See also: List of Economic Topics

INFLATION - macroeconomics

Inflation rates of five core members of the G8 from 1950 to 1994. Pink = France, Green = Germany, Gray = Japan, Red = UK, Blue = US.

 

In economics, inflation is an increase in the general level of prices of a given kind. General inflation is a fall in the market value or purchasing power of money within an economy, as opposed to currency devaluation which is the fall of the market value of a currency between economies. General inflation is referred to as a rise in the general level of prices. The former applies to the value of the currency within the national region of use, whereas the latter applies to the external value on international markets. The extent to which these two phenomena are related is open to economic debate.

Inflation is the opposite of deflation. Zero or very low positive inflation is called price stability.

In some contexts the word "inflation" is used to mean an increase in the money supply, which is sometimes seen as the cause of price increases. Some economists (of the Austrian school) still prefer this meaning of the term, rather than to mean the price increases themselves. Thus, for example, some observers of the 1920s in the United States refer to "inflation" even though prices were not increasing at the time. Below, the word "inflation" will be used to refer to a general increase in prices unless otherwise specified.

Inflation can be contrasted with "reflation," which is either a rise of prices from a deflated state, or alternately a reduction in the rate of deflation, that is, the general level of prices is falling, but at a decreasing rate. A related term is "disinflation", which is a reduction in the rate of inflation but not enough to cause deflation.

Measuring inflation

Inflation is measured by observing the change in the price of a large number of goods and services in an economy (usually based on data collected by government agencies, though labor unions and business magazines have also done this job). The prices of goods and services are combined to give a price index measuring an average price level, the average price of a set of products. The inflation rate is the percentage rate of increase in this index; while the price level might be seen as measuring the size of a balloon, inflation refers to the increase in its size.

There is no single true measure of inflation, because the value of inflation will depend on the weight given to each good in the index. Examples of common measures of inflation include:

• The Cost of Living Index or CLI is the theoretical increase in the cost of living of an individual, which Consumer Price Indexes are supposed to approximate. Economists argue over whether a particular CPI over or under estimates the CLI. This is referred to as "bias" within the CPI. The CLI may be adjusted for "purchasing power parity" to reflect the differences in prices for land or other local commodities which differ widely from world prices.
• The consumer price index (CPIs) which measures the price of a selection of goods purchased by a "typical consumer". In many industrial nations, annualised percentage changes in these indexes are the most commonly reported inflation figure. These measures are often used in wage and salary negotiations, since employees wish to have (nominal) pay raises that equal or exceed the rate of increase of the CPI. Sometimes, labor contracts include cost of living escalators (or adjustments) that imply nominal pay raises automatically occur due to CPI increases, usually at a slower rate than actual inflation (and after inflation has occurred).
• The producer price index (PPIs) which measures the price received by a producer. This differs from the CPI in that price subsidation, 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. Many believe that this allows a rough-and-ready prediction of CPI inflation tomorrow based on PPI inflation today, although the composition of the indexes varies; one important difference is the treatment and inclusion of services.
• The wholesale price index which measures the change in price of a selection of goods at wholesale (i.e., typically prior to sales taxes). These are very similar to the PPI.
• The commodity price index which measures the change in price of a selection of commodities. In the case of the gold standard the sole commodity used was gold. While under the USA bimetallic standard the index included both gold and silver.
• The GDP deflator which is based on calculations of the gross domestic product: it is based on the ratio of the total amount of money spent on GDP (nominal GDP) to the inflation-corrected measure of GDP (constant-price or "real" GDP). (See real vs. nominal in economics.) It is the broadest measure of the price level. Deflators are also calculated for components of GDP such as personal consumption expenditure. In the United States, the Federal Reserve has shifted over to using the personal consumption deflator and other deflators for guiding its anti-inflation policies.
• The personal consumption expenditures price index (PCEPI). In its semi-annually "Monetary Policy Report to the Congress" ("Humphrey-Hawkins Report") from February 17, 2000 the FOMC said it was changing its primary measure of inflation from the CPI to the "chain-type price index for personal consumption expenditures".

Because each measure is based on both other measures, and a model that brings them together, economists often dispute whether there is "bias" either in measurement or in the model of inflation. For example In 1995, the Boskin Commission found the CPI produced by the US Department of Labor's Bureau of Labor Statistics (BLS) to be a biased measure, and gave a quantitative analysis of the bias, arguing that inflation was overstated because of people substituting away from expensive goods, and because of the "hedonic" improvements that technology created, these both reduced the rate of CPI-U increase. Another example from the early 1980's was the finding that the rental component of the CPI-U and CPI-W did not factor in the increase on rental units that were unoccupied, and that, when factored in, the rate of inflation was dramatically understated. This change was adopted in 1982 into the CPI calculations.

