Difference between revisions of "Inflation" - New World Encyclopedia

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[[Category:Economics]]
 
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In [[mainstream economics]], '''inflation''' is a rise in the general level of prices, as measured against some baseline of [[purchasing power]].  
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[[Image:Inflation rate world 2007.png|thumb|250 px|Inflation rates around the world, 2007.]]
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[[Image:US Historical Inflation Ancient.svg|thumb|250 px|Annual inflation rates in the U.S., 1666-2004.]]
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'''Inflation''' is measured as the growth of the [[money supply]] in an [[economy]], without a commensurate increase in the supply of goods and services. This results in a rise in the general [[price]] level as measured against a standard level of purchasing power. There are a variety of inflation measures in use, related to different [[price index|price indices]], because different prices affect different people. Two widely known indices for which inflation rates are commonly reported are the [[Consumer Price Index]] (CPI), which measures nominal consumer prices, and the [[GDP deflator]], which measures the nominal prices of goods and services produced by a given country or region.
  
The prevailing view in mainstream economics is that inflation is caused by the interaction of the supply of [[money supply|money]] with output and [[interest rate]]s. In general, mainstream economists divide into two camps: those who believe that monetary effects dominate all others in setting the rate of inflation, or broadly speaking, [[monetarist]]s, and those who believe that the interaction of money, interest and output dominate over other effects, or broadly speaking [[Keynesian]]s.  
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Mainstream [[economics|economists]]' views on the causes of inflation can be broadly divided into two camps: the "[[monetarism|monetarist]]s" who believe that monetary effects dominate all others in setting the rate of inflation, and the "[[Keynesian economics|Keynesian]]s" who believe that the interaction of money, [[interest]] rates, and output dominate other effects. Keynesians also tend to add a capital-goods (or asset) price inflation to the standard measure of consumption-goods inflation. Other theories, such as those of the [[Austrian school of economics]], believe that inflation results when [[central bank]]ing authorities increase the money supply.
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{{toc}}
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Inflation is generally seen as a problem for a society, and [[central bank]]s aim to prevent it from reaching unmanageable proportions. Whether they find appropriate policies to achieve control over inflation has serious consequences for the prosperity and happiness of everyone in that society.  
  
Related terms include: [[deflation (economics)|deflation]], a general falling level of prices, [[disinflation]], the reduction of the rate of inflation, [[hyper-inflation]], an out of control inflationary spiral, and [[reflation]], which is an attempt to raise prices to counteract deflationary pressures.
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==Terminology==
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'''Inflation''' is defined as a widespread, substantial rise in [[price]]s across an economy related to an increased volume of [[money]], which results in a loss of value for that [[currency]].  
  
== Measures of inflation ==
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In classical [[political economy]], inflation' meant increasing the [[money supply]]. The purpose of this increase in money supply is to accommodate any increase in real [[GDP]]. This increased money supply would prevent the phenomenon of deflation, which occurs when there is not enough money, thereby increasing the value of money and decreasing the value of goods and services. [[Central bank]]s or other similar government entities solve this problem through putting more currency into circulation to accommodate [[economic growth]]. Some economists in a few schools of economic thought still retain this usage.
  
Measuring inflation is a question of [[econometrics]], that is, finding objective ways of comparing nominal prices to real activity. In many places in economics, "real" variables need to be compared, in order to calculate GDP, effective interest rate and improvements in productivity. Each inflationary measure takes a "basket" of good and services, then the prices of the items in the basket are compared to a previous time, then adjustments are made for the changes in the goods in the basket itself. For example if a month ago canned corn was sold in 10 oz. jars, and this month it is sold in 9.5 oz jars, then the prices of the two cans have to be adjusted for the contents. The result is the amount of increase in price which is attributed to "inflation" and not to improvements in productivity.  
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Related concepts include: [[disinflation]], the reduction of the rate of inflation; [[hyper-inflation]], an out-of-control inflationary spiral; [[stagflation]], a combination of inflation and rising [[unemployment]]; and [[reflation]], which is an attempt to raise prices to counteract deflationary pressures.
  
This means that there are many measures of inflation, depending on which basket of goods and services are used as the basis for comparison. Different kinds of inflation measure are used to determine the real change in prices, depending on what the context is.
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There are three major types of inflation:
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* Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending, and so on.
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* Cost-push inflation: presently termed "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
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* Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.
  
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==Measures of inflation==
 
Examples of common measures of inflation include:
 
Examples of common measures of inflation include:
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*[[Consumer price index|Consumer price indices]] (CPIs) which measures the price of a selection of goods purchased by a "typical consumer."
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*[[Cost-of-living index|Cost-of-living indices]] (COLI) which often adjust fixed incomes and contractual incomes based on measures of goods and services price changes.
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*[[Producer price index|Producer price indices]] (PPIs) which measure the price received by a producer. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. Producer price inflation measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" as consumer inflation, or it could be absorbed by profits, or offset by increasing productivity.
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*[[Wholesale price index|Wholesale price indices]], which measure the change in price of a selection of goods at wholesale, prior to retail mark ups and sales taxes. These are very similar to the Producer Price Indices.
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*[[Commodity price index|Commodity price indices]], which measure the change in price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee.
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*[[GDP Deflator]] measures price increases in all assets rather than some particular subset. The term "deflator" in this case means the percentage to reduce current prices to get the equivalent price in a previous period. The US Commerce Department publishes a deflator series for the U.S. economy.
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*[[Capital goods price Index]], although so far no attempt at building such an index has been tried, several economists have recently pointed the necessity to measure separately [[capital goods]] inflation (inflation in the price of stocks, real estate, and other assets). Indeed a given increase in the supply of money can lead to a rise in inflation (consumption goods inflation) and or to a rise in capital goods price inflation. The growth in money supply has remained fairly constant through since the 1970's however consumption goods price inflation has been reduced because most of the inflation has happened in the capital goods prices.
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*[[Regional Inflation]] The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US.
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*[[Historical Inflation]] Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology. This is equivalent to not adjusting the composition of baskets over time.
  
