NATURAL ECONOMIC THEORY

INFLATION:
ORIGIN AND GLOBAL DYNAMICS

NATURAL ECONOMIC THEORY

NEW GENERAL THEORY OF ECONOMICS,
POSITIVE IN NATURE AND GLOBAL IN SCOPE

GONZALO PÉREZ-SEOANE

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 NATURAL ECONOMIC THEORY

NATURAL ECONOMIC THEORY (NAT)

This document reproduces, with permission of the publisher, Chapter XIV of the book: "Natural
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CHAPTER XIV

INFLATION:
ORIGIN AND GLOBAL DYNAMICS

I. THEORETICAL APPROACH

“There is no single type of inflation. Like diseases, it originates for different reasons”,
(Samuelson, Nordhaus1).

The Natural theory, while having points in common on the origin of inflation with the
Neoclassical and Austrian schools, proposes a new hypothesis. It can be summarized as
being the opposite to the Marginalist school’s hypothesis on inflation. This new
hypothesis expands on the theory of cost-push inflation.

If the functioning of the economy adjusts to the cost of production theory of value
(Smith), the economy, in the end, is a huge price system. Of all the prices in the
economy there are three special ones, the prices of the basic economic markets: i)
wages, ii) interest rates, and iii) the price of non-renewable natural resources (NRRs).
The variation of these prices, contrary to other prices, affects the entire value chain of
the economy, or the price system as a whole. Thus, according to our hypothesis,
inflation would be: the generalized and constant increase in prices rising from the
variation in the prices of the three basic economic elements. Thus we can speak of : i)
wage inflation, ii) interest rate inflation and iii) NRR price inflation.

The three kinds of inflation have velocities and signals that are not identical in time.
The general index of consumer prices, and its variations, is the sum of the three kinds of
inflation, after passing through the entire value chain of the economy. This new
definition of inflation allows a unified theoretical approach to the origin of inflation
and, its empirical demonstration.

1
SAMUELSON, P.; NORDHAUS, W.; (1996); “Economía”, McGraw Hill, p.596.

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II. THE ORIGINS OF INFLATION

I. WAGE INFLATION

What increases the labor cost per employee? In the labor market, along with the natural
variation of wages derived from the spontaneous value system, there are two relevant
exogenous factors: i) the government's labor policy and ii) union action.

Indexing salaries to inflation, rigid collective agreements, the increase in the cost of
social security and other social contributions associated with labor, are actions that,
among others, increase the labor cost per employee. The increase in the wage cost raises
the production cost and, as a result, the price. However, at the same time, the labor force
gives rise to productivity, which affects prices in the opposite way to that mentioned
above. The final wage inflation that permeates the economy is the difference between
these two opposing forces. The empirical evidence below shows that if productivity
grows above the aggregate wage increase, then wage inflation will fall and vice versa.
The evidence confirms, from a different theoretical perspective, Keynes’cost-push
inflation.

II. INTEREST RATE INFLATION

As was discussed in the Natural Theory of Money, the supply of money is endogenous
and the interest rate is exogenous.

If the monetary horizontalism hypothesis is true and if the economy functions according
to the cost of production theory of value, the variation in time of interest rates acquires
a dimension which has been unexpected up to the present. Variations in the cost of
money, money being a basic economic element, will affect the entire value chain of the
economy, or, in other words, interest rates produce inflation. The empirical evidence
below shows that raising the effective interest rate of the economy (the weighted
average of the cost of money) will increase interest rate inflation and vice versa.

