In the previous section, we saw how economic theories changed from Classical to Keynesian to Monetarist over the course of the 20th century. These changes were driven by historical events. Taking this historical context into account deepens our understanding of economic theories. This contrasts with the conventional methodology of economic textbooks, which treats economic theories as scientific laws, which are universally applicable to all societies. In this section, we describe one of the central lessons which emerges from the study of money over the millennia.

The transition of economic theories from Classical to Keynesian to Neoclassical can be seen as a miniature illustration of the Quality-Quantity Pendulum, which is a consistent pattern relating to money observed over millennia. Modern economic theory strips theories of their historical context, depriving us of critical insights into both theories and history. Before studying the QQ Pendulum, we will pause to discuss how this defective methodology was adopted by economists.

The Battle of Methodologies: As Geoffry Hodgson has detailed in his book entitled “How Economists Forgot History”, a challenger to the dominant historical and qualitative methodology emerged in the late 19th Century. The new methodology was quantitative, mathematical, and empirical, in imitation of scientific methodology. The devastation of World War 1 destroyed the prestige of the traditional approach to social science, so that this scientific approach became the dominant methodology in economics by the 1950s.  This ahistorical approach blinds us to the fact that all social theory is developed to analyze a particular society situated in a particular historical context. Treating it as a universal scientific law, invariant across time and space, is hugely mistaken.

Lessons from History: In this section, we will discuss some insights about the nature of money, and monetary economies, derived from the study of history by Glyn Davies in “A History of Money: From Ancient Times to Modernity”. Davies writes that: “… despite the antiquity and ubiquity of money its proper management and control have eluded the rulers of most modern states partly because they have ignored the wide-ranging lessons of the past or have taken too blinkered and narrow a view of money.” For example, Keynesians and Monetarists agree that a contraction of the money supply was the immediate cause of the Great Depression of 1929, ill effects of which persisted until the outbreak of World War 2 in 1942. From a broader perspective, a study of the history of money should have made both the nature of depression, and the remedy, abundantly clear. Unfortunately, as the previous quote indicates, policymakers ignored the lessons history teaches us about the role of money, and made errors which caused misery to millions for decades.

Money as a Social Institution: A study of history shows that money has played a central role in shaping history across the centuries. Also, history teaches us money is not purely a transaction technology; it is deeply embedded into the social fabric of society. Use of money requires building social consensus on trustworthiness of the monetary institutions. Building this trust requires building high quality institutions and mechanisms, which guarantee the value of money in the eyes of the public. The quality of money refers to the public trust and social consensus both on the value of money, and the stability of this value across time.

High Quality Money: History provides us with an incredibly diverse set of examples of monetary institutions which provided society with trustworthy money with stable value across time. Cattle and cowries in Africa, paper money in China, Wampum in America, and Yap stones in Pacific Islands, were used as money for centuries. Many systems even survived in competition with modern monetary systems. So, we conclude that there is a wide variety of ways to create high quality money.

The Gold Standard: One of ways to create high quality money is to use gold or silver. These metals have characteristics – discussed in textbooks – which make them particularly suitable for use as money. There is very little public awareness that there are many different varieties and conflicting interpretations of what “gold standard” means. The best reference for this is Morrison’s England’s Cross of Gold: Keynes, Churchill, and the Governance of Economic Beliefs. The strictest form of the standard – use of actual gold – has been very rare, historically. Coins of minted gold have been far more popular. The mint certifies the quantity and quality of gold in the coin, making it far more convenient for public use.   

Minted Money and Token Money: The highest quality of money comes from minted coins which have value equal to the content of the metal (gold or silver). This is because the coin itself is the guarantor of its own value.  There is still the question of what it is about gold and silver that creates nearly universal consensus on their intrinsic value? Perhaps the answer is that love of gold and silver has been built into human nature, as an ayah of the Quran suggests. The numismatic evidence from buried coins shows that high quality gold coins are almost always followed by “debased” coins – coins with significantly less gold content than the face value of the coin. History tells us of the varied reasons for such debasements. Most often, high expenses of wars require vast amounts of money, beyond available stocks of gold. Governments resort to debasement, to get more money from the same gold stock. Since gold is very valuable, even the smallest gold coins are not useful for daily transactions. So, token monies, made of copper or other cheap metals, are often used for small change. The metal value of these coins is not equivalent to their market value – instead, these coins considered as fractions of the gold coin, and are exchangeable.