* '''[[consumer price index]]es''' (CPIs) which measure the price of a selection of goods purchased by a "typical consumer". 
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===Hedonic adjustments to measuring inflation===
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Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods from the present are compared with goods from the past. This includes [[hedonic adjustments]] (the idea that goods are priced based both on their intrinsic value and on external factors such as popularity) and “reweighing” as well as using chained measures of inflation. As with many economic numbers, inflation numbers are often [[seasonally adjusted]] in order to differentiate expected cyclical cost increases, versus changes in the economy. Inflation numbers are averaged or otherwise subjected to statistical techniques in order to remove [[statistical noise]] and [[Volatility (finance)|volatility]] of individual prices. Finally, when looking at inflation, economic institutions sometimes only look at subsets or ''special indices.'' One common set is inflation ex-food and energy, which is often called “[[core inflation]].” Inflation is also measured by the CPIX which stands for consumer price index
  
* '''[[producer price index]]es''' (PPIs) which measure the price received by a producer. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. Producer price inflation measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" as consumer inflation, or it could be absorbed by profits, or offset by increasing productivity.
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==Role of inflation in the economy==
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The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian schools. In [[monetarism]] prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trendline. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.
  
* '''[[wholesale price index]]es''', which measure the change in price of a selection of goods at wholesale, prior to retail mark ups and sales taxes. These are very similar to the Producer Price Indexes.
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Notable effects of inflation include:
 
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*Increasing [[uncertainty]] may discourage [[investment]] and [[saving]].
* '''[[commodity price index]]es''', which measure the change in price of a selection of commodities. In the present commodity price indexes are weighted by the relative importance of the components to the "all in" cost of an employee.
 
 
 
* '''GDP Deflators''' use an entire economy as the basket of goods and services, rather than some particular subset. The term "deflator" in this case means the percentage to reduce current prices to get the equivalent price in a previous period. The US Commerce Department publishes a deflator series for the US economy.
 
 
 
* '''Purchasing Power Parity''' adjusts for the inflationary effects of goods being non-tradeable between two or more economies, for example land prices, to compare standard of living purchasing power between two economies. PPP adjustments are, therefore, measuring inflation in location, rather than in time. Many inflation series numbers are also published for particular geographic regions. For example, the US Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US.
 
 
 
* '''Historical Inflation''' Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology. This is equivalent to not adjusting the composition of baskets over time.
 
 
 
Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods from the present are compared with goods from the past. This includes [[hedonic adjustments]] and "reweighing" as well as using chained measures of inflation. As with many economic numbers, inflation numbers are often [[seasonally adjusted]] in order to differentiate expected cyclical cost increases, versus changes in the economy. Inflation numbers are averaged or otherwise subjected to statistical techniques in order to remove [[statistical noise]] and [[volatility]] of individual prices. Finally, when looking at inflation, economic institutions sometimes only look at subsets or "special indexes". One common set is inflation ex-food and energy, which is often called "[[core inflation]]".
 
 
 
In classical political economy, inflation referred to the money supply itself: inflation meant increasing the money supply over and above that necessary to accommodate any increase in real GDP, while deflation meant decreasing it. A few schools of economic thought, generally described as libertarian or ultra-conservative, still retain this usage. In mainstream economic terms these would be referred to as expansionary and contractionary monetary policies. Some believe that the mainstream view is intended to disguise the effects of inflation in the money supply as they discount the increases in asset classes such as stocks, bonds and real estate; whereas central banks can control the rate of inflation, they cannot direct where the extra fiat money will go. In addition, a "basket of goods" may not be representative. The increase in money supply can also create false GDP growth as per the equations:
 
 
 
velocity of money x money supply = nominal GDP = real GDP x GDP deflator.
 
 
 
== The role of inflation in the economy ==
 
 
 
In the long run, inflation is generally believed to be a monetary phenomenon, while in the short and medium term, it is influenced by the relative elasticity of wages, prices and interest rates. <ref>[http://www.federalreserve.gov/boarddocs/hh/2004/july/testimony.htm ''Federal Reserve Board's semiannual Monetary Policy Report to the Congress''];
 
[http://www.federalreserve.gov/BOARDDOCS/Speeches/2003/20030723/default.htm ''Remarks by Governor Ben S. Bernanke Before the Economics Roundtable];
 
[http://www.ecb.int/press/pressconf/2004/html/is040701.en.html ''Introductory statement by Jean-Claude Trichet on 1 July 2004]''</ref> The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian schools. In [[monetarism]], prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trendline. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.
 
 
 
A great deal of economic literature concerns the question of what causes inflation and what effect it has.  A small amount of inflation is often viewed as having a positive effect on the economy.  One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are "sticky downward" and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Efforts to attain complete price stability can also lead to [[deflation (economics)|deflation]], which is generally viewed as a negative outcome because of the significant downward adjustments in wages and output that are associated with it.
 
 
 
Inflation is also viewed as a hidden risk pressure that provides an incentive for those with savings to invest them, rather than have the purchasing power of those savings erode through inflation. In investing inflation risks often cause investors to take on more [[systematic risk]], in order to gain returns that will stay ahead of expected inflation. Inflation is also used as an index for cost of living adjustments and as a peg for some bonds. In effect, inflation is the rate at which previous economic transactions are [[discounted]] economically.
 
 
 
Inflation also gives central banks room to maneuver, since their primary tool for controlling the money supply and [[velocity of money]] is by setting the lowest interest rate in an economy - the discount rate at which banks can borrow from the central bank. Since borrowing at negative interest is generally ineffective, a positive inflation rate gives central bankers "ammunition", as it is sometimes called, to stimulate the economy.
 
 
 
However, in general, inflation rates above the nominal amounts required to give monetary freedom, and investing incentive, are regarded as negative, particularly because in current economic theory, inflation begets further inflationary expectations.
 
 
 
*Increasing ''uncertainty'' may discourage investment and saving.
 
