Open Access Library Journal

2017, Volume 4, e3333

ISSN Online: 2333-9721
ISSN Print: 2333-9705

A Kind of Neither Keynesian Nor Neoclassical

Model (3): The Decision of Inflation

Ming’an Zhan1, Zhan Zhan2

Yunnan University, Kunming, China

1

Westa College, Southwest University, Chongqing, China

2

How to cite this paper: Zhan, M.A. and Abstract

Zhan, Z. (2017) A Kind of Neither Keyne-
sian Nor Neoclassical Model (3): The Deci- The difficulty of inflation theory is to explain the fluctuations of the price level
sion of Inflation. Open Access Library Jour- in short-term. First, we use the relationship between price and money in the
nal, 4: e3333. traditional quantity equation to derive the inflation equation that can explain
http://dx.doi.org/10.4236/oalib.1103333
changes of the price level in the long-term and short-term. Then, by analyzing
Received: December 26, 2016 the phase diagram of the single variable and the complex variable in the infla-
Accepted: January 14, 2017 tion equation, we find that the fundamental reason of the periodic change of
Published: January 18, 2017
the short-term price is the periodic change of the real interest rate. Because
Copyright © 2017 by authors and Open
fluctuations of the inflation rate and interest rate are the same in phase, so
Access Library Inc. there is no difference in the business cycle. Finally, this paper analyzes the rise
This work is licensed under the Creative and fall of core price under the influence of money and real interest rate re-
Commons Attribution International
spectively. It lays the foundation for further discussion of the relationship be-
License (CC BY 4.0).
http://creativecommons.org/licenses/by/4.0/
tween inflation and unemployment in Phillips curve.
Open Access
Subject Areas
Economics

Keywords
Inflation, Interest Rate, Quantity Equation, Phase Diagram

1. Introduction
Generally, problems of inflation are regarded as the relation between price and
currency, and the price and real output. We need to ask the question that
whether currency only has impacts on price or on both price and real output?
Friedman concluded that: “Inflation is always and everywhere a monetary phe-
nomenon” [1]. However, since the quantity theory of money cannot explain the
change pattern of price in short-term, people are willing to believe that there is a

DOI: 10.4236/oalib.1103333 January 18, 2017

 M. A. Zhan, Z. Zhan

certain relation between currency and real output based on Phillips curve [2].
Categorized by the transaction motive, speculative motive and precautionary
motive in Keynesian theory, the demand for money has different models: Di-
amond built up the iterative model based on the storage functionality of money
[3]; Baumol-Tobin model provided the analysis of speculation demand for
money to bonds [4] [5]; McCallum model analyzed how the demand for money
restrained by the transaction cost [6]; models of Patinkin, Whalen, Weinrobe,
Frenkel and Jovanobic, Blanchard and Fischer analyzed the precautionary or
uncertain demand for money from different aspects [7] [8] [9] [10] [11]. Al-
though different models of demand for money have different preconditions, they
all lead to the same conclusion: the demand for money is positively related to the
real income and negatively related to the interest rate.
However, statistical data since 1970s have shown that there is no stable func-
tional relation between currency and output as well as currency and interest rate
[12]. The concept of “demand for money” may be abandoned in the inflation
theory, and it will be easier to find the essence of price changes by analyzing the
relationship between any amount of money and real output.

2. Derivation of Inflation Equation

Since there is no specific currency variable in Cobb-Douglas function, we cannot
deduce the relation among the quantity of money, output and the price lever
based only on Cobb-Douglas function. The fundemental function of currency is
to increase the exchange efficiency between different kinds of wealth, or in other
words, to decrease the transaction cost. Assume the nominal output Y as the ex-
changing object of currency, then we can get the easiest exchange equation of
money:
aM = Y (1)
In which, a refers to the exchange coefficient (varies in terms of different
currencies, such as U.S. dollars or Japanese yen), M refers to the quantity of
currency or the currency stock, Y refers to the nominal output. To express
Equation (1) by growth rate, and a is a constant, then:
dM dY
= = , namely M Y (2)
M Y
Since there are statistical data on both sides of the equation (take M2 as M in
the Equation), we can verify the rationality of Equation (2) in reality. As Figure
1 shows, during 1970-2015 statistics in the United States, although the direction
of fluctuation of Y and M 2 has significant difference, the average of Y =
0.0649, which is quite close to the average of M 2 = 0.0685, so there is still a link
between Y and M . 2