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The proposed hypothesis, opens the way to three interesting considerations:

i. Interest rates are underlying variables of inflation. The generation of interest rate
inflation is linked to the variation over time of the underlying variables of the interest
rates, or monetary policy on: i) the neutral rate (inflation expectation), ii) intrinsic risk
and iii) sovereign risk. Thus, for example, in a scenario of low intrinsic and sovereign
risk, it is the central bank's policy on the neutral rate that directs the process of creating
interest rate inflation (ceteris paribus wages and prices of NRRs). If the neutral rate does
not move or it moves slowly in the scenario described, the economy’s effective interest
rate will remain stable, producing little or no interest rate inflation (Japan, USA and
some EMU countries, at the present time or recently).

ii. Quantitative theory of money. This theory is one of the oldest and most enduring of
economic thought. It began with Bodin (1568), Azpilicueta (1556) and Hume (1739).
Its status as a monetary axiom continues to this day thanks to Fisher (Fisher's equation
of exchange), Friedman and the Chicago Monetarist School.

The quantitative theory raises the hypothesis of a close functional relationship between
the volume of money supply and general level of prices. However, in recent situations
of quantitative expansion, the observed effect is the opposite. Summers commented
after the Subprime crisis: “In my opinion, the quantitative expansion is less effective for
the real economy than what most people suppose (...) if the quantitative expansion does
not have a great effect on the [aggregate] demand, it will not have a big effect on
inflation either”2. What Summers' observed at a global level is not new. This
consideration was previously expressed in similar terms by Stiglitz and studied in a
profound and brilliant way by Krugman and Bernanke3. The latter economists
associated the disruption or ineffectiveness of the expansive monetary policy with

2
SUMMERS, L.; (2013); Drobny Global Conference, Santa Monica (Financial Times), April 3
3
BERNANKE, B., S.; (1999); “Japanese Monetary Policy: A Case of Self-Induced Paralysis?, Presentation
at the ASSA meetings, Boston MA, January 9, 2000, Princeton University
BERNANKE, B, S.; (2002); “Deflation: Making Sure “It” Doesn’t Happen Here,” Remarks before the
National Economists Club,
BERNANKE, B. S.; (2009); “The Crisis and the Policy Response”, Remarks at the Stamp Lecture, London
School of Economics

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Keynes’ liquidity trap (as in the case of Japan). For the Natural theory the quantitative
theory is true in a gold standard system ("price revolution", XVI century), but it is
ineffective in explaining the current monetary system.

iii. Gibson´s paradox. In 1923 Gibson observed that long term nominal interest rates
and the general price index (CPI) were highly correlated in a positive manner for long
periods of economic history. The reality is that the evidence4 found by Gibson (or
Tooke) contradicts the predictions of classical monetary theory. The quantitative theory
established that a slow growth in the money supply led to a slow growth in the price
level. On the other hand, the slow growth in the money supply generated a slow growth
of loanable funds and, thus, an increase in the interest rate. Gibson's evidence showed
exactly the opposite of what was affirmed: as the general price index decreased, the
interest rate decreased, and vice versa.

In 1930 Keynes claimed that Gibson's evidence was "one of the most thoroughly tested
empirical facts in the entire field of quantitative economics”5, and he called the
theoretical anomaly the “Gibson paradox”. The Gibson paradox has been studied by
countless economists, although, "the Gibson paradox continues to be an economic
phenomenon without theoretical explanation", (Friedman, Schwartz6). Fisher
commented: "No problem in the economy has been debated so heatedly“7. To date,
Gibson's paradox remains a mystery of Economic Science.

For the Natural theory, Gibson’s evidence ratifies the validity in the economy of interest
rate inflation. Nonetheless, it is advisable to make three considerations that complete
our understanding of Gibson's evidence.

Interest rate inflation varies by reason of:

i. the underlying variables of interest rates (Natural Theory of Money).

ii. The level and composition of total national debt (the higher the total national
debt, the higher the inflationary impact, and vice versa; the higher the percentage
of foreign debt in hard currency, the greater the impact, and vice versa) (Mexico,
1982);

iii. The monetary system. In the gold standard system, the variation in the general
price index will be positive and very close to the long-term sovereign debt yield,
(Gibson’s evidence). In the fiduciary monetary system with full exchange freedom,
the creation of interest rate inflation is equally true, However, Gibson's evidence
is more difficult to observe because the significant economic inflation is not
domestic inflation but differential inflation. In addition, it should be taken into
consideration that the variation in the economy’s prices is the sum result of three
different inflations.