From Quality to Quantity: The lesson of history, repeated across the globe, and across the centuries, is that the temptation to expand the stock of money – more quantity – proves irresistible in the long run.  A modest expansion of money stock via small dilutions of gold content or small issues of token money, brings major economic benefits. Small expansions of money stock beyond gold content do not cause noticeable changes in the public trust which is the central guarantor of the value of money. However, over a longer period of time, the temptation to expand the quantity over safe limits becomes irresistible. Events like wars, or private greed, or government need, lead to over-expansion of the money stock. An excessive quantity of money causes inflation, a loss of value, and a breakdown of public confidence in money. The drive to expand the money stock leads to low quality of money. But large fluctuations in the value of money disrupt the lives, and cause distress to all members of a monetary economy. As a result, consensus builds on monetary reforms required to create high quality money. Eventually, excess money is removed from circulation, and a high quality money is restored, to complete the swing of the pendulum between quality and quantity.

The Pendulum of Economic Theories: Many authors have noted that history is a battle between the creditors and the debtors. In eras of high quality money, money is scarce, and the creditors are few and powerful. They propagate pro-creditor economic theories which favor “sound” money: high quality with restricted quantity.  However, the need for expansion of money stock becomes overwhelming in many different scenarios. Then the pro-debtor economic theories emerge. These favor the expansion of the money stock, and cite numerous advantages from doing so. Creditors argue in vain against the slippery slope of modest expansions leading to ruin. The benefits from expansion are immediate and obvious to all. But in the long run, their gloomy predictions turn out to be valid. Over-expansion destroys the quality of money, and also the reputation of the pro-debtor economic theories.

This drama has played out over the centuries in many different guises, and with different terminologies in use to describe the two opposing schools of thought about money. Confusingly, the quantity theory of money (QTM) advocates maintenance of high quality money, and argues against expansions of the money stock to bring prosperity to the masses. The Real Bills doctrine versus the QTM, the Anti-Bullionists versus the Bullionists, the Banking School versus the Currency School, Keynesians versus Monetarists, and most recently, Minsky’s Financial Fragility Hypothesis versus the Real Business Cycle theories, are all illustrative of the quantity-quality controversy which spans centuries of monetary history.

Long-Run Versus Short Run Perspectives: Davies emphasizes that this quantity-quality pendulum becomes discernible only in the long run. Over any short period of time, spanning a few decades, the immediate benefits of one or the other school of thought seem overwhelming. When tight money is creating recession and unemployment, the benefits of looser money seem obvious to all, and tight money adherents find little support for their positions among the masses. However, in periods of high inflation, the harms of loose money again appear obvious, and tight money policies gain public support. Over any short period of time, one or the other policy seems obviously superior. It is only a long-term examination of history which shows the regularity with which the pendulum swings between the two poles.

There are three conclusions we would like to draw from the quantity-quality pendulum, which emerges from the study of millennia of monetary history.

1. The study of equilibrium is an illusion. A stable and high-quality money creates an irresistible temptation towards expansion, leading to a breakdown in quality. Also, excessive money stock which destabilizes the value of money creates powerful forces which seek to stabilize its value and create high quality money. At no point in the trajectory of the monetary pendulum do we see any resting place, or equilibrium.
2. The value of money rests on the social consensus created by confidence in the monetary institutions governing the creation of money.  History is full of examples where this confidence was weakened or strengthened, leading to changes in the value of money. Recently, a crisis of confidence in the Euro was stemmed simply by an announcement by Mario Draghi the he would do “whatever it takes” to stabilize and protect the Euro. Conventional treatments of money pay no attention to these psychological aspects of money.
3. The historical perspective provides deeper insights into monetary theory than conventional methodology. When the Great Depression created tight money, Keynesian theory favoring expansion of money stock emerged and became popular. Inflation in the 1970’s led to rejection of Keynesian theory and a return to the tight-money policies implemented by Volker. Conventional methodology searches for absolute scientific truths, without realizing that truth may be relative to a particular historical context.

