the rise and fall of inflation

The rise in inflation to just over 9 percent in June 2022 is no mystery. Excess demand and insufficient supply were caused by a combination of an abrupt supply disruption due to the COVID-19 pandemic and a spike in demand from the Trump and Biden stimulus expenditures. The fall in inflation more recently to between 3 and 3.5 percent is more interesting and more complicated.

On the supply side American manufacturers have learned that minimizing inventory costs following just-in-time delivery of their products that they manufacture cheaply overseas has caused them dearly in the face of the sudden supply disruption. Their revenues and profits dropped dramatically in the face of the sudden cutoff in the supply of their products. With the encouragement of the Biden administration, manufactures have created just-in-case production facilities here in America. They now want to have some manufacturing production in America that is designed to be easily expanded in the face of another overseas supply disruption. This is especially important in the face of the increasing tension between China and the United States, especially if China were to invade Taiwan.

The demand for construction workers initially put upward pressure on wages and prices. But the resulting increase in the supply of manufactured products here in America in addition to the renewed supply from overseas has put downward pressure on inflation. Economy-wide demand is also falling due to the end of the stimulus expenditures, the end of the deferment of student loan payments, and the increase in work requirements for welfare recipients recently imposed by Congress. This combination of increased supply and decreased demand is putting downward pressure on the rate of inflation. Prices are then rising at not nearly the rate that they were at the height of this inflationary cycle.

But what role has the Federal Reserve played in all this? What effect has the Fed’s raising of interest rates had on our economy? When the Federal Reserve raises interest rates, wealthy people say: “Oh, good. I will be earning more on my savings.” Poor and middle class people say: “Oh, no. I will have to pay more on my debts.” People often need a loan to buy a car, purchase a home, or get a college degree. Raising the cost of borrowing blocks these options for many people. During times of excessive inflation, people need to spend their money quickly before it loses more of its purchasing power. The longer they wait, the less their money is worth. Consequently, by raising the cost of borrowing when too much money is chasing too few goods, the Fed just shifts the inflation from things that require a loan to less expensive things that don’t require a loan.

However, raising the cost of borrowing stops excess inflation by suppressing supply in a manner that ultimately effectively suppresses demand. Many firms borrow money to operate. Some retail firms run in the red most of the year until reaching the holiday season at the end of the year where they cover their costs and make their profit. Farmers borrow to prepare fields with plowing, fertilizing and watering their crop and then pay back their loans when the harvest comes in. When the cost of borrowing goes up, firms that borrow money will cut hours, lay off workers, and close outlets. Workers get less money and some lose their paychecks altogether. They can’t spend money they don’t have, so this effectively suppresses demand and stops excessive inflation, but at the risk of creating a recession.

The current Federal Reserve strategy that relies exclusively on their cost-of-borrowing tool rewards the rich and punishes the poor for inflation. A more equitable approach that avoids the threat of recession is for Congress to reissue the Postal Savings Act of 1910 to allow the Federal Reserve to off 10 percent interest on savings for relatively small amounts (no more than ten thousand dollars) for any person with a Social Security number. As explained in introductory economics, prices are set on the margin and not on the average. Stopping inflation requires getting the marginal saver to save more and spend less. The poorest of the poor cannot afford to save any money and the richest people are just moving their money around to get the best return with little or no effect on their consumption behavior. Two thirds of Americans have no college degree and typically earn fifty thousand dollars a year or less. These are the marginal savers who have to decide whether to buy that new expensive pair of shoes or instead put that money in a savings account. A big sign at the entrance of each neighborhood post office offering ten percent on savings might be just what is needed to stop too much money chasing too few goods.

Asking your Congressional representative to support reissuing the Postal Savings Act of 1910 would provide the Federal Reserve with a return-on-savings tool that will help stop excessive inflation without causing a recession so that the Federal Reserve does not have to rely exclusively on their cost-of-borrowing tool. This will not have a big impact on banks when the Fed is trying to slow the economy because banks typically have excess reserves under our fractional reserve banking system and cut back on loans when the Fed is trying to slow the economy. Banks don’t want to be overextended with lots of loans in default as the economy slows. At such a time banks do not want to have to pay for more savings that they don’t need and don’t want. The Federal Reserve can run the postal savings accounts with its own money from the profits and fees it makes in the financial markets so reissuing the Postal Savings Act of 1910 would not cost the taxpayer a penny. Typically the Federal Reserve makes profits of fifty billion dollars or more each year. The Federal Reserve could afford to run these postal savings accounts without having to print any additional money. In any case there would be no need to increase taxes to pay for these postal savings accounts and inflation could be brought under control without punishing the poor by using this new return-on-savings tool and not relying exclusively on the Fed’s cost-of-borrowing tool.

