As central banks fret over inflation, a small number of contrarian but influential economists are saying that the central bankers have it all wrong. They argue that by tightening interest rates the central banks are fighting the last war and that the real threat to the economy is, in fact, deflation. They foresee a large recession ahead that will lead to falling prices and living standards.
The economists who espouse these views are associated with the monetarist school, which came to prominence in the 1960s and 1970s through the work of Milton Friedman. The school teaches that inflation is caused by excess growth in money supply – the amount of currency and other liquid assets circulating in the economy. “Inflation,” Friedman famously wrote, “is always and everywhere a monetary phenomenon.”
The idea is simple enough. Monetarists believe that the money supply is controlled by central-bank policy. By flooding the banking system with monetary reserves, the central bank increases lending as these reserves are released as loans into the economy.
