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In 1970 the New York Times cost 15 cents, the median price of a single-family
home was $23,400, and the average wage in manufacturing was $3.36 per hour.
In 2000 the Times cost 75 cents, the price of a home was $166,000, and the average
wage was $14.26 per hour.This overall increase in prices is called inflation,
and it is the subject of this chapter.
The rate of inflation—the percentage change in the overall level of prices—
varies greatly over time and across countries. In the United States, according to
the consumer price index, prices rose an average of 2.4 percent per year in the
1960s, 7.1 percent per year in the 1970s, 5.5 percent per year in the 1980s, and
3.0 percent in the 1990s. Even when the U.S inflation problem became severe
during the 1970s, it was nothing compared to the episodes of extraordinarily
high inflation, called hyperinflation, that other countries have experienced
from time to time.A classic example is Germany in 1923, when prices rose an
average of 500 percent per month.
In this chapter we examine the classical theory of the causes, effects, and social
costs of inflation.The theory is “classical” in the sense that it assumes that prices
are flexible. As we first discussed in Chapter 1, most economists believe this assumption
describes the behavior of the economy in the long run. By contrast,
many prices are thought to be sticky in the short run, and beginning in Chapter
9, we incorporate this fact into our analysis.Yet, for now, we ignore short-run
price stickiness.As we will see, the classical theory of inflation not only provides
a good description of the long run, it also provides a useful foundation for the
short- ...