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There are different schools of thought as to what causes inflation.
One of the most widespread theories of inflation is also the most straightforward: inflation is an increase in the supply or velocity of money at a rate greater than the expansion in the size of the economy. This is practically measured by comparing the GDP deflator to the rate of increase of the money supply, and setting the interest rate through the central bank to maintain a constant quantity of money. This view differs from the Austrian school below in that it focuses on a "quantity of money" theory, rather than the "quality of money" theory. In the monetarist framework, it is the aggregate money supply which is important.
The Quantity Theory of Money, simply stated is that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:
The quantity of money theory has been ennunciated repeatedly, and is the logic behind hard currency systems such as the gold standard and "tight money policies". However, its current form is attributed to Milton Friedman who coined the term "monetarism". The simple model takes the Money Supply, with particular attention to M1 (see money supply above) and sets a target for money supply growth that is equal to the increase in GDP. The simplest means of implementing this monetary demand model is the rule of setting the discount rate at 7.5 + GDP deflator - unemployment rate.
From this perspective, the root cause of inflation is an increase in money supply over demand for money, and therefore "inflation is always and everywhere a monetary phenomenon", as Friedman puts it. This means that controlling inflation rests on monetary and fiscal restraint: the government must neither make it too easy to borrow, nor must it borrow excessively itself. This view focuses on the importance of controlling central government budget deficits and interest rates, as well as the productivity of the economy, which is, in effect, "cost pull" inflation.
An example of a monetarist policy towards inflation is the current European Central Bank.
The Austrian economists claim that the only cause of inflation is the increase of the money supply relative to the output of the economy. 1 These economists outright reject the theories behind cost push inflation, wage push inflation and other common theories of inflation. From their perspective, the correct policy is not based on the total quantity of money, but to set a particular quality of money, a relationship between the MZM, that is "Money to Zero Maturity" and the growth of the economy. Because controlling the available immediately spendable currency is crucial to price stability in this view, economists who subscribe to this idea often advocate the return to a gold standard.
According to Neo- Keynesian economic theory there are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":
These three types of inflation can be added up at any time to get an explanation of the current inflation rate. However, over time, the first two (and the actual inflation rate) affect the amount of built-in inflation: persistently high (or low) actual inflation leads to higher (lower) built-in inflation.
Within the context of the triangle model, there are two main elements: movements along the Phillips Curve, for example as unemployment rates fall, encouraging greater inflation, and shifts of that curve, as when inflation rises or falls at a given unemployment rate.
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