for real goods and assets will quickly drive those prices up. Any movement to spend those hoards "once started would become a tremendous avalanche, which could rampage for a long time before it would spend itself."[70] Thus, a regime of long-term deflation is likely to be interrupted by periodic spikes of rapid inflation and consequent real economic disruptions. Moderate and stable inflation would avoid such a seesawing of price movements.

The second effect noted by Tsiang is that when savers have substituted money holding for lending on financial markets, the role of those markets in channeling savings into investment is undermined. With nominal interest rates driven to zero, or near zero, from the competition with a high return money asset, there would be no price mechanism in whatever is left of those markets. With financial markets effectively euthanized, the remaining goods and physical asset prices would move in perverse directions. For example, an increased desire to save could not push interest rates further down (and thereby stimulate investment) but would instead cause additional money hoarding, driving consumer prices further down and making investment in consumer goods production thereby less attractive. Moderate inflation, once its expectation is incorporated into nominal interest rates, would give those interest rates room to go both up and down in response to shifting investment opportunities, or savers' preferences, and thus allow financial markets to function in a more normal fashion.

Although both fiscal and monetary policy can affect inflation, ever since the 1980s, most countries primarily rely on monetary policy to control inflation. When inflation beyond an acceptable level is taking place, the country's central bank can increase the interest rate, which typically will tend to slow or stop the growth of the money supply. Some central banks have a symmetrical inflation target while others only control inflation when it rises above a threshold, whether publicly disclosed or not.

In the 21st century, most economists favor a low and steady rate of inflation. In most countries, central banks or other monetary authorities are tasked with keeping their interbank lending rates at low stable levels, and the target inflation rate of about 2% to 3%. Central banks target a low inflation rate because they believe that high inflation is economically costly because it would create uncertainty about differences in relative prices and about the inflation rate itself. A low positive inflation rate is targeted rather than a zero or negative one because the latter could cause or worsen recessions;[13] low (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary policy from stabilizing the economy.[14]

Higher interest rates reduce the economy's money supply because fewer people seek loans. When banks make loans, the loan proceeds are generally deposited in bank accounts that are part of the money supply. Therefore, when a person pays back a loan and no other loans are made to replace it, the amount of bank deposits and hence the money supply decrease. For example, in the early 1980s, when the federal funds rate exceeded 15%, the quantity of Federal Reserve dollars fell 8.1%, from US$8.6 trillion down to $7.9 trillion.

In the latter part of the 20th century, there was a debate between Keynesians and monetarists about the appropriate instrument to use to control inflation. Monetarists emphasize a low and steady growth rate of the money supply, while the Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy (increased taxation or reduced government spending to reduce demand).

A variety of other methods and policies have been proposed and used to control inflation. The inflationary nature of fiat systems provides a potential large market opportunity for new technologies such as blockchain-based solutions that mitigate or even solve for the erosion in purchasing power. These systems may take on the form of simple fiat pegs immediately available for credit markets, or more sophisticated systaes that avoid inflationary products entirely, swapping one asset presentation for another — similar to commodity-backed currencies of the past.[71]

Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability.

Under the Bretton Woods agreement, most countries around the world had currencies that were fixed to the U.S. dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attacks. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e.g. Argentina (1991–2002), Bolivia, Brazil, and Chile).

Two 20 krona gold coins from the Scandinavian Monetary Union, a historical example of an international gold standard

The gold standard is a monetary system in which a region's common medium of exchange is paper notes (or other monetary token) that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver.

The gold standard was partially abandoned via the international adoption of the Bretton Woods system. Under this system all other major currencies were tied at fixed rates to the US dollar, which itself was tied by the US government to gold at the rate of US$35 per ounce. The Bretton Woods system broke down in 1971, causing most countries to switch to fiat money – money backed only by the laws of the country.

Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output.[72] Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining.[73][74]

Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands.

In general, wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.

Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed (see creative destruction).