COMMENT | Fatal flaws - inflation, interest rates and the ringgit

COMMENT | There is an intricate, convoluted, but eventually logical relationship between inflation, interest rates and the exchange rate which if misunderstood or if adherence to a particular school of thought is too strict can result in some fatal flaws in economic decision-making.

When prominent economist Milton Friedman said “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”, he provided a tool for fighting inflation - controlling money supply.

In other words, he was saying that inflation was caused by too much money chasing too few goods. His prescription was to raise the cost of money, in other words increase interest rates by controlling money supply. Those advocating these views were called monetarists.

This has been used by central banks across the world, particularly the US Federal Reserve to fight inflation. But that does not mean that it is the only way to control inflation - the circumstances have to be right.

Friedman’s thoughts displaced those of the arguably more famous economist, John Maynard Keynes, whose thinking dominated economics until the 1970s when Friedman’s monetarism gradually began to dominate.

Keynesians believed in government intervention at appropriate times to keep the economy on an even keel and to stimulate demand when there are signs that the economy is slacking off. In other words, the government should spend when...