 
*''Redistribution''
 
*''Redistribution''
** It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and profits which may keep pace with inflation.
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**It will redistribute income from those on fixed incomes, such as [[pension]]ers, and shifts it to those who draw a variable income, for example from wages and [[profit]]s which may keep pace with inflation.
** Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, it will reduce this [[debt]] redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden [[tax]].
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**Similarly it will redistribute [[wealth]] from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, it will reduce this [[debt]] redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden [[tax]].
* ''International trade'': If the rate of inflation is higher than that abroad, a fixed [[exchange rate]] will be undermined through a weakening [[balance of trade]].
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*''International trade'': If the rate of inflation is higher than that abroad, a fixed [[exchange rate]] will be undermined through a weakening [[balance of trade]].
*''Shoe leather costs'': Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.)
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*''Shoe leather costs'': Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.)
 
*''Menu costs'': Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
 
*''Menu costs'': Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
 
*''Relative Price Distortions'': Firms do not generally synchronize adjustment in prices. If there is higher inflation, firms that do not adjust their prices will have much lower prices relative to firms that do adjust them. This will distort economic decisions, since relative prices will not be reflecting relative scarcity of different goods.  
 
*''Relative Price Distortions'': Firms do not generally synchronize adjustment in prices. If there is higher inflation, firms that do not adjust their prices will have much lower prices relative to firms that do adjust them. This will distort economic decisions, since relative prices will not be reflecting relative scarcity of different goods.  
*''Hyperinflation'': if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.  
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*''[[Hyperinflation]]'': if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.  
*''Inflation tax'' when a government can improve its net financial position by allowing inflation, then this represents a tax on certain holders of currency. Governments may decide to use this "stealth tax" in order to avoid hard fiscal decisions to cut expenditures, raise taxes, or confront government unions with greater efficiency.
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*''Bracket Creep'' (also called ''[[fiscal drag]]'') is related to the inflation tax. By allowing inflation to move upwards, certain sticky aspects of the tax code are met by more and more people. Commonly income tax brackets, where the next dollar of income is taxed at a higher rate than previous dollars. Governments that allow inflation to "bump" people over these thresholds are, in effect, allowing a tax increase because the same real purchasing power is being taxed at a higher rate.
*''Bracket Creep'' is related to the inflation tax. By allowing inflation to move upwards, certain sticky aspects of the tax code are met by more and more people. Commonly income tax brackets, where the next dollar of income is taxed at a higher rate than previous dollars. Governments that allow inflation to "bump" people over these thresholds are, in effect, allowing a tax increase because the same real purchasing power is being taxed at a higher rate.
 
*''Corporate Return on Investment'' is effected by generating inflation. Should a firm increase productivity, this would tend to reduce the prices as per supply/demand ratios. Inflation enables firms to reap the reward from productivity investment instead of benefitting the consumer as happened prior to 1913 in the US.
 
 
 
As noted, some economists see moderate inflation as a benefit; some business executives see mild inflation as "greasing the wheels of commerce." A very few economists have advocated reducing inflation to zero as a monetary policy goal - particularly in the late 1990s at the end of a long disinflationary period, when the policy seemed within reach.
 
 
 
== Causes of inflation ==
 
 
 
There are different schools of thought as to what causes inflation. Most can be divided into two broad areas: quality theories of inflation, and quantity theories of inflation. Many theories of inflation combine the two. The quality theory of inflation rests on the expectation of a buyer accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer.  The quantity theory of inflation rests on the equation of the money supply, its velocity, and exchanges. [[Adam Smith]] and [[David Hume]] proposed a quantity theory of inflation for money, and a quality theory of inflation for production.
 
 
 
=== Keynesian Theory ===
 
 
 
[[Keynesian]] economic theory proposes that money is transparent to real forces in the economy, and that visible inflation is the result of pressures in the economy expressing themselves in prices.
 
 
 
There are three major types of inflation, as part of what [http://faculty-web.at.nwu.edu/economics/gordon/indexlayers.html Robert J. Gordon] calls the "'''triangle model'''":
 
*'''[[Demand pull inflation]]''' — inflation from high demand for goods and low unemployment.
 
*'''[[Cost push inflation]]''' — presently termed "supply shock inflation," from an event such as a sudden decrease in the supply of oil.
 
*'''[[Built-in inflation]]''' — induced by [[adaptive expectations]], often linked to the "[[price/wage spiral]]" because it involves workers trying to keep their wages up with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as [[hangover inflation]].
 
 
 
A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of [[money]] in circulation relative to the ability of the economy to supply (its [[potential output]]).  This has been seen most graphically when governments have financed spending in a crisis by printing money excessively (from war or civil war conditions), often leading to [[hyperinflation]] where prices rise at extremely high rates (such as, doubling every month).  Another cause can be a rapid decline in the ''demand'' for money as happened in Europe during the black plague.
 
 
 
The [[money supply]] is also thought to play a major role in determining levels of more moderate levels of inflation, although there are differences of opinion on how important it is.  For example, [[Monetarism|Monetarist]] economists believe that the link is very strong; [[Keynesian economics]] by contrast typically emphasize the role of [[aggregate demand]] in the economy rather than the money supply in determining inflation. That is, for Keynesians, the money supply is only one determinant of aggregate demand.
 
  
A fundamental concept in such Keynesian analysis is the relationship between inflation and [[unemployment]], called the [[Phillips curve]].  This model suggested that price stability was a [[trade off]] against employment.  Therefore some level of inflation could be considered desirable in order to minimize unemployment.  The Philips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as ''[[stagflation]]'') experienced in the 1970s.
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==Theories==
 
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===Monetarism===
Thus, modern macroeconomics describes inflation using a Phillips curve that ''shifts'' (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the [[price/wage spiral]] and [[inflationary expectations]] implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the [[demand pull inflation|demand-pull]] component of the triangle model.
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{{Main|Monetarism}}
 
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Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The Quantity Theory of Money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:
Another Keynesian concept is the [[potential output]] (sometimes called the "[[natural gross domestic product]]"), a level of [[GDP]] where the economy is at its optimal level of production, given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, [[NAIRU]], or the "natural" rate of unemployment or the full-employment unemployment rate.)  If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will ''accelerate'' as suppliers increase their prices and built-in inflation worsens.  If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will ''decelerate'' as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.
 