4
GIBSON, A.H., (1923), “The Future Course of High Class Investment Values”, Bankers Mag., 115.
5
KEYNES, J.M., (1930), “The Treatise of Money” , Vol.2, p.198
6
FRIEDMAN, M.; SCHWARTZ, A.; (1976), “From Gibson to Fisher”. Explorations in Economic Research
NBER vol. 3,2 (Spring)
7
FISHER, I., (1930), “The Theory of Interest”

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III. BANKING INFLATION

The hypothesis of banking inflation is old. The hypothesis is different to but not far
removed from the quantitative theory of money. As is well known, among many other
economists and institutions, this hypothesis was sustained by: Rothbard, Wicksell,
Fisher (“100% reserve system”), University of Chicago 1937 ("Chicago Proposal"),
decisions of the Federal Reserve Committee in 19378 (...).

Surprisingly, simple empirical evidenceN shows the opposite to the hypothesis of

banking inflation. It seriously questions the opinions expressed by exceptional
economists and academic and monetary institutions during the Great Depression of
1929 and later years. Were these economists and institutions wrong? The empirical
evidence below, which has been chosen intentionally from among other possible
evidence pointing in the same direction (the natural equation of exchange), shows that
if the interest rate of the economy increases, the effective money supply will increase,
and vice versa.

How can this evidence be interpreted?

i. Interest rates and the banking money supply. The banking money supply (effective
money supply) depends on the level of interest rates. The banking money supply will
increase when the interest rate (and risk) is attractive for the brokerage business
between the active and passive banking rate, and vice versa. More specifically, the
banking money supply is adjusted to the functioning of the entire economy, or to the
relationship between the interest rate and the expected rate of real return on assets
(ROA), (Keynes).

ii. Keynes’ “liquidity trap”. The evidence of the years of negative effective money
supply correspond to the years of crisis (2009, 2010). It shows that while there was a
strong monetary expansion, forcing the fall of interest rates in the short and long term,
(beginning with the QE, November, 2008), the banking money supply contracted
severely. This evidence, without clarifying whether there is a relationship between

8
FEINMAN, J.; (1993); “Reserve Requirements: History, Current Practice, and Potential Reform”,
Federal Reserve Bulletin, (June)
N
The data of the annual variation of the credit portfolio of the US banking system ("Total Loans and
Leases") for the period 1983 to 2016, and the annual US inflation rate (or its variation) for said period,
show that there is no relationship between both variables.

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banking activity and inflation, encourages us to consider, as did Krugman and

Bernanke, that Keynes’ “liquidity trap” is mainly a bank effect.

In periods of crises, an expansive monetary policy has a well-known double formal

objective: i) to force the reference interest rates to fall and ii) to guarantee the liquidity
of the government, banking and productive sectors. In order to bring down interest
rates, the central bank will use a substantial part of the QE in the partial nationalization
of the yield curve (mainly short-term and long-term public debt, three months and ten
years). This is a sound monetary action after a crisis. This monetary action will have
three deep seated effects.

The extension of Keynes’ economic cycle hypothesis. According to the Natural theory,
this is the heart of the functioning of the current free market economy. Monetary
expansion will force the reduction of the effective interest rate of the economy, leading
to the recovery of the expected rate of real return on assets (ROA). This will promote
rapid economic recovery.

Intrinsic monetary risk and sovereign risk. The above monetary action will prevent the
appearance of the intrinsic monetary risk and the sovereign risk. This is a relevant
aspect which will be discussed later.

Crowding out effect of bank liquidity in the productive system. After a crisis, the
banking sector, due to endogenous reasons (crisis in the sector), or to exogenous
reasons (low interest rates and the economy’s depleted and unstable payment capacity)
will remain inactive. This will produce mild or severe banking propensity to the
liquidity and, with it, the crowding out effect to the productive system. The final
consequence of the paralysis of the effective money supply will be the low effect of the
quantitative expansion on aggregate demand, as Summers mentioned. Keynes “liquidity
trap” arises: i) from the crowding out effect of bank liquidity in the productive system,
and ii) from the effect of retraction of expectations of business profitability. The
banking sector’s propensity to liquidity is the main cause in the obstruction of the policy
of monetary expansion.