Links to Related Materials

• Bit.ly/ME01: Monetary Economies: A Historical Perspective
• Bit.ly/MONE02: Writeup of THIS video-lecture
• Bit.ly/WEAmom: Method or Madness? (battle of methodologies)
• Bit.ly/MONBX: Books on Monetary Theory and History
• Bit.ly/Azmmai: Modern Money and Inflation

Today (January 31, 2024), the Australian Bureau of Statistics released the latest – Consumer Price Index, Australia – for the December-quarter 2023. The data showed that the inflation rate continues to fall sharply – down to 4.1 per cent from 5.2 per cent in line with global supply trends. There is nothing in this quarterly…

Lennart Brandt, Natalie Burr and Krisztian Gado

The Bank of England has a 2% annual inflation rate target in the ONS’ consumer prices index. But looking at its 700 item categories, we find that very few prices ever change by 2%. In fact, on a month-on-month basis, only about one fifth of prices change at all. Instead, we observe what economists call ‘sticky prices’: the price of an item will remain fixed for an extended amount of time and then adjust in one large step. We document the time-varying nature of stickiness by looking at the share of price changes and their distribution in the UK microdata. We find a visible discontinuity in price-setting in the first quarter of 2022, which has only partially unwound.

Theory of sticky prices and related literature

Understanding price-setting dynamics is essential for central banks. Most structural models in the literature use a form of time-dependent pricing, under which firms keep prices the same for fixed amounts of time (Taylor (1980)), or for random amounts of time such that there is uncertainty about the precise length of the price spell (Calvo (1983)). Another way of modelling sticky prices emphasises that firms will not just look at the time that has passed since they last adjusted its price, but also at how far their price is from some desired price level. This is called state-dependent pricing. Macroeconomic models don’t typically allow for time-variation in the degree of stickiness or switching between pricing strategies. Recently, however, firms in the Decision Maker Panel tell us that they have moved increasingly away from time-dependent towards state-dependent pricing. In this case, when there is a large shock affecting many firms, the shock leads to an increased frequency of price changes and so more immediate pass-through to overall inflation.

In order to better understand the pricing behaviour of firms in times of large inflationary shocks, we explore the pricing dynamics at the micro level using CPI microdata published by the ONS. We are of course not the only ones who have been interested in this type of data. Bank authors have been using this data set for a number of years. For example, Bunn and Ellis (2011) document stylised facts about pricing behaviour from the UK microdata and the August 2020 Monetary Policy Report used CPI microdata to inform policy. Elsewhere, Karadi et al (2020) use US microdata to analyse firms’ price-setting in response to changes in credit conditions and monetary policy. Nakamura et al (2018) analyse the societal cost of high inflation using microdata from the 1970s and 1980s, and Montag and Villar (2023) analyse the effect of more frequent price-changes on aggregate inflation during Covid. Relatedly, Davies (2021) finds that the difference between the share of price rises and price cuts in the UK microdata is related to aggregate inflation, focusing on price-setting during the pandemic. And finally, authors of the FT’s Alphaville blog have also been looking into these data (see here and here).

The data

The microdata spanning from 1996 until September 2023 is publicly available and updated monthly after each CPI release. It contains the monthly price quote data underpinning the ONS’ CPI series for over 700 items with identifiers at the shop, shop type, and region levels. We clean the data which works out to about 30 million observations. When identifying a price change in the data, which is ultimately what matters for inflation, we try to be as precise as possible with regards to the product and the timing of the change. To that end we only count the change if we find the same item, in the same region, in the same shop, in two exactly neighbouring months. For example, if a bag of potatoes cost £2 in January and £3 in March but was not recorded in February, rather than imputing a price we discard the observation since we cannot be sure in which month the change actually happened.

Stylised facts from the microdata

A brief look at the data lets us establish some stylised facts. Chart 1 shows a decomposition of these month-on-month price movements over all items in the data set. Four key observations stand out:

1. Prices rise and fall all the time, but the vast majority of prices do not change between months. In any given month, on average since 1996, around 80% of prices remain unchanged relative to the previous month (blue line).
2. The share of prices rising (in green) has increased notably since 2021 to an extent that has not happened in previous inflationary episodes in the sample (excluding VAT changes).
3. The share of prices falling (in red) has fallen somewhat but remains stable since 2021, relative to historical average. The main margin of adjustment has been in the share of price increases.
4. But, in recent months, while the share of prices rising has tapered off, it remains elevated relative to its historical average. 

