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.
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.
- 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.
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 P is the general price level of consumer goods, DC is the aggregate demand for consumer goods and SC 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 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 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 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 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.
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.
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- Economic Horizon's WorldInflation.net, inflating the world one economy at a time Retrieved December 22, 2007.
- United States Bureau of Labor Statistics Consumer Price Index homepage Retrieved December 22, 2007.
- Current Value of Old Money - discusses changes in the value of money over time. Retrieved December 22, 2007.
- Various inflation calculators - US Dollars (1790-2005), UK pounds (1830-2005), price of gold (1257-2005) Retrieved December 22, 2007.
- US Inflation calculator - Based on consumer price indices (1800-2006) Retrieved December 22, 2007.
- What Has Government Done to Our Money? by Austrian School economist Murray Rothbard. Retrieved December 22, 2007.
- Relationship between inflation and unemployment in Dollars & Sense magazine. Retrieved December 22, 2007.
- There's no such thing as fiat money Retrieved December 9, 2007.
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