We have calculated that using M2 as the M is a better to use other monetary

indices (such as M0 or M1) in Equation (2). Therefore, according to statistical
data in the United States, we can regard M2 as M in our theoretical analysis.
The nominal output Y is the multiplier of price index P and the real output
Yr , namely Y = PYr , then Equation (2) can be expressed as:

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Figure 1. Relations between statistical data of Y and M 2 . Calculation and resources:

Y = dY Y ≈ ∆Y Y = ∆GDP GDP= , M 2 dM 2 M 2 ≈ ∆M 2 M 2 . Data of GDP are from
http://www.bea.gov. Data of M2 are from Table-H.6 in http://www.federalreserve.gov.

dM dYr dP
= + , namely M =
Yr + P (3)
M Yr P

In the Equation (3), M can be observed directly from the statistical data, but
only one of Yr and P is from the statistical data, and the other can be calcu-
lated indirectly by the definition Y = PYr . Friedman and Schwartz states in “A
Monetary History of the United States, 1867-1960” that there is a fact but not
strict relation between the growth rate of currency and price [13]. As shown in
Figure 2, there are relations between P and M in long-term trend, but fluc-
tuation directions are very different in the short-term.
In order to explain the difference of P and M in the fluctuation, we define
the residual of M and P as V , namely V= Y − M , and observe the direc-
tion of fluctuation of V and M . As Figure 3 shows, V and M change re-
versely in short-term. Since Y includes the change of price index P and that of
real output Yr , unless we have already known the relation between P and V, or
Yr and V, otherwise it is impossible to explain the reverse changing trend of V
and M in short-term.
In fact, V= Y − M equals to d ( ln V ) =d ( ln Y ) − d ( ln M ) =d ln (Y M )  . By
neglecting initial conditions, we can rewrite it as V = Y M . Since Y = PYr ,
then:
MV = PYr , or M + V = P + Yr (4)

The above equation is the famous Fisher equation with different symbols from
the original equation [14], in which V is called the velocity of currency flow. Al-
though there are more variables in Equation (4) compares to that in Equation
(3), it still does not provide more information to analyze the short-term change
of P, unless we clarify the relation between V and other variables. If we assume V
as a constant as Keynes and Friedman did [15] [16], then Equation (4) became
Equation (3), so it is unhelpful for us to explain the change of P in short-term.
From the above derivation process, we can see that Equation (4) is not sacred
by people’s imagination, but is an identity defined by the hypothesis V= Y − M .

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( )
Figure 2. Relations between statistical data of P and M M 2 . Calculation and resources:
1) M = M 2 , data of M 2 see Figure 1. 2) The inflation rate=P dP P ≈ ∆P P . The price
index P is calculated by nominal GDP and real GDP, data of nominal and real GDP are
from http://www.bea.gov.

Figure 3. Relations between V and M . Calculation and resources: V= Y − M . Data of

Y and M see Figure 1.

It is easy to fall into the trap of subjective judgment or cyclic interpretation, as

the various explanations based on the identity Y = C + I g + ( X − M ) .
In Equation (4), M and Yr are exogenous variables, in which M is generally
determined by the monetary authority, and Yr is theoretically determined by
Cobb-Douglas function. We cannot rewrite Equation (4) into Yr = MV P and
regard M and P as reasons for the change of Yr . Otherwise, when V is a con-
stant, the real output can be increased as long as the money supply is increased,
as the IS-LM model does. Unfortunately, in traditional macroeconomics, there
are many such subjective theories.
Under the thought of the exchanging proportion of currency and real wealth
is varying along with time, then Equation (4) is a quantity equation of currency
and real wealth at a certain point of time. At time point t, the monetary income
collected at t would suffer lose when it is exchanged to real wealth at time point
( t + 1) due to the increase of price. In that case, the most rational chose in a in-
flationary environment should be: in consumption area, to exchange monetary
income into real wealth at each point of time; in investment area, to switch in-