Recreate Postal Banking to Slow Inflation

Once again we are using a dysfunctional approach to stopping inflation. Inflation is when too much money is chasing too few goods. But the Federal Reserve relies solely on a cost-of-borrowing tool, which suppresses supply as well as demand, instead of using a return-on-savings tool to absorb excess demand by getting people to spend less and save more.

When I was a young boy in the 1950s, you could go to any post office and set up a savings account. The Postal Savings Act of 1910 allowed for postal savings for 56 years from 1911 to 1966. The postal savings accounts were limited in size so you couldn’t put in much money. If postal savings accounts existed today, a high return on savings could get the marginal saver to put off buying that new phone or television and save the money. Getting people to save more and spend less will slow inflation.

The Federal Reserve is raising interest rates, which is shifting demand (and inflation) from goods that require a loan (automobiles and homes) to ones that don’t require a loan. By raising the cost of borrowing, the Federal Reserve causes businesses that rely on credit to cut hours, lay off workers, and close outlets. It is suppressing supply! But it also suppresses demand, because less money to workers means less demand for goods and services. You can’t spend the money you don’t have. That slows inflation, but at a great cost to the people with the most debt – the poorest Americans. It could also push our economy into a recession.

Most poor people are too poor to save any money. The wealthy just move their money around to get the best return on savings without changing their consumption behavior. Any attempt to reduce excess demand needs to target the marginal saver, who typically earns around $50,000 a year and is among the two-thirds of Americans with no college degree. Getting marginal savers to save more and spend less will help slow inflation. To divert money from spending to saving, any opportunity for a high return on savings needs to be vigorously promoted and advertised at popular athletic contests, Nascar races, and other venues frequented by the marginal saver.

Some observers claim that 30-year U.S. Treasury I-bonds already offer a high return on savings. I-bonds work well for the wealthy, but the severe withdrawal restrictions make I-bonds a non-starter for the marginal saver, who needs immediate access to their money to deal with an automobile accident, a medical emergency, or an unexpected rent increase or job loss.

Why rely exclusively on the stick of a cost-of-borrowing tool and ignore the carrot of a return-on-savings tool? Congress needs to recreate the Postal Savings Act of 1910 and bring in the Federal Reserve to oversee savings accounts at our 30,000+ post offices. With inflation running between 6 and 7 percent, postal savings accounts could offer 10 percent on savings with a limit of no more than $10,000 per person to avoid the transfer of large amounts of money.

When the Fed acts to slow the economy, banks cut back on loans in fear of an economic downturn. You can’t rely on them at such times to offer a good return on savings. Under our fractional reserve banking system, they typically have excess reserves and don’t want more money. Banks don’t want to pay for additional deposits to get money they don’t need and won’t use.

Congress needs to act now to authorize the Federal Reserve to create savings accounts at the 30,000+ post offices throughout the United States and offer a 10 percent return on savings. Getting people to save more and spend less will slow and eventually stop inflation without causing a recession.

Once excessive inflation is fully suppressed, then the promotional advertising of postal savings accounts can be dropped and the high interest rate on postal savings can be lowered. Thus, this new return-on-savings tool can be used to counter the irrational exuberance during booms that drives inflation and the excessive contraction of the money supply by private banks during economic downturns.

Inflation from multiple causes requires multiple cures

Consider all the relevant and important factors that have generated our current inflation.

First, the pandemic has played an important role in interfering with our unexpectedly fragile supply chain. Other commentators have already pointed out that too much emphasis on efficiency created our rather unstable “just-in-time” system. This needs to be replaced with a more secure “just-in-case” system that is robust and resilient to disruptions.

Second, many economists have reported that COVID-19 also caused people to cut way back on services (e.g., travel and dining) and to use those savings to increase demand for durable goods such as automobiles. This occurred just as the vehicle computer chips were in short supply. There has also been a significant increase in demand for housing driving up prices partially due to a new, widespread effort by some Wall Street investors to buy up single family homes around the country and turn them into rental units. Perhaps you have received a phone call recently from one of them offering to buy your home.