Thus, from what we have shown, it is not possible to maintain that there is a
relationship between the banking money supply and the creation of inflation in normal
or exceptional economic situations (QE policy).

But, is this always the case? What happens if a systemic banking crisis starts and the
interbank interest rate suddenly increases? The increase in the interbank interest rate
will increase the intrinsic monetary risk, affecting the interest rate of the economy,
which will result in the rapid increase of interest rate inflation. In other words, for bank
inflation to exist there must be banking risk (liquidity, solvency, or systemic that are not
controlled by the Central Bank). This consideration, although it originates from a new
theoretical perspective, converges with the conclusions of Fisher, the Chicago School,
the Federal Reserve (1937) and the Austrian School, after the Great Depression of 1929.

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IV. FISHER INFLATION

The variation in the free exchange rate is the first step on the natural path by which the
monetary standards are adjusted in terms of relative value. The adjustment between
monetary standards is completed with the variation of the long-term reference interest
rate in an inverse manner to the exchange rate variation, or the brilliant Fisher open
hypothesis.

The process described, curiously, does not end with the monetary system, it transcends
the productive system and, thus, the price system. When the currency is devalued, the
long-term interest rate will increase, causing a gradual increase in the interest rate of the
economy, creating interest rate inflation, and vice versa. In the end, the adjustment
between monetary standards will induce, internally, the adjustment between the relative
prices of the productive systems.

A sudden variation in the exchange rate parity can have multiple origins, such as:
competitive devaluations by governments, massive capital flight for various reasons, a
sudden change in sovereign risk as a result of the increase in the current or expected
fiscal deficit, the level of national indebtedness or excessive public debt (...). In all these
cases, Fisher inflation will be activated. This unique interest rate inflation has been
called Fisher inflation, because it is linked to the adjustment between monetary
standards, a situation described and resolved exceptionally by Fisher.

V. NRR SUPPLY AND DEMAND INFLATION

i. NRR supply and demand inflation. The quantity supplied of a given NRR may drop
precipitously if there are conflicts, or extreme natural phenomena near relevant deposits,
causing the price to rise and thus the NRR supply inflation. In addition, in the situation
described, if the uncertainty about the future supply is high, this situation may induce
financial speculation, temporarily increasing demand above the normal market
equilibrium, which will push the price up again , creating NRR demand inflation.

ii. Structural NRR inflation. As with wages, any action that increases the final market
price of an NRR (such as taxes) in an artificial manner will promptly produce structural
inflation.

VI. COLLAPSE INFLATION

Extreme inflation or collapse inflation, is the result: of the production collapse,

monetary collapse or market collapse of an NRR. A production collapse occurred in
Venezuela in 2015-2016, a monetary collapse occurred in the Weimar Republic in
1921-1922, and the situation provoked by the OPEC in 1970 is an example of the
market collapse of an NRR. There is an strong connection between the first two types of
collapse inflation.

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III. THE DOMESTIC DYNAMICS OF INFLATION

I. PHILLIPS CURVE

The pragmatic importance of the Phillips curve9, or the negative correlation between the
rate of unemployment and wage variation (inflation), has been remarkable since its
appearance in 1958. Solitary voices, such as those of Friedman and Phelps10, at the time
questioned overall Keynesian opinion on the issue, or the opinions of Samuelson and
Solow11. As Friedman said in (1976): "In recent years higher inflation has often been
accompanied by higher and not lower unemployment (...) A simple statistical Phillips
curve for such periods seems to be a positive, not a vertical slope”12.

In fact, the appearance of stagflation, high inflation and unemployment, opened a

wound, which has never been healed, in the traditional theory on the Phillips curve.
Phillips' empirical evidence is much more than a statistical coincidence, as numerous
subsequent studies confirm (Hussman13). The central question in this intense and
divisive debate is: why does the Phillips curve have a positive and negative slope?