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vestment objects on those object whose nominal revenue could reflects the latest
inflation rate. The assumption above indicates that the change of price would
affect the velocity of currency flow. We assume the velocity of currency flow is
the function of inflation rate, namely V = f ( P ) . Since:
df ( P ) dP
= df ( P=
dV ) ⋅ ⋅ P , simplified as df ( P=
) f ′ ( P ) PP
 
dP P
then

dV df ( P ) Pf
 ′ ( P )
V =
= = 
⋅P (5)
V f ( P ) f ( P )

Substitute Equation (5) into (4),

  ′ ( P )
PPf  Pf ′ ( P ) 
M =−V + P + Yr =− + P + Yr =P 1 −  + Yr ,
f ( P )  f ( P ) 

therefore
M − Yr
P = (6)
f ′ ( P )
1− 
⋅P
f ( P )

Equation (6) indicates that the change of P is not only related to ( M − Yr ) ,
but also to f ( P ) and the growth rate of P in short-term. In long-term, the
average value of f ′ ( P ) and P
 are equal to 0, otherwise there is a contradic-
tion between Equation (6) and P = M − Y in Equation (3). In that case, we
r
 or f ′ ( P ) is equal to 0.
need to verify if the average value of P
Since we do not know the details of the function V = f ( P ) , it is impossible
to verify the average value of f ′ ( P ) . However, we could estimate the average
value of P  by observing statistical data of P . As Figure 4 shows, during
1970-2015, the trend line of P is horizontal and it’s the average value in long-
term is 0.01, which approximately equal to 0.
If the average value of M and Y in long-term are the same, then their re-
sidual V should be equal to 0. In short-term, when the direction of fluctuation
of V and P  are the same, then we can assume the changing pattern of V is
determined by P  . Make θ = Pf ′ ( P ) f ( P ) , and according to Equation (5),
then V = θ P . In Figure 4, we can see that the long-term trend of V and P 
is consistent (their trend lines are parallel), and the short-term fluctuation direc-
tion of P  is also related. If the range of fluctuation of θ is significantly nar-
rower than that of P  in V = θ P
 , then we can take θ as a constant.
In fact, the value of θ is not important in the long-term, because as long as the
long-term average of P  is 0, there is P
= M − Y according to Equation (6).
r

This is the reason that money is always neutral in long-term, but is not clear in
the medium and short term.
As Figure 4 shows, based on statistical data during 1970-2015, make θ = 0.1,
 equals to 0.0010 and its long-term trend is approx-
then the average of 0.1P
imately horizontal. The average of V equals to −0.0040, therefore the average

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Figure 4. Relations between P and V . Calculation and resources: 1)= dP P ≈ ∆P P ,
P
=P dP P ≈ ∆P P . Data of P see Figure 2. 2) Theoretically, trend of θ P  and V are
consistent in long-term, and the direction of fluctuation and range of fluctuation should
be the same. The difference showed in Figure 4 indicates: θ is not necessarily a constant.
However, it is often regarded as a constant when P changes in a certain rand and the
change of θ is comparatively small compared to that of P .

of 0.1P  is close to that of V , and the direction of fluctuation of 0.1P is con-

sistent with that of V , but some differences in the range of fluctuation. Substi-
tute V = θ P into Equation (4), then:
P − θ P
 = M − Y
r (7)

Equation (7) indicates that the inflation rate P is not only affected by ex-
ogenous variables M and Yr , but also its own change rate P  . More impor-
tantly, the variables in Equation (7) have corresponding statistical data in the
United States, so that we can verify the results of the inference. Since the rela-
tionship between P and P  can be drawn as a phase diagram, therefore the
change of difference between M and Y determines the change of phase dia-
r

gram P ~ P
 .