Third, consider the stimulus packages. Larry Summers was among the first to point out that the Biden stimulus package was too big and would result in too strong consumer demand. Ironically, President Obama had made the opposite mistake in 2009 in trying to compromise with Republicans who sought to minimize the stimulus to minimize the role of government in recovering from the Great Recession. Ultimately, Obama failed to gain bipartisan support for his stimulus package anyway. Obama’s stimulus bill was too small, but President Biden went too far in the other direction and produced a stimulus that was too big.

The pandemic also discouraged some people from going to work so the workforce was reduced just when more supply was needed to meet an increase in demand. At the same time demand increased for medical and other essential workers. The surge in demand led to a shortage of workers in general and truck drivers in particular who are needed to provide the corresponding increase in supply. The increase in wages due to the shortage of workers helped raise prices of many commodities including food and fuel. President Trump had better relations with the OPEC countries, especially Saudi Arabia, than President Biden, due, in part, to their different reactions to the murder of Jamal Khashoggi, which didn’t seem to bother Trump, but deeply upset Biden. Biden’s pleas to the OPEC countries to increase the supply of oil have gone largely unanswered. Obviously, the war in Ukraine will only make things worse so expect prices (especially food and oil prices) to continue to rise substantially.

On top of all this is an economy dominated by less than fully competitive firms which took advantage of the new inflationary environment to raise their prices even if not justified by supply shortages or excessive demand. Jonathan Tepper wrote “The Myth of Capitalism” to reveal the amazing amount of concentration in American industries. For example, our patent laws have allowed the production of eye glasses to be dominated by just two companies. You would think that a small amount of glass and plastic would cost just a few dollars, but glasses typically cost close to 100 dollars or more. Patent laws originally were intended to encourage innovation, but in many cases have suppressed both competition and innovation. Adam Smith actually provided us with two invisible hands: (1) the explicit invisible hand of competition to increase quality and lower prices, and (2) the implicit invisible hand of economic power where firms conspired together to suppress competition and raise prices. It is this second invisible hand that has become so active in our current inflationary economy. To restore competition and reduce prices patent laws must be severely limited in their application and large dominant firms must be broken up. Some import duties may be necessary to avoid excessive dependence on production in overseas countries. 

Our politicians have been reluctant to take responsibility for all this and have instead relied on the Federal Reserve to stop excessive inflation. The Fed, in turn, has emphasized the need to ‘’stay in its lane” by limiting its action to cutting back or even reversing its purchases of securities and raising interest rates. This means increasing the cost of borrowing. Unfortunately the Fed’s restrictive policies suppress both supply and demand. To meet excessive demand for its products, a firm may want to add another line of production. This requires investment. Borrowing the money to invest in another line of production may turn out to be too expensive after the Federal  Reserve raises interest rates to suppress borrowing. This approach to stopping inflation slows the economy to the point of causing a recession.

It would be much better if the Fed could target demand by those people with the highest marginal propensities to consume (hundreds of millions of poor and middle class Americans). The whole point of the existence of interest rates is to pay someone to delay consumption. Private banks cannot afford to offer a higher interest rate on savings than the interest rate they charge on borrowing. But the Federal Reserve could offer a high interest rate on savings if it was limited to relatively small balances aimed at reducing consumer demand by those most likely to spend any extra dollars. Such small balances would not have much effect on private banks or the rates that they set for borrowing and saving. Most of the money in our banking system is owned by a few thousand wealthy families who have very low marginal propensities to consume and would probably not bother taking the time to move such a relatively small amount of money. However, the total increase in savings by hundreds of millions of Americans could amount to billions of dollars in reduced spending. Most prices would stabilize in the face of such a substantial reduction in consumer demand.

Too often policy is devised by politicians, who interact with the bankers, doctors, and lawyers who represent the small minority of Americans who are exceptionally wealthy. Instead we need to target middle class families who would save more money and spend less if offered a high enough interest rate on relatively small amounts of savings. This could be done by creating Federal Reserve digital currency bank accounts for every American. To combat excessive inflation very high interest rates could be offered on small balances for only one account per Social Security number. Anyone else in the world would be allowed to have a digital currency account with the Federal Reserve (unless sanctioned by Congress) but they would not be allowed to earn interest on their account balance. The Federal Reserve is currently considering the possibility of offering such digital currency bank accounts, and I have answered the 22 questions they have asked on how this new policy tool could be implemented. Going forward we will see if they follow my never-too-humble advice.

