Free To Choose Network | Free To Choose
Free To Choose
Money and Economic Development
The Horowitz Lectures of 1972
Milton Friedman

SECOND LECTURE: Monetary Policy in Developing Countries

Inflation and Development

It is widely believed that there is a close relation between inflation and development. Sometimes the relation is supposed to be that economic development causes inflation. Sometimes the relation is supposed to be that inflation promotes development.

In my opinion, neither the one nor the other is correct. We can find examples of all four combinations. Some striking examples of development without inflation are the development of Great Britain in the eighteenth and nineteenth centuries, of the United States in the nineteenth century, of Japan after the Meiji Restoration in 1867 to World War I; and the more modern examples of Hong Kong, Malaya, and Singapore in the past thirty years; of Greece in the late 1950s and early 1960s.

Examples of inflation without development include India in recent decades, many South American countries, Indonesia until perhaps recent years, all of the hyper inflations after World Wars I and II, and Great Britain in the past decade.

Examples of inflation with development include Israel, Japan in the past decade, Taiwan for much of its existence.

Examples of no inflation and no development include Venezuela, many European countries and India in the inter-war period, and numerous examples from earlier times.

So, historically, all possible combinations have occurred: inflation with and without development, no inflation with and without development.

Why, then, is it so widely believed that inflation promotes development? I believe there are two systematic effects that might work in that direction.

First, if inflation is not anticipated, if it is an unexpected inflation, it may for a time transfer resources to active businessmen, innovators or entrepreneurs, and in this way add to investment. Apparently that is what happened in Europe in the sixteenth and seventeenth centuries as a consequence of Spanish imports of specie from the New World. These imports raised the quantity of money, which produced inflation; the inflation was not anticipated so prices of final products rose more rapidly than wages. Interest rates failed to reflect inflation fully, so that the real interest rate fell, and in the process transferred wealth from land owners and workers to entrepreneurs.

The studies of the price revolution in Europe by my colleague, Professor Earl Hamilton, are by now classic documentations of this process.
This effect operates only so long as inflation is not anticipated. Once inflation is widely anticipated, wages will escalate as rapidly as prices, and interest rates will rise to offset the anticipated inflation.

In the modern era, when inflation comes from the actions of legislators and central banks, rather than from such acts of God as specie discoveries, when the press, radio and television rapidly transmit information to the ends of the world, inflation is not likely to proceed very long without being anticipated, and perhaps, over-anticipated. So this effect can hardly be counted upon as a matter of deliberate development policy.

Certainly, if this is true anywhere, it is true in Israel, where there has developed a very sensitive and sophisticated reaction on the part of the public at large to inflation, and where the central bank publicly announces that it plans to produce at least 6 per cent per year inflation for the next five years. It publicly announces this by offering linked bonds on terms that imply a minimum of 6 per cent inflation.

That is the first relation between inflation and development: inflation may promote development by transferring funds to entrepreneurs if it is not anticipated.

A second way in which inflation may affect development is that inflation is, or can be, a method of taxation that yields revenue to the government, and this revenue can be used to finance development.

I believe that this link between inflation and development has been mainly responsible for the widespread belief that the two go together. In most developing countries in the modern era governments have, wisely or unwisely, and I believe unwisely, tried to play a large role. This has led to demands for government revenue that could not readily be met by traditional sources of government funds. Neither the bureaucratic apparatus nor private attitudes and institutions permitted the large-scale use of such new sources as income and corporation tax. This statement again is less true for Israel than it is for most other developing countries. Israel has had a much better developed system of income and corporation taxes and so on than have most developing countries.

The absence of these modes of raising revenue has tempted governments to resort to the printing press to finance their activities.

Inflation produced in this way has been a mixed blessing as a means of development for several reasons. First, the amount of revenue that can be raised by inflation is not very large in under-developed countries. It is not very large because cash balances tend to be rather small relative to total income, and hence the tax base is small. This is concealed initially, because governments at first benefit from the fact that inflation has not been anticipated. For a time, people expect inflation to be temporary, and so add to their cash balances in real terms. But as soon as people come to expect the inflation to continue they reduce their cash balances in real terms, and the yield from inflation declines sharply.

Second, governments have many demands for funds, so that there is no assurance that the revenue will be used to promote development.

Third, even if the revenue is used to promote development, it is used to promote development as viewed by the government, which means that the revenue is likely to go for the standard development monuments, for international airlines, luxury hotels, steel mills, automobile assembly plants and the like, rather than for productive investment.

Unfortunately, this is an area in which Israel has not been lagging.

A fourth and extremely important reason why inflation has been a mixed blessing as a means of development is that inflation is almost always accompanied by governmental controls and intervention that offset much of the possible benefit from governmental development assistance. These controls and interventions discourage private investment, often lead to a flight of private capital, and produce economic waste and inefficiency.


1. Nominal income is net national product; money is currency outside commercial banks plus all deposits (time and demand) of the public at commercial banks.
2. Each rate of change is computed as the slope of a least squares straight line between the natural logarithm of the variable (income or money) and time fitted to three successive phase averages.
3. This summary is adapted from Milton Friedman, The Counter-Revolution in Monetary Theory, Occasional Paper 33 (London: Institute of Economic Affairs, 1970), pp. 22-26.
4. See my "The Optimum Quantity of Money" in The Optimum Quantity of Money and Other Essays (Chicago: Aldine Publishing Co. 1969).
5. "Government Revenue from Inflation, "Journal of Political Economy, Vol. 79 (July/August, 1971), 846-856.

Reprinted from Money and Economic Development The Horowitz Lectures 1972 by Milton Friedman, copyright © 1973

Back to 'Money and Economic Development' Home