 
 
However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls.  Worse, it can change because of policy: for example, high unemployment under Prime Minister [[Margaret Thatcher]] in the UK may have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as [[Structural unemployment|structurally unemployed]] (also see [[unemployment]]), unable to find jobs that fit their skills in the British economy. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.
 
 
 
=== Monetarism ===
 
 
 
One of the most influential schools of economic thinking rests on a quantity theory of money, namely monetarism. Monetarists assert that empirical study of monetary history shows that "inflation is always and everywhere a monetary phenomenon."  Modern mainstream central bank practice until recently adhered closely to this concept.
 
 
 
These economists derive this belief from what is known as the [[Quantity Theory of Money]]. The Quantity Theory of Money, simply stated, is that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:
 
  
 
<math>P=\frac{D_C}{S_C}</math>
 
<math>P=\frac{D_C}{S_C}</math>
  
where <math>P</math> is the general price level of consumers' goods, <math>D_C</math> is the aggregate demand for consumers' goods and <math>S_C</math> is the aggregate supply of consumers' goods. The idea behind this formula is that the general price level of consumers' goods will rise only if the aggregate supply of consumers' goods goes down relative to the aggregate demand for consumers' goods, or if the aggregate demand increases relative to the aggregate supply of consumers' goods. Based on the idea that total spending is based primarily on the total amount of money in existence, the economists calculate aggregate demand for consumers' goods based on the total quantity of money. Therefore, they posit that as the quantity of money increases, total spending increases and the aggregate demand for consumers' goods increases as well. For this reason the economists who believe in the Quantity Theory of Money also believe that the only cause for rising prices in a growing economy (this means aggregate supply of consumers' goods is increasing), is an increase of the total quantity of money in existence, which is caused by monetary policies, generally of [[central bank]]s where there is a monopoly on currency issue and the lack of a commodity peg to currency. The [[central bank]] of the United States is the [[Federal Reserve]]; the central bank backing the [[euro]] is the [[European Central Bank]].
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where <math>P</math> is the general price level of consumer goods, <math>D_C</math> is the aggregate demand for consumer goods and <math>S_C</math> is the aggregate supply of consumer goods. The idea is that the general price level of consumer goods will rise only if the aggregate supply of consumer goods falls relative to aggregate demand for consumer goods, or if aggregate demand increases relative to aggregate supply. Based on the idea that total spending is based primarily on the total amount of money in existence, the economists calculate aggregate demand for consumers' goods based on the total quantity of money. Therefore, they posit that as the quantity of money increases, total spending increases and aggregate demand for consumer goods increases too. For this reason, economists who believe in the Quantity Theory of Money also believe that the only cause of rising prices in a growing economy (this means the aggregate supply of consumer goods is increasing) is an increase of the quantity of money in existence, which is a function of monetary policies, generally set by [[central bank]]s that have a monopoly on the issuance of [[currency]], which is not pegged to a commodity, such as gold. The central bank of the United States is the [[Federal Reserve]]; the central bank backing the [[euro]] is the [[European Central Bank]].
 
 
=== Rational Expectations ===
 
 
 
Rational expectations, or "rashex" is a view of macroeconomics that states that economic actors look into the future and try and maximize their general sense of future states of well-being, and do not simply respond to the immediate opportunity cost and pressures of the present. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.
 
 
 
One core assertion of rashex is that actors will seek to "head off" central bank decisions, by preemptively engaging in inflationary behavior. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession which would be very damaging to the economy, and possibly require government bailouts. In this view central banks might be at an advantage renouncing some flexibility of monetary policy, in order to persuade economic actors that the central bank will not allow inflation.
 
 
 
=== Other Theories ===
 
 
 
==== Austrian economics ====
 
 
 
[[Austrian_School|Austrian economics]] views inflation as an increase in the money supply itself, and views moves in the general price level as being subsidiary to changes in money supply. While this is not a mainstream view, Austrian economics, as one of the original marginalist schools of economics, has had considerable influence on both neo-classical and Keynesian schools of thinking. In the Austrian view, money must be denominated in a stable unit of account, against which other prices are measured. This typically leads to the support for a [[gold standard]] of a very strict variety where all notes are convertible on demand to gold. In the Austrian view, inflation is equivalent to an increase in the money supply. In this view price changes only represent inflation if they are driven by monetary effects, where as price changes, whether up or down, that do not correlate to monetary effects are merely the workings of the market mechanism.
 
  
In this framework, there is a real rate of inflation, which is based on the money supply and the real rate of interest. Price fluctuations are measured against this real rate of inflation, to determine whether the money supply is being expanded above real potential output. In the Austrian view both the 1920's and the 1990's saw "inflation" because of increases in the money supply, even though price levels were relatively stable. In the Austrian framework, prices should have fallen during both periods, and the stability represented inflation over this real price level.
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No one denies that inflation is associated with excessive [[money supply]], but opinions differ as to whether excessive money supply is the cause.
  
This also means that in the Austrian view, deflation is not a negative outcome, but a positive one, because it shows that the same level of real production can be accomplished at a lower expenditure of scarce resources. Falling prices because of lower costs of production are seen as improving standards of living, rather than as a threat to real output.  
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===Rational expectations===
 +
[[Rational expectations theory]] holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.
  
The Austrian formalism focuses on the supply and demand for money, and sees inflation as a fall in the demand for money - that is, people want money less, and therefore will give less in the way of goods or services for it, or will demand more interest to lend the money. Deflation is seen as increase in the demand for money. These correspond to the mainstream concepts of liquidity preference.
+
A core assertion of rational expectations theory is that actors will seek to “head off” [[central bank]] decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession.
  
==== Marxist theory ====
+
===Austrian School===
 +
[[Austrian School]] economics falls within the general tradition of the quantity theory of money, but is notable for providing a theory of the process whereby, upon an increase of the money supply, a new equilibrium is pursued. More specifically, possessors of the additional money are held to react to their new purchasing power by changing their buying habits in a way that generally increases demand for goods and for services. Austrian School economists do not believe that production will simply rise to meet all this new demand, so that prices increase and the new purchasing power erodes. The Austrian School emphasizes that this process is not instantaneous, and that the changes in demand are not distributed uniformly, so that the process does not ultimately lead to an equilibrium identical to the old except for some proportionate increase in prices; that “nominal” values thus have real effects. Austrian economists tend to view fiat increases in the money supply as particularly pernicious in their real effects. This view typically leads to the support for a [[commodity]] standard (such as the [[gold standard]]) of a very strict variety where all notes are convertible on demand to some commodity or basket of commodities.
  