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Why Punish the Poor to Stop Inflation and Make It Harder for Firms to Increase Supply?

Why Punish the Poor to Stop Inflation and Make it Harder for Firms to Increase Supply?

When the Federal Reserve raises interest rates in New York financial markets, it becomes harder for businesses to borrow, which causes businesses to cut hours, lay off workers and close outlets. This is an indirect and rather brutal way to reduce demand for goods and services that also reduces supply. The effect is to make it harder for firms to increase supply and harder for people working paycheck-to-paycheck to handle medical emergencies, automobile accidents and other situations where they need a small loan just to get by.

But trashing the economy to stop inflation is not necessary. A more direct, more efficient and more effective way to stop inflation is possible. When the demand for goods and services exceeds the supply, prices rise. Demand can be reduced with either a carrot or stick approach. Why use the stick of raising interest rates on loans that punishes poor people facing a personal crisis and businesses that want to supply more, and instead offer the carrot of higher interest rates on savings to get people to voluntarily put off unnecessary spending and save some money?

In 2018 Senator Kirsten Gillibrand introduced Senate bill S.2755 as “The Postal Banking Act” as a way to use post offices to restore the “The Postal Savings Act” of 1910 which allowed people to cash checks and set up savings accounts in the over 30,000 post offices throughout the United States from 1911 to 1966. Senator Gillibrand sought to use our local post offices as a venue for the poor to get small loans to deal with various crises without becoming prey to loan sharks, pawn shops, payday loan dealers, or “cash now” providers who typically charge exorbitant interest rates.

The Federal Reserve is already considering creating a central bank digital currency (CBDC) as China and several other countries have already done. The Federal Reserve could use post offices as physical locations to access individual CBDC savings accounts. People could also register their smartphones at post offices for more direct and immediate access to their CBDC accounts. When excessive inflation threatens, these CBDC accounts could offer a high interest rate on savings. Encouraging people to save money and spend less will reduce the excess demand where too much money is chasing too few goods and driving up prices.

Ordinarily, to make a profit a bank must charge a higher interest rate on loans than it pays on savings. But as the creator of money, the Federal Reserve is in a unique position. To reduce demand for goods and services, the Fed can offer a higher interest rate on savings. However, in line with “The Postal Savings Act” of 1910 and in order to avoid disrupting commercial banking, the Fed will need to set a limit on the size of savings accounts. With one account per Social Security number and a limit of $10,000 per account, the Fed can avoid competing with private banks for the large savings of wealthy investors.

Encouraging people to build up their savings will also serve as an automatic stabilizer for the economy. Whenever an economic downturn threatens, people with savings do not have to cut their expenditures so dramatically. This avoids a sudden drop in expenditures which would just make economic downturns more severe. A larger pool of savings would shorten and lessen the severity of recessions.

If everyone had a Federal Reserve bank account accessible from their computer or smartphone, it would become easier to transfer money. If someone cuts your grass, rakes your leaves or shovels your snow, you can pay them easily with a smartphone-to-smartphone transfer between your individual Federal Reserve accounts.

Alternatively, when inflation is low and unemployment rises, the Fed could lower the interest rates on both savings and loans to help stimulate the economy. This new tool would give the Fed much tighter control in meeting its mandate of maintaining full employment with stable prices.

Large banks already have bank accounts with the Federal Reserve. There is no reason why the rest of us couldn’t also have bank accounts with the Fed. The rise of digital currencies, especially stablecoins, threaten the Federal Reserve’s dominance and control over our currency. By setting up digital currency smartphone postal savings accounts for every American, the Fed can reestablish its control over our currency and gain a much better way of dealing with the challenge of excessive inflation on one hand and high levels of unemployment on the other.

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Stop Inflation Without Causing Recession

Don’t repeat our historically dysfunctional approach to stopping excessive price inflation. The Federal Reserve uses a supply-side tool to stop excessive inflation by raising interest rates that works by constraining business enough to cause a cutback in working hours and layoffs that suppresses consumer demand. But postal bank accounts could be created to provide the Federal Reserve with a demand-side tool to directly reduce demand pressure to stop inflation without throwing the economy into recession.