3. Phase Diagram Analysis of Inflation Equation

In our paper “A Kind of neither Keynesian nor Neoclassical Model (2): The
Business Cycle” [17], we use the phase diagram to analyze the periodic fluctua-
tions of r and Y , and according to changes of phase diagram r ~ r , we divide
the 1970-2015 period into 9 cycles, as shown in Figure 5.
When we analyze the relationship between the variable P and other variables,
the other variables should be real variables that are not affected by the price, so
that there is no suspicion that the loop is interpreted. P is not only related to
M but also to Yr in Equation (7). Theoretically, the periodicity of Yr is de-
termined by the periodicity of r , so the fluctuation of P is likely to be related
r

to rr or r . In Figure 5, P , r and rr vary in the time path of the wave pat-

terns, but they are similar on the characteristics in the cycle. According to the
Equation (7), we can analyze the relationship between r and P theoretically.
r

According to time path of P in Figure 5, we estimate there might be a

phase diagram of P and θ P with circulating characteristics. It can be testi-
fied with statistical data, as shown in Figure 6.

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Figure 5. Time paths of r , rr and P . Calculation and resources: Data of P see Fig-
ure 2. r = r − P , r is the arithmetic mean of annualized earnings of various US Trea-
r

sury bonds, data are from http://www.federalreserve.gov/. See paper “A Kind of neither
Keynesian nor Neoclassical Model (2): the Business Cycle” [17].

Figure 6. Phase diagram P ~ θ P of statistical data. Calculation and resources: θ = 0.1.
 
When θ P > 0 , then P moves to the right; and when θ P  < 0 , P moves to the left.
 
Therefore the phase diagram P ~ P rotates clockwise.= P dP P ≈ ∆P P =
 , P dP P ≈
∆P P , data of P see Figure 2.

The theoretical analysis of the phase diagram P ~ θ P

 can be seen: the rota-
tion of P ~ θ P
 must be clockwise based on mathematical logic as shown in
Figure 7(a). Since θ P  > 0 above the horizontal axis, then P should more
towards right, vice versa. We call P in the ellipse as the core inflation rate,
which is determine by the average of P in a business cycle.
Take ( P − θ P
 ) in Equation (7) as a composite variable, then we can draw the
(
phase diagram of P ~ P − θ P )
 which rotates counterclockwise as Figure 7(b)
shows. The dotted line P = θ P  is an auxiliary line for drawing the phase dia-
 ) . The phase diagram P ~ ( P − θ P
gram P ~ ( P − θ P  ) under the bisector
P = θ P
 correspond to parts of P ~ θ P
 above the horizontal axis, vice versa.

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 M. A. Zhan, Z. Zhan

(a) (b)

Figure 7. (a) Standard shape of the phase diagram P ~ θ P

 , (b) Phase dia-

(
gram P ~ P − θ P )
 . Notice: In (a), we firstly draw the auxiliary line
P = θ P
 . Point a and c in the phase diagram P ~ θ P
 correspond to point a
and c in the phase diagram P ~ P − θ P(
 )  = 0 . Then we can
since θ P
draw other points on the phase diagram based on the composite variable
( P − θ P) . The phase diagram P ~ ( P − θ P ) rotates counterclockwise be-
 .
cause there is a negative sign in front of θ P

Since the direction of rotation of P ~ θ P  and P ~ ( P − θ P

 ) are reverse,
 and P ~ ( P − θ P
P ~ θ P  ) will be significant differences in the time path. In
Figure 7(b), point c on the phase diagram P ~ θ P  express the maximum value
of P , which locates in the middle of a cycle; point d on the phase diagram
P ~ ( P − θ P
 ) express the maximum value of the composite variable ( P − θ P
 ) ,
which locates in the second half of a cycle since Point d exists later than point c
on the phase diagram P ~ ( P − θ P  ) . As a result, peaks of the composite variable
( P − θ P ) exist later than that of P in terms of time paths. This can be verified
 
by statistical data, as shown in Figure 8.
The average of P and the composite variables ( P − θ P) are 0.035 and
0.036 for 1970-2015 respectively, and their trends are also consistent in long-
term. As the Figure 8 shows, ( P − θ P
 ) have a particularly large peaks and val-
leys in each cycle. This helps us to confirm the cycle more clearly. Even we can
use the phase diagram P ~ θ P  or time path of ( P − θ P
 ) to divide the busi-
ness cycle in the absence of statistical data r.
In the equation P − θ P = M − Y , since the composite variable
r ( P − θ P) on
the left side of the equation changes periodically, the composite variable ( M − Y ) r

on the right side should also change periodically.