Presently there are those who argue that even more hedonic adjustment should be factored in, including the tendency of people to move to less expensive areas when more expensive ones become out of reach, while others argue that the housing part of the index is dramatically understating the impact of home values on cost of living, and dramatically under accounting for the cost of medications in the cost of living for retirees.

The role of inflation in the economy

One effect of small steady inflation 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. Thus, some business executives see mild inflation as "greasing the wheels of commerce". Efforts to attain complete price stability can also lead to deflation (steadily falling prices), which can be very destructive, encouraging bankruptcy and recession (or even depression).

Many in the financial community regard the "hidden risk" of inflation as an essential incentive to invest, rather than simply save, accumulated wealth. Inflation, from this perspective, is seen as the market expression of what the time value of money is. That is, if a dollar today is worth more to someone than a dollar a year from now, then there should be a discount in the economy as a whole for dollars in the future. From this perspective, inflation represents the uncertainty about the value of future dollars.

Inflation, however, above these relatively low amounts is recognized as having increasingly negative effects on the economy. These negative effects are the result of "discounting" previous economic activity. Since inflation is often the result of government policies to increase the money supply, the government contribution to an inflationary environment is a tax on holding currency. As inflation increases, it increases the tax on holding currency, and therefore encourages spending and borrowing, which increase the velocity of money, and therefore reinforce the inflationary environment, a "vicous circle". To extremes this can become hyperinflation.

• Increasing uncertainty may discourage investment and saving
• Redistribution: It will redistribute income from those on fixed incomes, such as pensioners, and shift it to those who draw a more flexible income, for example from profits and most wages which may keep pace with inflation.
  Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow (if the lenders are caught by surprise or cannot adjust to inflation). 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 the "inflation 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.
• 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.

In an economy where some sectors are "indexed" to inflation, while others are not, inflation acts as a redistribution towards the indexed sectors away from the unindexed sectors. Again, in small amounts this is a policy choice, acting as a tax on "liquidity preference" and hoarding, rather than saving. However, beyond this amount, the effect becomes distorting, as individuals begin "investing in inflation", which, again, encourages inflationary expectations.

Because of the above reasons for discouraging inflation above the small amounts needed to discount previous actions and discourage hoarding of currency, most Central Banks define price stability as a central goal, with a perceptible, but low, rate of inflation as the target.

Causes of inflation

There are different schools of thought as to what causes inflation.

Monetary Theory

One of the most widespread theories of inflation is also the most straightforward: inflation is an increase in the supply or velocity of money at a rate greater than the expansion in the size of the economy. This is practically measured by comparing the GDP deflator to the rate of increase of the money supply, and setting the interest rate through the central bank to maintain a constant quantity of money. This view differs from the Austrian school below in that it focuses on a "quantity of money" theory, rather than the "quality of money" theory. In the monetarist framework, it is the aggregate money supply which is important.

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:

P is the general price level of consumers' goods, DC is the aggregate demand for consumers' goods and SC 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 of central banks.

The quantity of money theory has been ennunciated repeatedly, and is the logic behind hard currency systems such as the gold standard and "tight money policies". However, its current form is attributed to Milton Friedman who coined the term "monetarism". The simple model takes the Money Supply, with particular attention to M1 (see money supply above) and sets a target for money supply growth that is equal to the increase in GDP. The simplest means of implementing this monetary demand model is the rule of setting the discount rate at 7.5 + GDP deflator - unemployment rate.

From this perspective, the root cause of inflation is an increase in money supply over demand for money, and therefore "inflation is always and everywhere a monetary phenomenon", as Friedman puts it. This means that controlling inflation rests on monetary and fiscal restraint: the government must neither make it too easy to borrow, nor must it borrow excessively itself. This view focuses on the importance of controlling central government budget deficits and interest rates, as well as the productivity of the economy, which is, in effect, "cost pull" inflation.

An example of a monetarist policy towards inflation is the current European Central Bank.

The Austrian economists claim that the only cause of inflation is the increase of the money supply relative to the output of the economy.1 These economists outright reject the theories behind cost push inflation, wage push inflation and other common theories of inflation. From their perspective, the correct policy is not based on the total quantity of money, but to set a particular quality of money, a relationship between the MZM, that is "Money to Zero Maturity" and the growth of the economy. Because controlling the available immediately spendable currency is crucial to price stability in this view, economists who subscribe to this idea often advocate the return to a gold standard.