When the Federal Reserve raises interest rates, it suppresses supply for seasonal, cyclical and other businesses that depend on short term liquidity to maintain and establish inventory and cash flow.  It suppresses business.  For example, farmers borrow money from the financial system to pay for seed, fertilizer and irrigation in the spring and to pay workers to harvest the crop in the fall, and pay it back after the harvest is sold. 

But production is cut back when borrowing costs increase as interest rates rise. This traditional approach suppresses both supply and demand as workers find less work and their incomes fall. High interest rates also cause businesses to put off long-term investments in plant and equipment that would increase supply. The economy slides into recession.

Inflation occurs when too much demand for goods and services is chasing too little supply. The financial markets exist to offer liquidity to businesses to maintain or expand the supply of goods and services. Countering the rapidly rising prices requires increasing supply while reducing demand. Current supply shortages call for encouraging supply. But the traditional Federal Reserve policy approach will do the opposite of what is needed.

Sure, suppressing business to lay off workers to reduce demand will work if you slam on the brakes hard enough. But trashing our economy to stop inflation is not necessary. What the Federal Reserve is missing is a demand-side tool to ratchet down demand when markets for goods and services become overheated.  

Under the Postal Savings Act of 1910, our post offices served as banks for 56 years from 1911 to 1966. You could go to any of our 34,000 post offices to cash a check or set up a savings account. The Public Banking Act, which was recently introduced in the Congress to create postal bank accounts, could be modified to provide the Federal Reserve with a demand-side tool to curb excessive inflation without throwing our economy into a recession.

Demand can be tamped down and supply encouraged by recreating the postal savings accounts and offering high interest rates in those savings accounts on balances up to some specified limit, such as $10,000 (with no interest earned on amounts above that limit), while leaving the rates in the New York financial markets relatively low to stimulate, not suppress, supply. 

Higher interest rates will encourage savings. Saving more and spending less is obviously what is needed when too much money is chasing too few goods. If we offer high enough interest rates in postal bank accounts dispersed in our 34,000 post offices around the country, excess demand can be reduced enough to stop inflation without forcing the economy into an unnecessary recession. This approach withdraws money from the economy by offering a return on investment, not by taxation. People will still be able to purchase their necessities, but will be motivated to delay or cut back on luxuries until the economy cools off and postal bank interest rates return to normal. 

This will especially benefit the elderly who need a good return on their savings to help finance their retirement. Having more people save more money will also serve as an automatic stabilizer by providing people with the savings they need to ride out economic downturns, which, in turn, will make such downturns shorter and less extreme.

Note that the Federal Reserve is independently financed from its bank fees and investments, which produce enough revenue such that the Federal Reserve donates more than $80 billion to the U.S Treasury each year. The Federal Reserve, not the taxpayers, can pay for setting up and operating the postal banks. The Federal Reserve could also help pay for postal employee pensions. This will reduce, not increase, the overall tax burden. 

With reasonable limits on the savings and loan amounts restricted to one account per person or small business, these postal banks can avoid interfering with the normal functioning of the commercial banking industry. Of course, banks will oppose any intrusion onto their turf, but the broader benefit to the country as a whole must be taken into account.

When the opposite conditions develop with low demand, high unemployment, and the start of a deflationary cycle, postal banks could offer small loans at relatively low interest rates to individuals and small businesses. Such a loan program has already been proposed in bills formulated in both the Senate and the House in the last few years such as Senator Kirsten Gillibrand’s Postal Banking Act as Senate bill S.2755 or Representative Rashida Tlaib’s Public Banking Act as House bill H.R.8721. These bills are aimed at helping unbanked and underbanked people who live paycheck to paycheck and suddenly face job loss, a medical emergency, an automobile accident, or some other event that forces them to go to loan sharks, pawn shops, payday loan dealers, or “cash now” providers who typically charge exorbitant interest rates.