Since the money has a capital attribute, it is assumed that the periodicity
of M in the short-term may be similar to the periodicity of the capital change
K in Cobb-Douglas function. By the marginal condition of Y = AK α Lβ ,
MPK =∂Y ∂K =r , there is K = α Y r , so

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Figure 8. Time paths of P and ( P − θ P) . Calculation and resources:= dP P ≈

P
∆P P =
, P dP P ≈ ∆P P , data of P see Figure 2. Since P is to be calculated in incre-
ments of P , the initial statistical data of P is one year later than P . It is 1971.

dK dY dr d α
= − + ,
K Y r α
According to the fundamental equation ∆Y =rY [18],
dY ∆Y rY
= lim= lim = r,
Y ∆Y →0 Y ∆Y →0 Y
r − dr r + dα α . hypothesis dα α = 0 , then
therefore, dK K =
dK dr
K = =r − =r − r.
K r
Compared with Y= r + r , the front of r is a negative sign in K = r − r , so
the rotation of the phase diagram r ~ K is counterclockwise. This causes the
peak of K to fall behind the peak of r in the time path, as shown in Figure 9. If
fluctuation of M is similar to K in short-term, then the peak of M will be
in the second half of a cycle, since the peak of Y is before the peak of r (the
peak of Y is in the first half of a cycle).
As guess from Figure 9, if the peak of Y is in the first half of a cycle, the
peak of M which is similar to K , will be in the second half of a cycle, in other
words the peak of M will follow the peak of Y . The statistical data of Figure
10 can verify this conjecture.
Because the phase diagram rr ~ M rotates counterclockwise, we can overlap
it on the phase diagram rr ~ ( −Yr ) and then get the phase diagram of the com-
posite variable ( M − Y ) . In this way, the phase diagram P ~ ( P − θ P
r
 ) and
rr ~ ( M − Yr ) can be related according to Equation (7).
Figure 11(a) shows the process to draw the phase diagram rr ~ ( M − Yr ) .
Firstly we draw the phase diagram rr ~ rr rotates clockwise, and draw the phase
diagram rr ~ Yr rotates clockwise based on equation Yr ≈ rr + rr (The reason
for using the symbol ≈ will be explained later in the analysis of the Phillips
curve). Then we can get the phase diagram rr ~ ( −Yr ) which is the mirror im-
age of rr ~ Yr and rotates counterclockwise.
The phase diagram rr ~ M rotates counterclockwise, and the core variable
M is affected by monetary policies and multiple times of the money supply of

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Figure 9. Phase diagram and time path of K and r . Drawing method see paper “A
Kind of neither Keynesian nor Neoclassical Model (2): the Business Cycle” [17].

Figure 10. Time paths of M and Yr . Resources: Yr= Y − P . Data of Y see Figure 1,
data of P and M see Figure 2.

central bank. The central bank supplies basic currency, and M comprises of
basic currency and other derived currency created by business banks and finan-
cial market. The bigger of the monetary multiplier of the basic currency and the
derived currency, the higher place on the vertical axis of M . In order to facili-
tate our narration, we assume M is determined by the supply of basic money
under a constant monetary multiplier even though the multiplier might not be a
constant in reality.

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Since the phase diagram rr ~ M and rr ~ ( −Yr ) both involve rr , we can

overlap corresponding points (point a, b, c, d) in these two diagrams and then
determine the location, shape and direction of rotation of the phase diagram
rr ~ ( M − Yr ) as show in Figure 11(a).
We now could relate the phase diagram P ~ ( P − θ P ) to r ~ ( M − Y ) .
r r

Since P − θ P = M − Y , then the direction of rotation of r ~ ( M − Y ) and

   
r r r

P ~ ( P − θ P
 ) are the same, and points on r ~ ( M − Y ) (as a, b, c, d) are cor-
r r

responding to that on P ~ ( P − θ P  ) . Since both phase diagrams rotate counter-

clockwise, then the maximum value of ( M − Yr ) and ( P − θ P  ) locates at the
second half of a cycle. We can verify this conclusion in statistical data in Figure
12.

