Inflation is about monetary policy

I continue to see all sorts of non-monetary theories of inflation. For instance, “demographics” is often cited for the low inflation rate in Japan. There’s a much simpler explanation for inflation—monetary policy.

The following graph shows the exchange rate for three European countries, Denmark, Switzerland and Sweden:

During this period, the Danish krone (red line) was pegged to the euro.  This meant that the Danish central bank was not able to adopt an independent monetary policy.  The Swiss franc was also pegged to the euro until January 2015, at which time the Swiss National bank sharply revalued the franc upwards, which shows up as a lower SF price of dollars on the graph (blue line).  The Swedish Riksbank pursued a more expansionary monetary policy in order to push inflation up to their 2% target, and hence the Swedish krona (green line) depreciated substantially against the Danish krone (and also against the euro.)

As a result of these diverging monetary policies, Sweden’s price level (red line) rose faster than the Danish price level (blue line), while Switzerland (green line) experienced an even slower rate of increase:

Of course purchasing power parity does not always hold.  But in the long run, a policy that consistently depreciates a currency against another currency will generally leave the depreciating country with higher inflation.

Sweden’s expansionary monetary policy has returned its inflation rate to 2% over the past few of years, while Denmark and Switzerland continue to fall short:

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