II. OKUNS´S LAW

Okun's law (Okun´s evidence14) establishes that starting from a certain rate of economic
growth the unemployment rate will decrease, and vice versa. From the academic
perspective, Okun's law is considered as isolated evidence. It is not reflected in or does
it have a connection to any theory. This unique situation remains unresolved at the
present time.

III. DOMESTIC DYNAMICS OF INFLATION

For the Natural theory, Phillips’evidence and Okun’s evidence are part of the same
economic phenomenon, they are an integral part of the domestic dynamics of inflation.
The synthesis below reflects the opinion of the Natural theory.

9
PHILLIPS, W.; (1958); “The relation between Unemployment and the Rate of Change of Money Wage
Rates in the United Kingdom, 1851-1957”, Económica, n.s., 25, no. 2: 283–299
10
FRIEDMAN, M.; (1968); “The Role of Monetary Policy”, American economic Association 58 n.1
FRIEDMAN, M.; (1975); “Unemployment versus inflation”, IEA, Lecture No. 2, Occasional paper
PHELPS, E.; (1967); “Phillips Curves, Expectations of Inflation and Optimal Employment over Time.”
Económica, n.s., 34, no. 3 (1967): 254–281
11
SAMUELSON, P.; SOLOW, R.; (1960); “Analytical Aspects of Anti-Inflation Policy.” American
Economic Review 40 (May): 177-94.
12
FRIEDMAN, M.; (1976); Nobel Memorial Lecture: “Inflation and Unemployment”, Nobel Foundation.
13
HUSSMAN, J. P.; (2011); “Will the Real Phillips Curve please stand up”, April 4, (Internet)
14
OKUN, A.; (1962),; “Potential GNP, its measurement and significance”, Cowles Foundation, Yale Uni.

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i. Phillips' evidence. According to the Natural synthesis, the relationship between

inflation and unemployment may have a negative slope as maintained by Phillips,
Samuelson, and Solow, and, likewise, a positive slope as maintained by Friedman and
Phelps. The slope will depend on the existence or not of intrinsic monetary risk and the
sovereign risk.

ii. Okun's evidence. For the Natural theory, there is an optimal differential inflation.
Moving away from this optimum has consequences for economic growth and, inversely,
for the variation in the unemployment rate. The optimal differential inflation facilitates,
in the short term, greater relative economic growth and a low unemployment rate.
Contrary to Okun's evidence, it is not the growth of productivity in the short term that
increases the unemployment rate. Rather it is the separation from optimal differential
inflation.

iii. Optimal differential inflation. If inflation is positive, low and stable, it will
approximate to what was denominated by Blanchard and Gali as the "divine
coincidence"15, or, according to this theory, to the optimal differential inflation.

iv. Inflation scenarios. This synthesis raises four possible scenarios born of the
relationship between inflation, economic development and employment: i) deflation, ii)
stagflation, iii) hyperinflation and iv) optimum inflation. These scenarios can be
briefly explained as follows:

Deflation

Low inflation, low real economic growth and low job creation. This is the normal state
after the bursting of a bubble in an asset market, such as real estate market or the stock
exchange. Its distinctive feature is that there is no intrinsic monetary risk and sovereign
risk as this is prevented by quantitative expansions (Japan 1990. Great Depression
2009). This leads to low or zero inflation of interest rates, banking inflation and Fisher
inflation. From the perspective of production, the extreme banking propensity to

15
BLANCHARD. O.; GALI, J.; (2005); “Real wage rigidities and the New Keynesian model”, Journal of
Money, Credit and Banking 39, (1): 35-65

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liquidity and the spillover effect, will result in the contraction of aggregate production
(supply), and, with it, of the purchasing power of the economy (the natural equation of
exchange). The final result will be a decrease in effective aggregate demand (the
functional relationship between effective aggregate supply and effective aggregate
demand is always positive).

