A Theory of Inflation

Jack L. Treynor

Volume 1, Number 1, First Quarter 2003

Inflation entails a loop running from prices to wages and back again from wages to prices. Change in inflation rates result from two types of intervention in that otherwise closed loop. Inflation surprise intervenes when the labor productivity of the marginal plant, hence the real wage, turns out different from what negotiators expected when they fixed the money wage. The second kind of intervention is quite predictable. Although changes in tradables prices affect money wages, changes in money wages don’t affect tradables prices. The practical result is that the tradables inflation rate affects the home goods inflation rate, but not vice versa. In small, open economies, the predictable tradables effect is more important. In large, closed economies, the effect of real wage surprise on home goods price, is more important. In the many countries somewhere between the extremes, both inflation mechanisms are too important to ignore.