Postal bank savings accounts offering high interest rates could attract middle-class and working-class people, and those with high marginal propensities to consume who tend to spend most of their income except when offered an exceptionally high interest rate on savings. This will provide the Federal Reserve with a demand-side tool to directly impact Main Street instead of relying on indirectly influencing demand through a supply-side tool aimed at Wall Street.  Targeting demand through postal bank accounts to stop excessive inflation or, alternatively, to stimulate demand in a weak economy will be much more cost effective in offering more bang for the buck, will be more direct and have a more immediate impact, use less money and be less disruptive of our economy than current Federal Reserve supply-side stabilization strategies. 

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The “Inflation Dilemma” and How to Solve It

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Fiscal conservatives claim that President Biden’s $1.9 trillion stimulus proposal surely will lead to excessive inflation. However, in Congress the recently proposed Public Banking Act opens the door to a new policy tool that could quickly and painlessly stop excessive inflation in its tracks were it to develop. 

Economists such as Stephanie Kelton in her book “The Deficit Myth” argue that although we must avoid excessive inflation, deficit spending is not inherently a problem. The key point in her argument is that interest rates have remained low.  Low interest rates make larger deficits manageable because they keep interest payments on the debt low.  Moreover, low interest rates are a sign that investors have not lost faith in the soundness of U.S. Treasury securities. Although the interest rate on 10-year government bonds has risen to around 1.5 percent, it has not yet approached levels that would be of any real concern.

But already we have seen the prices of gasoline, lumber and some foods rising significantly. What if President Biden’s $1.9 trillion COVID stimulus package were to push us into an upward inflationary spiral? Biden supporters argue that this is unlikely, but what if it did?  Would the Federal Reserve have the policy tools to stop excessive inflation quickly without throwing the economy into recession?

In the past the Federal Reserve has stopped inflation by significantly raising interest rates in the New York financial markets. Most notably in the early 1980s after inflation soared to 13.5 percent, Chairman Paul Volker led the Federal Reserve to raise rates and throw the economy into a deep recession. Could the Biden stimulus bring this upon us once again?

The key to solving this problem is in understanding “The Inflation Dilemma.”  The fundamental cause of excessive inflation is when too much money is chasing too few goods which drives up prices. In the face of excessive inflation, high interest rates are needed to encourage consumers to divert more of their money to savings to earn the higher interest rate and, therefore, cut back on unnecessary expenditures.  This reduces the demand for goods and services.

However, at the same time, low interest rates are needed to encourage producers to supply more goods and services to help drive prices back down. Businesses would like to respond to excessive demand by supplying more. But high interest rates discourage them from borrowing the money they need to add another line of production. 

When faced with rising prices, we need to cut back on demand and raise supply.  Raising interest rates enables the former, but discourages the latter. This inflation dilemma can be overcome only by providing high interest rates for consumers, motivating them to increase their savings and reduce demand, and at the same time providing low interest rate to companies to increase supply.  

The Public Banking Act opens up the opportunity to solve this inflation dilemma.  From 1910 to 1966 the post offices throughout the United States offered banking services. You could go to any post office to cash a check or set up a savings account.  A resumption of these services as currently proposed in the Public Banking Act would be particularly beneficial to low-income, disadvantaged people, who, after a job loss, car accident or uninsured medical emergency, need to borrow money but have to go to loan sharks, pawn shops or “cash now” opportunists and end up paying high interest rates. Under the Public Banking Act they could apply for a small loan at a relatively low interest rate at any post office. 

But the Public Banking Act could also serve to defeat the threat of excessive inflation and solve the inflation dilemma. Limiting postal savings accounts to individuals based on their Social Security numbers and placing a limit on how much of the savings in their accounts could earn interest, the accounts could offer a high interest rate when excessive inflation threatened. Limiting interest payments to accounts with $10,000 or less would keep wealthy individuals from transferring large amounts of money to these savings accounts from the private banking system. At the same time, the Federal Reserve could keep interest rates low in the New York financial markets enabling both the payments on the federal deficit to remain low and encouraging businesses to employ more workers, not less, as they expanded supply in the face of rising prices. Thus, the inflation dilemma would be solved by offering consumers high interest rates to reduce demand and businesses low interest rates to increase supply. The combination of less demand and more supply could slow or stop price increases without entering a recession.

Please provide your insights and comments on The Inflation Dilemma and How to Solve It.
Lawrence C. Marsh is Professor Emeritus in Economics at the University of Notre Dame and author of the 2020 book: Optimal Money Flow: A New Vision on How a Dynamic-Growth Economy Can Work for Everyone
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