Stagflation

High relative inflation, low real economic growth and low job creation. This state is
common in economies with structural wage inflation, which is also accompanied by
some interest rate inflation. The high relative rates of inflation will give rise to
inadequate differential inflation, reducing the economy’s external competitiveness, and
decreasing domestic and foreign investment. All of which produces a decline in
potential growth and job creation. There is usually no intrinsic or sovereign risk or it is
low.

Hyperinflation

Very high relative inflation, negative real economic growth and high unemployment.
This state can be reached after a previous situation of deflation or stagflation. Due to
endogenous or exogenous reasons this state is characterized by a sharp increase in
intrinsic monetary risk and sovereign risk, and these risks continue to increase over
time. The increase in intrinsic and sovereign risk will lead to a sudden nominal increase
in interest rates, which will have three relevant effects.

Firstly, the expected real rate of return on assets (ROA of the economy) will be lower
than the economy’s interest rate and this will lead to a slowdown in production and
banking activity, thereby reducing new investment, economic growth and employment.
Secondly, by increasing the effective interest rate of the economy, interest rate inflation
will increase. Thirdly, the currency will be devalued in an inverse sense to the long-term
interest rate. If the paralysis in production is notable and prolonged, the shortfall will
lead to productive collapse inflation. This is turn will intensify the devaluation of the
currency, the inverse rise of interest rates, and initiate the process of monetary collapse
inflation.

Increasing inflation will cause a continual decline in the purchasing power of the
currency (and society). Meanwhile, the central bank will issue huge amounts of high-
powered money that, in part, will never enter the economy as a result of the banking
sector’s propensity to liquidity and the fall in business profitability expectations.

The unceasing fall in the purchasing power of the currency will eventually lead to a loss
of credibility in the domestic currency.

Optimal inflation

This is the most important variable for short term economic growth.
(It is expanded later).

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IV. THE EXTERNAL DYNAMICS OF INFLATION

I. THE DIFFERENTIAL INFLATION OPTIMUM

The common denominator of the formal objectives of central banks is price stability.
However, there is no unanimous criterion in the search for such stability. For example;
for the ECB the inflation objective is a static target (2%) (Maastricht Treaty), while for
the US Federal Reserve the inflation objective is a term target ("inflation target rate",
Bernanke16) .

The Natural theory moves away from these hypotheses and advances alone towards a
stimulating and relevant hypothesis which has largely been discarded by the
Neoclassical school: the existence of an optimal inflation. This hypothesis is ignored
because if there exists an optimal inflation, then there should be a monetary optimum. If
this monetary scenario is true, then it refutes the "neutrality" of monetary policy.

Is the concept of "monetary neutrality" true?. Empirical evidence continually suggests

that there is no such thing as monetary neutrality. After the subprime crisis, the Federal
Reserve engaged in one of the largest monetary expansions in its history. This has
resulted in historically low interest rates, and the US economy has achieved the longest
lasting increase in employment ever recorded: 100 consecutive months of job creation
(Sept.2010-Jan.2019). The high and prolonged creation of employment in the USA
provides evidence that monetary policy is not innocuous in terms of economic
development. So, what can be learned from this?

Optimal inflation is the general level of prices where the real rate of return on assets is
maximized in global relative terms, promoting constant new domestic and foreign
investment, and, as a result, a greater relative growth in production, aggregate demand,
employment, etc. This price level is dynamic and it materializes as differential inflation.
Thus, there exists a global differential inflation optimum that arises from the behavior of
inflation in all nations. This optimum determines the inflation optimum and the
monetary optimum (neutral rate) of each nation. The existence of an optimum of world
differential inflation, can lead us to think that the optimal inflation and monetary
optimum of each nation should be the same. But, this is not so. The calculation of the
differential inflation of each nation is based on its competitive environment, including
the relative risk which is always a unique variable.