In Marxist economic theory, value is based on the labor required to extract a given commodity versus the demand for that commodity by those with money. The fluctuations of price in money terms are inconsequential compared to the rise and fall of the labor cost of a commodity, since this determines the true cost of a good or service. In this Marxist economics is related to other "classical" economic theories that argue that monetary inflation is caused solely by printing notes in excess of the basic quantity of gold. However, Marx argues that the real kind of inflation is in the cost of production measured in labor. Because of the classical labor theory of value, the only factor that is important is whether more or less labor is required to produce a given commodity at the rate it is demanded.
+
===Marxist theory===
 +
In [[Marxist economics]] value is based on the [[labor]] required to extract a given commodity versus the demand for that commodity by those with money. The fluctuations of [[price]] in [[money]] terms are inconsequential compared to the rise and fall of the labor cost of a commodity, since this determines the true cost of a good or service. In this, Marxist economics is related to other "classical" economic theories that argue that monetary inflation is caused solely by printing notes in excess of the basic quantity of gold. However, Marx argues that the real kind of inflation is in the cost of production measured in labor. Because of the classical labor theory of value, the only factor that is important is whether more or less labor is required to produce a given commodity at the rate it is demanded.
  
==== Supply-side economics ====
+
===Supply-side economics===
 +
[[Supply-side economics]] asserts that inflation is caused by either an increase in the supply of money or a decrease in the demand for balances of money. Thus the inflation experienced during the [[Black Plague]] in medieval Europe is seen as being caused by a decrease in the demand for money, the money stock used was [[gold]] [[coin]] and it was relatively fixed, while inflation in the 1970s is regarded as initially caused by an increased supply of money that occurred following the U.S. exit from the [[Bretton Woods system|Bretton Woods]] [[gold standard]].
  
[[Supply-side economics]] asserts that inflation is always caused by either an increase in the supply of money or a decrease in the demand for money. The value of money is seen as being purely subject to these two factors. Thus the inflation experienced during the [[Black Plague]] in medieval Europe is seen as being caused by a decrease in the demand for money (the money stock used was gold coin and it was relatively fixed), whilst the inflation of the 1970s is regarded as initially caused by an increased supply of money that occurred following the US exit from the Bretton Woods [[gold standard]]. [[Supply-side economics]] asserts that the money supply can grow without causing inflation as long as the demand for money also grows.
+
===Issues of classical political economy===
 +
While economic theory before the "[[marginal revolution]]" is no longer the basis for current economic theory, many of the institutions, concepts, and terms used in economics come from the "classical" period of political economy, including monetary policy, quantity and quality theories of economics, [[central bank]]ing, velocity of money, price levels and division of the economy into production and consumption. For this reason debates about present economics often reference problems of classical political economy, particularly the classical gold standard of 1871-1913, and the currency versus banking debates of that period.
  
=== Issues of classical political economy ===
+
===Currency and banking schools===
While economic theory before the "marginal revolution" is no longer the basis for current economic theory, many of the institutions, concepts, and terms used in economics come from the "classical" period of political economy, including monetary policy, quantity and quality theories of economics, central banking, velocity of money, price levels and division of the economy into production and consumption. For this reason debates about present economics often reference problems of classical political economy, particularly the classical gold standard of 1871-1913, and the currency versus banking debates of that period.
+
Within the context of a fixed specie basis for money, one important controversy was between the "Quantity Theory" of money and the [[Real bills doctrine|Real Bills Doctrine]], or RBD. Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally [[gold]], held by a [[bank]]. The RBD argues that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the nineteenth century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the [[Federal Reserve]]. In the wake of the collapse of the international gold standard post-1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as [[currency board]]s. It is generally held in ill repute today, with [[Frederic Mishkin]] going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with [[libertarian]] principles of [[laissez-faire]], even though almost all libertarian economists are opposed to the RBD.
  
==== Currency and Banking Schools ====
+
The debate between currency, or quantity theory, and banking schools in Britain during the nineteenth century prefigures current questions about the credibility of money in the present. In the nineteenth century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent," that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.
  
Within the context of a fixed specie basis for money, one important controversy was between the "Quantity Theory" of money and the [[Real bills doctrine|Real Bills Doctrine]], or RBD. Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. The RBD argues that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the 19th century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the [[Federal Reserve]]. In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as [[currency board]]s. It is generally held in ill repute today, with [[Frederic Mishkin]] going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with [[libertarian]] principles of laissez-faire, even though almost all libertarian economists are opposed to the RBD.
+
===Anti-classical or backing theory===
 +
Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory." The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency. Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions.
  
The debate between currency, or quantity theory, and banking schools in Britain during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.
+
==Controlling inflation==
 +
Inflation is generally seen as a problem for a society, and [[central bank]]s aim to prevent it from reaching unmanageable proportions. There are a number of methods that have been suggested to stop inflation, although a 0 percent inflation rate has never been achieved over any sustained period of time in the past. Central banks such as the U.S. [[Federal Reserve]] can affect inflation to a significant extent through setting interest rates and through other operations (that is, using [[monetary policy]]). High [[interest rate]]s and slow growth of the [[money supply]] are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a [[symmetrical inflation target]] while others only control inflation when it rises above a target, whether express or implied.
  
==== Anti-Classical or Backing Theory ====
+
[[Monetarism|Monetarists]] emphasize increasing interest rates (slowing the rise in the money supply, [[monetary policy]]) to fight inflation. [[Keynesian economics|Keynesians]] emphasize reducing demand in general, often through [[fiscal policy]], using increased taxation or reduced government spending to reduce demand as well as by using monetary policy. [[supply-side economics|Supply-side economists]] advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a return to the [[gold standard]]. All of these policies are achieved in practice through a process of [[open market operations]].
  
Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory". The backing theory [http://www.econ.ucla.edu/workingpapers/wp830.pdf] argues that the value of money is determined by the assets and liabilities of the issuing agency. Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions.
+
Another method attempted in the past have been wage and price controls ("[[incomes policies]]"). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by [[Richard Nixon]]. In general wage and price controls are regarded as a drastic measure, and only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. Many developed nations set prices extensively, including for basic commodities as gasoline. The usual economic analysis is that that which is under priced is over-consumed, and that the distortions that occur will force adjustments in supply. For example, if the official price of bread is too low, there will be too little bread at official prices.  
  
== Stopping inflation ==
+
Temporary controls may ''complement'' a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase [[unemployment]]), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed.
 
 
There are a number of methods that have been suggested to stop inflation. [[Central Bank]]s such as the U.S. [[Federal Reserve]] can affect inflation to a significant extent through setting interest rates and through other operations (that is,  using [[monetary policy]]).  High [[interest rate]]s (and slow growth of the money supply) are the traditional way that Central Banks fight inflation, using unemployment and the decline of production to prevent price increases.
 
 
 
However, Central Banks view the means of controlling the inflation differently. For instance, some follow a [[symmetrical inflation target]] while others only control inflation when it rises above a target, whether express or implied.
 
 
 
Monetarists emphasize increasing interest rates (reducing the money supply, [[monetary policy]]) to fight inflation.  Keynesians emphasize reducing demand in general, often through [[fiscal policy]], using increased taxation or reduced government spending to reduce demand as well as by using monetary policy.  [[supply-side economics|Supply-side economists]] advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a return to the [[gold standard]]. All of these policies are achieved in practice through a process of [[open market operations]].
 
 
 
Another method attempted is simply instituting wage and price controls ("[[incomes policies]]'). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. In general wage and price controls are regarded as a drastic measure, and only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. Many developed nations set prices extensively, including for basic commodities as gasoline. The usual economic analysis is that that which is under priced is overconsumed, and that the distortions that occur will force adjustments in supply. For example, if the official price of bread is too low, there will be too little bread at official prices.
 
 
 
Temporary controls may ''complement'' a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase [[unemployment]]), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls, but to liberalize prices, assuming that the economy will adjust, abandoning unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated, and is thus often very unpopular with the people whose livelihoods are destroyed. (See [[Creative destruction]])
 
 
 
==See also==
 
* [[Hyperinflation]]
 
* [[Stagflation]]
 
* [[Deflation (economics)|Deflation]]
 
* [[Disinflation]]
 
* [[Devaluation]]
 
* [[Central bank]]
 
* [[Macroeconomics]]
 
* [[Economics]]
 
* [[Phillips Curve]]
 
* [[Price revolution]]
 
* [[Rule of 72]]- a rule of thumb for calculating the period for inflation to halve the purchasing value of a fixed amount
 
 
 
== Notes ==
 
<div class="references-small">
 
<references />
 
</div>
 
  
 
==References==
 
==References==
 +
*Baumol, William J. and Alan S. Blinder, ''Macroeconomics: Principles and Policy,'' Tenth edition. Thomson South-Western, 2006. ISBN 0324221142
 +
* Bresciani-Turroni, Constantino. ''The Economics Of Inflation - A Study Of Currency Depreciation In Post War Germany.'' Hesperides Press, 2006. ISBN 1406722413
 +
* Frank, Ellen. ''The Raw Deal: How Myths and Misinformation About the Deficit, Inflation, and Wealth Impoverish America.'' Beacon Press, 2005. ISBN 0807047279
 +
* Mayer, Thomas. ''Monetary Policy and the Great Inflation in the United States: The Federal Reserve and the Failure of Macroeconomic Policy, 1965-1979.'' Edward Elger, 1999. ISBN 1858989531
 +
* Mishkin, Frederic S., ''The Economics of Money, Banking, and Financial Markets.'' New York, NY: Harper Collins, 1995.
 +
* Paarlberg, Don. ''An Analysis and History of Inflation.'' Praeger Publishers, 1992. ISBN 0275944166
 +
* Reisman, George. [http://www.mises.org/books/capitalism.pdf ''Capitalism: A Treatise on Economics''] Ottawa: Jameson Books, 1990, 503-506 & Chapter 19  ISBN 0915463733
 +
* Sargent, Thomas. ''The Conquest of American Inflation.'' Princeton, NJ: Princeton University Press, 2001. ISBN 0691090122
  
* George Reisman, [http://www.mises.org/books/capitalism.pdf ''Capitalism: A Treatise on Economics''] (Ottawa : Jameson Books, 1990), 503-506 & Chapter 19 ISBN 0-915463-73-3
+
==External links==
* Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, New York, Harper Collins, 1995.
+
All links retrieved April 15, 2014.
* Baumol, William J. and Alan S. Blinder, ''Macroeconomics: Principles and Policy'', Tenth edition. Thomson South-Western, 2006. ISBN 0-324-22114-2
 
 
 
=== Mainstream ===
 
 
 
* [http://www.bls.gov/cpi/ United States Bureau of Labor Statistics Consumer Price Index homepage]
 
* [http://www.ex.ac.uk/~RDavies/arian/current/howmuch.html Current Value of Old Money] - discusses changes in the value of money over time.
 
* [http://eh.net/hmit Various inflation calculators] - US Dollars (1790-2005), UK pounds (1830-2004), price of gold (1257-2001)
 
* [http://www.westegg.com/inflation/ US Inflation calculator] - Based on consumer price indexes (1800-2005).
 
 
 
=== Austrian ===
 
* [http://workforall.net/can_we_still-avoid_inflation.html Hayek : Can we still avoid Inflation ?] - Hayek's Critique on Monetary Policy from the [[Austrian School]] of economics.
 
* [http://www.mises.org/money.asp What Has Government Done to Our Money?] by anarcho-capitalist economist [[Murray Rothbard]].
 
