Dynamic Macroeconomics

1.3.3 Trends and Fluctuations in the Price Level and Inflation
A third key macroeconomic variable that concerns both the general public
and policymakers is the price level, and its rate of change, the rate of
inflation. The price level and its rate of change is what determines the

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purchasing power of money incomes. 
Figures 1.8
and 
1.9
depict the
evolution of the price level in the United States and the United Kingdom,
respectively, as measured by the index of consumer prices, while 
figures
1.10
 and 
1.11
 depict the evolution of inflation.
Figure 1.8
Evolution of the price level in the United States (shaded areas indicate recessions).
Figure 1.9
Evolution of the price level in the United Kingdom (shaded areas indicate recessions).

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Figure 1.10
Evolution of consumer price index(CPI) inflation in the United States (shaded areas indicate
recessions).
Figure 1.11
Evolution of CPI inflation in the United Kingdom (shaded areas indicate recessions).
Some interesting facts emerge from these figures with regard to the
evolution of the price level and inflation.
The first fact is that before World War II, the price level did not display a
marked upward trend, as it did after World War II. If anything, there were

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long periods of a falling price level, both during the gold standard period and
in the interwar years. Inflation was a temporary phenomenon, associated with
wars, such as the American Civil War of 1861–1865, World War I, or
periods of economic boom. In contrast, the price level tended to fall during
recessions, which were thus also periods of deflation.
Average annual inflation during 1854–1913 was only 0.6% in the United
States, and average annual inflation during 1821–1913 in the United
Kingdom was negative, −0.2% (
figures 1.10
 and 
1.11
). The price level in the
United Kingdom was on a slightly negative trend until World War I. Had it
not been for the American Civil War, the United States would probably also
have been characterized by falling prices.
During the American Civil War, US inflation averaged approximately
15% per year, with peak inflation rates of about 25% in both 1863 and 1864.
During World War I, average annual inflation was equal to 9.7% in the
United States and to 15.3% in the United Kingdom.
During the interwar period (1919–1939), deflation occurred in both
countries. Prices in the United States were falling by 0.2% per year on
average, whereas prices in the United Kingdom were falling by 0.9% per
year on average.
As can be seen from 
figures 1.8–1.11
, after World War II, the price level
displays a significant positive trend in both the United States and the United
Kingdom. Average inflation has been positive and periodically high in both
countries throughout the post–World War II period.
In addition, the negative impact of recessions on the price level and
inflation, which was a regular characteristic of the pre–World War II period,
does not seem to hold as firmly in the postwar period. The recessions of the
1970s and the early 1980s are associated with an increase rather than a
decrease in inflation, a phenomenon that has been described as stagflation.
What stands out when trying to explain the long-run trends of the price
level and inflation is (1) the very high correlation of inflation and the rate of
growth of the money supply and (2) the total lack of correlation of economic
growth and the growth of the money supply.
Figure 1.12
 shows the close correlation between inflation and the rate of
growth of the money supply, as measured by a broad measure of the money
stock (M2) in 110 countries, for 1960–1990. The correlation coefficient is
equal to 0.95. In 
figure 1.13
, one can see the complete absence of any

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correlation between the growth rate of real GDP and the rate of growth of the
money supply. The correlation coefficient is −0.014 and is not statistically
significant.