II. THE BLACK AND WHITE EFFECT

The economy is a price system, where all prices, (with the exception of the price of the
NRRs), are related and adjusted in relative terms. In the case of monetary and financial
assets, these are related and adjusted worldwide following the axiom "higher real return
and lower relative risk" (natural Rule). Thus, it is easy to observe the high positive
correlation in the variation of prices of monetary and financial assets at a worldwide
level. But, what happens to the savings of a country if there are other countries with a
more attractive expected real return on assets?

16
BERNANKE, B.; LAUBACH, T.; MISHKIN, F.; POSEN, A.; (1998); “Inflation Targeting”

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The black and white effect means the mobilization of savings and future new investment
from the country where they have been generated to other countries, because of the
substitution effect between monetary and financial assets in their search for a more
attractive real return. The consequence of this phenomenon is extremely serious because
it is at the root of the world economy’s principal problem, that of poverty and global
inequality. Savings, acting honestly and legitimately in the search of the highest real
return and lowest relative risk, unconsciously functions with an objective which is
asymmetric to global economic convergence. Thus, some countries are permanent
beneficiaries of this negative monetary externality. Others suffer from it temporarily or
permanently, seeing their savings fall, with negative effects on future new investment,
employment growth, and, ultimately, relative economic and social progress.

Therefore, it can be said that in the world monetary and financial market the “Nash
equilibrium” does not exist. Some win and others lose, permanently affecting the
relative development among nations. Without seeking to do so these considerations lead
to a clarification of the well-known "Lucas paradox"17 (or Lucas puzzle): "capital does
not flow from the developed nations to the undeveloped ones, even though the less
developed ones have lower levels of capital per employed person ".

The black and white effect could be corrected without affecting the system of market
freedom and the monetary and economic sovereignty of each nation. (This topic will be
expanded on).

III. THE EXTERNAL DYNAMICS OF INFLATION

The external dynamics of inflation is specified in the variable: differential inflation.

Thus, there is a worldwide optimum of differential inflation, from which the optimal
inflation and the optimal monetary of each nation is born. To be close to the optimum
of world differential inflation is the most important competitive weapon of relative
development among nations in the short term.

17
LUCAS, R.; (1990); “Why doesn´t Capital Flow from Rich to Poor Countries?”, AE Review

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This variable is more relevant than the two natural causes of economic growth (natural
growth of the population and productivity). Conversely, those countries that move away
from the optimum of world differential inflation will have a real rate of return on assets
that is less attractive in relative terms. If the differential inflation is negative, savings
will disappear and with it new investment and future development i.e. the black and
white effect.

V. INFLATION FORMULATION

If we follow the natural exchange equation, it is possible to formulate inflation as

follows:

VI. THE NATURAL EXCHANGE EQUATION

Finally, and if we accept as true the hypotheses of: i) the Natural rule and ii) the black
and white effect, the natural exchange equation previously proposed must be adjusted.
Adjustment that means the introduction of the PPP and relative risk in the formulation;
which is equal to admitting that the level of production and the monetary and financial
system of each nation is affected by the relative changes between domestic and foreign
purchasing power.

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In short, the new adjustment gives: i) a global dimension to the exchange equation
compared to the traditional domestic dimension of the Fisher exchange equation, ii)
while giving differential inflation a transcendental role in the development and
competitiveness of each nation.

VII. SUMMARY

I. DEFINITION OF INFLATION

Inflation is the generalized and constant increase in prices originating from the variation
in the prices of the three basic elements of the economy i.e. wage inflation, interest rate
inflation, and, NRR price inflation. The three types of inflations have velocities and
signals which are not identical in time.

II. GLOBAL DYNAMICS OF INFLATION

The multiple origin of inflation is of undoubted scientific interest. It is of greater

importance for society and economic science to determine the dynamics of this variable
in terms of economic development and job creation. From our perspective, the critical
inflation in the economy is not, strictly speaking, domestic inflation, but the differential
inflation among nations. The Natural theory affirms that the relative development
among nations depends in the short-term on this unique variable. The optimum of world
differential inflation determines the optimal inflation and the monetary optimum of each
nation (the neutral rate).

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