(a) (b)

Figure 11. (a) Phase diagram rr ~ rr , (b) Phase diagram P ~ P − θ P ( )

 . Notice: 1) In (a),
assume a phase diagram rr ~ rr with the core variable rr . Then draw the phase diagram
rr ~ Yr with the core variable Yr , Yr= rr + rr , therefore Yr = rr . The phase diagram
rr ~ ( −Yr ) is the mirror image of phase diagram rr ~ Yr . We can get the phase diagram

rr ~ ( M − Yr ) by overlapping rr ~ M and rr ~ ( −Yr ) . 2) (b), firstly draw the phase di-
 , then the corresponding diagram P ~ P − θ P
agram P ~ θ P ( )
 . Then adjust the location

and shape of the phase diagram P ~ θ P

 based on r ~ ( M − Y )
r r until the phase

P ~ ( P − θ P ) is corresponding to rr ~ ( M − Yr ) , namely M − Yr = P − θ P .

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Figure 12. Time paths of ( M − Y )

r and ( P −θ P) . Calculation and resources:

Yr= Y − P . Data of Y see Figure 1, data of ( P − θ P) see Figure 8.

In addition, the cycle of ( P − θ P) and ( M − Y )r fluctuates in accordance

with the inflation equation, but also their long-term average should be equal.
The statistical data show that the average value of ( P − θ P
 ) and ( M − Y ) are
r

0.036 and 0.041 for the period 1970-2015. There are two reasons why the average
value of ( P − θ P
 ) is slightly smaller than ( M − Y ) . First, the time of the sta-
r

tistical data is not long enough. The impact of money will lag behind for some
time to be reflected in P , especially in the monetary policy of QE (quantitative
easing) over the years. Second, there are leakages of the money, such as part of
the currency flow to other countries and regions.

4. The Change of Price by the Influence of M and rr

Theoretical analysis in Figure 11 show that there are four factors affect the
change of macroeconomic price: firstly, the change of M which is closely re-
lated to base money supply; secondly, the periodic change of variable M ; third-
ly, the change of core variable rr which reflects the operating efficiency of the
system; fourthly, the periodic change of rr .
In order to identify all above factors, we call M , r and P as “core va-
r

riables” which stand for changes of M , rr and P due to the migration of

phase diagrams rr ~ M , rr ~ rr and P ~ θ P . M , rr and P as “fluctuating
variables” which stand for changes of M , rr and P due to the fluctuation of
 M + M , r= r + r , P= P + P .
phase diagrams. There relations are: M= r r r

In this way, we can more clearly understand the factors that affect price
changes, and get some preliminary inference. For example, with an established
phase diagram rr ~ rr , we can analyze the impact of change of exogenous varia-
ble M on P .
As Figure 13 shows, assume the initial state of M as ( M ) , then we can lo-
0

cate the phase diagram rr ~ ( M − Yr ) , P ~ ( P − θ P

 ) and P ~ (θ P
 ) accord-
0 0 0

ing to rr ~ rr . Under the effect of monetary policies, ( M ) 0

drop to ( M ) ,
1

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 M. A. Zhan, Z. Zhan

Figure 13. Impacts of changing M on P . Notice: 1) This figure is a simplified version

r r ( )
of Figure 11, there is no phase diagrams r ~ Y and rr ~ −Yr . 2) Assume r stay r

unchanged, then the smaller value of M , the further place of the core variable P to-
wards left.

and make ( M ) = Y , then ( M − Y )

1
r r
1
equals to 0, therefore ( P − θ P ) =
1
0,

P1 = 0 .
It not only indicates P and M change to the same direction, but also the
central bank could make the core inflation rate P = 0 by controlling M (no-
tice: P = 0 is different from P = 0 ). Since P= P + P , and P fluctuates
around P , the value of P might be less or more than 0.
Even though we know that there is relation between the phase diagram
rr ~ rr and P ~ θ P
 in Figure 11, we do not know whether the periodic change
of P is determined by that of r or the periodic change of r is determined
r r

