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
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
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
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
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.