 
 
=== Left Wing ===
 
* [http://www.dollarsandsense.org/archives/2006/0906drdollar.html Relationship between inflation and unemployment] in [[Dollars & Sense]] magazine
 
 
 
 
 
  
{{Credit1|Inflation|92223670|}}
+
*[http://www.bls.gov/cpi/ United States Bureau of Labor Statistics Consumer Price Index homepage]
 +
*[http://www.ex.ac.uk/~RDavies/arian/current/howmuch.html Current Value of Old Money] - discusses changes in the value of money over time.
 +
*[http://www.measuringworth.com Various inflation calculators] ''Measuring Worth''.
 +
*[http://www.westegg.com/inflation/ US Inflation calculator]
 +
*[http://www.mises.org/money.asp ''What Has Government Done to Our Money?''] by Austrian School economist Murray Rothbard.
 +
*[http://www.dollarsandsense.org/archives/2006/0906drdollar.html Relationship between inflation and unemployment] in ''Dollars & Sense'' magazine.
 +
*[http://www.econ.ucla.edu/workingpapers/wp830.pdf There's no such thing as fiat money]
 +
{{Credits|Inflation|168305632|}}

Revision as of 15:09, 15 April 2014


Inflation rates around the world, 2007.
Annual inflation rates in the U.S., 1666-2004.

Inflation is measured as the growth of the money supply in an economy, without a commensurate increase in the supply of goods and services. This results in a rise in the general price level as measured against a standard level of purchasing power. There are a variety of inflation measures in use, related to different price indices, because different prices affect different people. Two widely known indices for which inflation rates are commonly reported are the Consumer Price Index (CPI), which measures nominal consumer prices, and the GDP deflator, which measures the nominal prices of goods and services produced by a given country or region.

Mainstream economists' views on the causes of inflation can be broadly divided into two camps: the "monetarists" who believe that monetary effects dominate all others in setting the rate of inflation, and the "Keynesians" who believe that the interaction of money, interest rates, and output dominate other effects. Keynesians also tend to add a capital-goods (or asset) price inflation to the standard measure of consumption-goods inflation. Other theories, such as those of the Austrian school of economics, believe that inflation results when central banking authorities increase the money supply.

Inflation is generally seen as a problem for a society, and central banks aim to prevent it from reaching unmanageable proportions. Whether they find appropriate policies to achieve control over inflation has serious consequences for the prosperity and happiness of everyone in that society.

Terminology

Inflation is defined as a widespread, substantial rise in prices across an economy related to an increased volume of money, which results in a loss of value for that currency.

In classical political economy, inflation' meant increasing the money supply. The purpose of this increase in money supply is to accommodate any increase in real GDP. This increased money supply would prevent the phenomenon of deflation, which occurs when there is not enough money, thereby increasing the value of money and decreasing the value of goods and services. Central banks or other similar government entities solve this problem through putting more currency into circulation to accommodate economic growth. Some economists in a few schools of economic thought still retain this usage.

Related concepts include: disinflation, the reduction of the rate of inflation; hyper-inflation, an out-of-control inflationary spiral; stagflation, a combination of inflation and rising unemployment; and reflation, which is an attempt to raise prices to counteract deflationary pressures.

There are three major types of inflation:

  • Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending, and so on.
  • Cost-push inflation: presently termed "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
  • Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Measures of inflation

Examples of common measures of inflation include:

  • Consumer price indices (CPIs) which measures the price of a selection of goods purchased by a "typical consumer."
  • Cost-of-living indices (COLI) which often adjust fixed incomes and contractual incomes based on measures of goods and services price changes.
  • Producer price indices (PPIs) which measure the price received by a producer. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. Producer price inflation measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" as consumer inflation, or it could be absorbed by profits, or offset by increasing productivity.
  • Wholesale price indices, which measure the change in price of a selection of goods at wholesale, prior to retail mark ups and sales taxes. These are very similar to the Producer Price Indices.
  • Commodity price indices, which measure the change in price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee.
  • GDP Deflator measures price increases in all assets rather than some particular subset. The term "deflator" in this case means the percentage to reduce current prices to get the equivalent price in a previous period. The US Commerce Department publishes a deflator series for the U.S. economy.
  • Capital goods price Index, although so far no attempt at building such an index has been tried, several economists have recently pointed the necessity to measure separately capital goods inflation (inflation in the price of stocks, real estate, and other assets). Indeed a given increase in the supply of money can lead to a rise in inflation (consumption goods inflation) and or to a rise in capital goods price inflation. The growth in money supply has remained fairly constant through since the 1970's however consumption goods price inflation has been reduced because most of the inflation has happened in the capital goods prices.
  • Regional Inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US.
  • Historical Inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology. This is equivalent to not adjusting the composition of baskets over time.

Hedonic adjustments to measuring inflation

Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods from the present are compared with goods from the past. This includes hedonic adjustments (the idea that goods are priced based both on their intrinsic value and on external factors such as popularity) and “reweighing” as well as using chained measures of inflation. As with many economic numbers, inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost increases, versus changes in the economy. Inflation numbers are averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices. Finally, when looking at inflation, economic institutions sometimes only look at subsets or special indices. One common set is inflation ex-food and energy, which is often called “core inflation.” Inflation is also measured by the CPIX which stands for consumer price index

Role of inflation in the economy

The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian schools. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trendline. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.

Notable effects of inflation include:

  • Increasing uncertainty may discourage investment and saving.
  • Redistribution
    • It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and profits which may keep pace with inflation.
    • Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax.
  • International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade.
  • Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.)
  • Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
  • Relative Price Distortions: Firms do not generally synchronize adjustment in prices. If there is higher inflation, firms that do not adjust their prices will have much lower prices relative to firms that do adjust them. This will distort economic decisions, since relative prices will not be reflecting relative scarcity of different goods.
  • Hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.
  • Bracket Creep (also called fiscal drag) is related to the inflation tax. By allowing inflation to move upwards, certain sticky aspects of the tax code are met by more and more people. Commonly income tax brackets, where the next dollar of income is taxed at a higher rate than previous dollars. Governments that allow inflation to "bump" people over these thresholds are, in effect, allowing a tax increase because the same real purchasing power is being taxed at a higher rate.