by that of P . Since the implicated premise of existence of phase diagrams

rr ~ M and P ~ θ P
 is that “money is the trading medium of real wealth”, the
initial fluctuation is the fluctuation of real interest rate rr and thereafter the
fluctuation of inflation rate P . In barter system, there only exist phase dia-
grams r ~ r and r ~ Y but not r ~ M and P ~ θ P
r r r r r
 , the periodic change
of rr still exists without money. Therefore, the periodic variation of P is de-
termined by the periodic variation of rr .
In order to eliminate the fluctuation of P or make P ≡ 0 in a system in
which currency are medium of exchange, the government could take two meas-
ures: firstly, to restrain the fluctuation of r ; secondly, to control M and
r

therefore cause the change of P to offset the change of P . The first measure
is usually applied by planned economy, and the second one need to make sure
the change of M would not cause the change of r , otherwise there would be
r

unexpected consequences.
As shown in Figure 14, assume M keep unchanged, we can discuss the im-
pacts of r on P . When r drops from ( r ) to ( r ) , the phase diagram
r r r 0 r 1

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 M. A. Zhan, Z. Zhan

Figure 14. Impacts of changing rr on P , Notice: 1) This Figure is a simplified version

( )
of Figure 11, there is no phase diagrams rr ~ Yr and rr ~ −Yr . 2) Assume M stay
unchanged, then the smaller value of rr , the further place of the core variable P to-
wards right.

rr ~ Yr moves downward along the slash line, and the phase diagram
r ( r )
r ~ M − Y moves from r ~ M − Y
r ( ) ( )
to r ~ M − Y . Correspondingly,
r 0 r r 1

the phase diagram P ~ ( P − θ P ) and P ~ θ P

 move upward and rightward,
respectively. This means that the decline in real interest rates will cause the price
level to rise. Even if the increase of M and the increase of rr occur at the
same time, the change of P and M are in the same direction, the change of
P and rr are the opposite direction, so P would not necessarily rise.
We can analyze the change of P by the inflation equation as in Figure 13
and Figure 14, but we do not know whether M and rr affect each other, or in
other words, when the increase or decrease of M leads to the rise or drop of
P , whether rr change along with the change of P .
Although the inflation equation does not tell us “whether currency only has
impacts on price or on both price and real output?” However, according to sta-
tistics in the United States, the change of P usually cause the change of rr ,
especially when P change to a significant extent. The final answer may require
an analysis of the microeconomic mechanism based on the inflation equation.

5. Conclusion
5.1. Hypothesis
• The production function: Y = AK α Lβ . A marginal condition:
r= ∂Y ∂K = αY K .
• The quantity equation: M = aY . Identity: Y = PYr .
among them, V =
• Residual: V= Y − M ,=  ′ ( P ) f ( P )  P
Pf  θ P
 , θ = 0.1 .


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 M. A. Zhan, Z. Zhan

5.2. Results
• The Inflation equation: P − θ P
 = M − Y .
r

• The decomposition of variables: M=  M + M , r= r + r , P= P + P .

r r r

5.3. Discussion
• By transforming of the residual V , we use the analysis method of phase di-
agram to explain the short-term and long-term changes of the price in one
equation: in the long-term, the average of P is 0, so P is determined by
M and Yr ; in the short-term, since P
 is not 0, P is determined by the
( )
phase diagram of the complex variable M − Yr . Since these conclusions
can be verified by statistical data, so they challenge the traditional theory of
“demand for money”. From the perspective that money is wealth, everyone
wants more money than existing ones. From the perspective that money is
the medium of exchange, with the popularity of non-currency payment,
people realize that their demand for transactions is not a demand for trading
medium (such as currency), but to transfer the real wealth of others into their
own accounts through monetary policy, or to pass on financial crisis to oth-
ers. Therefore, the “demand for money” analysis is difficult to explain the
changes in inflation.
• Although this paper explains the factors that affect inflation, it is not able to
answer whether money will affect real output at the same time as it affects
prices. Omitting the fluctuation factor, if P increases with M increases,
will r also increase. Because the change of P is the result of the change of
r

rr and M , if the change of M will cause the change of rr by P , then rr

is the reason of change of P , and is affected by the change of P . This logic
trap may be an important reason for the unclear role of money in the eco-
nomic system. We will clarify this problem further by analyzing the Phillips
curve in the next paper.

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