Chart 1: Decomposition of price movements month-on-month

Notes: The share of prices rising and falling reflect month-on-month changes. Shares are seasonally adjusted using the R package seasonal. Spikes in 2008, 2010 and 2011 are a consequence of UK VAT changes (17.5% to 15% in 2008, increase to 17.5% in 2010 and increase to 20% in 2011). The grey shaded area covers the time between March 2020 and July 2021 when the economy (and data collection) was most affected by the Covid pandemic. Dashed lines show the 2011–19 averages. Latest observation: September 2023.

Sources: ONS and authors’ calculations.

To be clear, this chart is not saying that 80% of products never change prices. If the price of an item remained constant between December and January, and rose between January and February, it would move from the blue into the green category during this period. Similarly, it would fall out of the green, into the blue or red, if from February to March the price again remained constant, or fell, respectively.

So, perhaps surprisingly, this chart shows that monthly price dynamics in the economy are driven by only a relatively small fraction of roughly 20% of all goods and services in the consumption basket. Also, we see that in the most recent episode, the shift into rising prices has been mostly out of the ‘no change’ category. Hence, fewer prices are staying fixed, and more are rising. It is worth noting that the recent up-tick in the shares of prices rising is only matched historically by those caused by VAT changes in 2008, 2010 and 2011, which however appear as one-off price spikes rather than a persistently higher share of price rises, as in 2022.

If it is a minority of total products whose price changes, it is important to take a closer look. Chart 2 shows the distribution of prices changes from 2019 by quarter (truncated at zero to exclude no-change observations). In line with the rise in the green line in Chart 1, we observe that over 2021 and 2022 a lot of mass moved into the right side of the distribution, that is the share of price increases, with the share of price decreases being relatively stable.

Chart 2: Evolution of the distribution of price changes by quarter 2019–23

Notes: The share of prices that did not change is excluded from these densities. The truncated densities are estimated in R via the Bounded Density Estimation package using the boundary kernel estimator. Darker colours correspond to quarters in which year-on-year CPI inflation was relatively high, lighter colours to quarters in which it was low. Each distribution represents month-on-month changes within the same quarter. Latest observation: 2023 Q3.

Sources: ONS and authors’ calculations.

A note on the chart: the distribution of price changes, when aggregate inflation is at or close to target, is roughly symmetric in logarithms. On this scale, a doubling (+100%) is equally far away from zero as a halving of the price (-50%). Due to sales, the doubling and halving of prices actually happens regularly in the data, which explains the bunching around these points. While these may be a source of seasonality in the data, which may obscure the underlying dynamics, we do not believe they are important for the overall shape of the distribution which we show here.

In Chart 3, we zoom in on a couple of these densities to better see differences in their shape. They are the densities corresponding to price changes in the third quarter of 2022 and 2023 alongside an average density over the pre-Covid period.

Chart 3: Comparison of densities from 2022 and 2023 against a pre-Covid average

Notes: The share of prices that did not change is excluded from these densities. The truncated densities are estimated in R via the Bounded Density Estimation package using the boundary kernel estimator. To compare densities across time, they are normalised to sum to the average share of prices falling and rising respectively within the quarter. The yellow line shows the pointwise average density over the third quarters of the years 2011–19.

Sources: ONS and authors’ calculations.

We can see how, compared to this historical average – which we use as a stand-in for pricing behaviour when inflation was close to the 2% inflation target – 2022 saw a huge number of prices increase while there was little change in the behaviour of the lower part of the distribution. In the latest data, this mass of increases has begun to subside, and, at the same time, there is a growing number of prices outright falling on the month. However, the modal price increase (that is, the most probable) is still elevated at about 6%, compared to roughly 3% on average during 2011–19).

Conclusion

To summarise, looking at the micro level of price changes, we find a visible discontinuity in price-setting in the first quarter of 2022. A variety of factors, such as the large rise in energy prices in early 2022, as well as supply-chain issues following Covid lockdowns, likely contributed to this significant change in price-setting dynamics in the UK (relative to any recent historical precedent at least). At the micro level, firms’ pricing decisions led to the emergence of a large rebalancing in the distribution of price changes. Suddenly, more prices for many different products were rising at the same time. Compared to the available history for these data, the recent period is unique. More research will be needed on the causes of this marked shift in the distribution of price changes, both at a micro and at a macro level.

In the very latest data, there is some evidence that the distribution of price changes has indeed begun to return in the direction of its historical average, though it is too soon to establish a trend.

Lennart Brandt and Natalie Burr work in the Bank’s External MPC Unit, and Krisztian Gado is a PhD candidate at Brandeis University.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

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