Theories

Monetarism

Main article: Monetarism

Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The Quantity Theory of Money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:

where is the general price level of consumer goods, is the aggregate demand for consumer goods and is the aggregate supply of consumer goods. The idea is that the general price level of consumer goods will rise only if the aggregate supply of consumer goods falls relative to aggregate demand for consumer goods, or if aggregate demand increases relative to aggregate supply. Based on the idea that total spending is based primarily on the total amount of money in existence, the economists calculate aggregate demand for consumers' goods based on the total quantity of money. Therefore, they posit that as the quantity of money increases, total spending increases and aggregate demand for consumer goods increases too. For this reason, economists who believe in the Quantity Theory of Money also believe that the only cause of rising prices in a growing economy (this means the aggregate supply of consumer goods is increasing) is an increase of the quantity of money in existence, which is a function of monetary policies, generally set by central banks that have a monopoly on the issuance of currency, which is not pegged to a commodity, such as gold. The central bank of the United States is the Federal Reserve; the central bank backing the euro is the European Central Bank.

No one denies that inflation is associated with excessive money supply, but opinions differ as to whether excessive money supply is the cause.

Rational expectations

Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.

A core assertion of rational expectations theory is that actors will seek to “head off” central bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession.

Austrian School

Austrian School economics falls within the general tradition of the quantity theory of money, but is notable for providing a theory of the process whereby, upon an increase of the money supply, a new equilibrium is pursued. More specifically, possessors of the additional money are held to react to their new purchasing power by changing their buying habits in a way that generally increases demand for goods and for services. Austrian School economists do not believe that production will simply rise to meet all this new demand, so that prices increase and the new purchasing power erodes. The Austrian School emphasizes that this process is not instantaneous, and that the changes in demand are not distributed uniformly, so that the process does not ultimately lead to an equilibrium identical to the old except for some proportionate increase in prices; that “nominal” values thus have real effects. Austrian economists tend to view fiat increases in the money supply as particularly pernicious in their real effects. This view typically leads to the support for a commodity standard (such as the gold standard) of a very strict variety where all notes are convertible on demand to some commodity or basket of commodities.

Marxist theory

In Marxist economics value is based on the labor required to extract a given commodity versus the demand for that commodity by those with money. The fluctuations of price in money terms are inconsequential compared to the rise and fall of the labor cost of a commodity, since this determines the true cost of a good or service. In this, Marxist economics is related to other "classical" economic theories that argue that monetary inflation is caused solely by printing notes in excess of the basic quantity of gold. However, Marx argues that the real kind of inflation is in the cost of production measured in labor. Because of the classical labor theory of value, the only factor that is important is whether more or less labor is required to produce a given commodity at the rate it is demanded.

Supply-side economics

Supply-side economics asserts that inflation is caused by either an increase in the supply of money or a decrease in the demand for balances of money. Thus the inflation experienced during the Black Plague in medieval Europe is seen as being caused by a decrease in the demand for money, the money stock used was gold coin and it was relatively fixed, while inflation in the 1970s is regarded as initially caused by an increased supply of money that occurred following the U.S. exit from the Bretton Woods gold standard.

Issues of classical political economy

While economic theory before the "marginal revolution" is no longer the basis for current economic theory, many of the institutions, concepts, and terms used in economics come from the "classical" period of political economy, including monetary policy, quantity and quality theories of economics, central banking, velocity of money, price levels and division of the economy into production and consumption. For this reason debates about present economics often reference problems of classical political economy, particularly the classical gold standard of 1871-1913, and the currency versus banking debates of that period.

Currency and banking schools

Within the context of a fixed specie basis for money, one important controversy was between the "Quantity Theory" of money and the Real Bills Doctrine, or RBD. Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. The RBD argues that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the nineteenth century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the collapse of the international gold standard post-1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as currency boards. It is generally held in ill repute today, with Frederic Mishkin going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with libertarian principles of laissez-faire, even though almost all libertarian economists are opposed to the RBD.

The debate between currency, or quantity theory, and banking schools in Britain during the nineteenth century prefigures current questions about the credibility of money in the present. In the nineteenth century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent," that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.

Anti-classical or backing theory

Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory." The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency. Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions.

Controlling inflation

Inflation is generally seen as a problem for a society, and central banks aim to prevent it from reaching unmanageable proportions. There are a number of methods that have been suggested to stop inflation, although a 0 percent inflation rate has never been achieved over any sustained period of time in the past. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations (that is, using monetary policy). High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.

Monetarists emphasize increasing interest rates (slowing the rise in the money supply, monetary policy) to fight inflation. Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand as well as by using monetary policy. Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a return to the gold standard. All of these policies are achieved in practice through a process of open market operations.

Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. In general wage and price controls are regarded as a drastic measure, and only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. Many developed nations set prices extensively, including for basic commodities as gasoline. The usual economic analysis is that that which is under priced is over-consumed, and that the distortions that occur will force adjustments in supply. For example, if the official price of bread is too low, there will be too little bread at official prices.

Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed.

References
ISBN links support NWE through referral fees

  • Baumol, William J. and Alan S. Blinder, Macroeconomics: Principles and Policy, Tenth edition. Thomson South-Western, 2006. ISBN 0324221142
  • Bresciani-Turroni, Constantino. The Economics Of Inflation - A Study Of Currency Depreciation In Post War Germany. Hesperides Press, 2006. ISBN 1406722413
  • Frank, Ellen. The Raw Deal: How Myths and Misinformation About the Deficit, Inflation, and Wealth Impoverish America. Beacon Press, 2005. ISBN 0807047279
  • Mayer, Thomas. Monetary Policy and the Great Inflation in the United States: The Federal Reserve and the Failure of Macroeconomic Policy, 1965-1979. Edward Elger, 1999. ISBN 1858989531
  • Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets. New York, NY: Harper Collins, 1995.
  • Paarlberg, Don. An Analysis and History of Inflation. Praeger Publishers, 1992. ISBN 0275944166
  • Reisman, George. Capitalism: A Treatise on Economics Ottawa: Jameson Books, 1990, 503-506 & Chapter 19 ISBN 0915463733
  • Sargent, Thomas. The Conquest of American Inflation. Princeton, NJ: Princeton University Press, 2001. ISBN 0691090122

External links

All links retrieved April 15, 2014.

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