It's worth noting that this is by no means a new, modern idea; Adam Smith wrote in The Wealth of Nations, "The quantity of labour which any particular quantity of [gold or silver] can purchase or command, or the quantity of other goods which it will exchange for, depends always upon the fertility or barrenness of the mines which happen to be known about the time such exchanges are made." (Book I, Chapter V) (Of course, those who advocate a return to a gold standard would say that most of the gold ever mined has been extracted since Adam Smith's time. Today, total mine production of about 2500 metric tons per year pales besides an estimated 125 000 metric tons believed to be extant above ground. Thus, variations in mining could have no significant affect upon price levels).

Neo-Keynesian Theory

According to Neo-Keynesian economic theory there are three major types of inflation, as part of what Robert J. Gordon (http://faculty-web.at.nwu.edu/economics/gordon/indexlayers.html) calls the "triangle model":

• Demand pull inflation - inflation due to high demand for GDP and low unemployment, also known as Phillips Curve inflation.
• Cost push inflation - nowadays termed "supply shock inflation", due to an event such as a sudden increase in the price 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. It is also known as "inertial" inflation, "inflationary momentum", and even "structural inflation".

These three types of inflation can be added up at any time to get an explanation of the current inflation rate. However, over time, the first two (and the actual inflation rate) affect the amount of built-in inflation: persistently high (or low) actual inflation leads to higher (lower) built-in inflation.

Within the context of the triangle model, there are two main elements: movements along the Phillips Curve, for example as unemployment rates fall, encouraging greater inflation, and shifts of that curve, as when inflation rises or falls at a given unemployment rate.

1. Phillips Curve or Demand 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 (say, due to war or civil war conditions), sometimes leading to hyperinflation where prices rise at extremely high rates (say, doubling every month).

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, Monetarist economists believe that the link is very strong; Keynesian economics by contrast typically emphasise 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 US 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. The modern use of the Phillips curve relates payroll growth to the general inflation rate, rather than relating the unemployment rate to the inflation rate.

2. Shifts of the Phillips Curve

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) due to 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 component of the triangle model.

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 NAIRU or the "natural" rate of unemployment or the full-employment unemployment rate. In this framework, the built-in inflation rate is determined endogenously (by the normal workings of the economy):

• if GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that, all else equal, inflation will accelerate as suppliers increase their prices and built-in inflation worsens. This causes the Phillips curve to shift in the stagflationary direction, toward greater inflation and greater unemployment. This kind of "inflationary acceleration" may have been seen in the late 1960s in the U.S., when Vietnam war spending (counteracted only by small tax hikes) kept unemployment below 4 percent for several years.
• if GDP falls below its potential level (and unemployment is above the NAIRU), all else equal inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation: there is disinflation. This causes the Phillips curve to shift in the desired direction, toward less inflation and less unemployment. This disinflation may have been seen in the early 1980s, when Fed chief Paul Volcker's anti-inflation campaign kept unemployment high for several years and at almost 10 percent for two years.
• If GDP is equal to potential (and the unemployment rate equals the NAIRU), the inflation rate will not change, as long as there are no supply shocks. In the "long run," most neo-Keynesian macroeconomists see the Phillips Curve as vertical. That is, the unemployment rate is given and equal to the NAIRU, while there are a large number of possible inflation rates that can prevail at that unemployment rate.

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 due to policy: for example, high unemployment under Prime Minister Margaret Thatcher in the U.K. may have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed, 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.

Most non-Keynesian theories of inflation can be understood within the neo-Keynesian perspective as assuming that the NAIRU and potential output are both unique and are attained relatively quickly. With the "supply side" at a fixed level, the amount of inflation is then determined by aggregate demand. The fixed supply side also implies that government and private-sector spending are always in conflict, so that government deficit spending leads to crowding out of the private sector and has no effect on the level of employment. Thus, it is only the money supply and monetary policy that determine the inflation rate.

Supply-side Theory

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, whilst the inflation of the 1970s is regarded as been 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.

One of the factors that supply side economists say was instrumental in ending the US experience of high inflation was the economic expansion of the 1980s ushered in by lower taxes. The argument is that an expanding economy creates an increased demand for base money and in so doing it counteracts inflation forces. An expanding economy can be seen as frequently leading to an increased demand for money and all else being equal an improvement in the value of money. In international currency markets such a principle is reasonably undisputed however supply side economists argue that economic expansion increases the domestic valuation of money and not just the international valuation.

Stopping inflation

There are a number of methods which have been suggested to stop inflation. Central Banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations (i.e., using monetary policy). High interest rates (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 gets too high.

Monetarists emphasize increasing interest rates by reducing the money supply through 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. They also note the role of monetary policy, particularly for inflation in basic commodities from the work of Robert Solow. Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some stable reference currency such as gold, or by reducing marginal tax rates in a floating currency regime to encourage capital formation 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 (see "incomes policies"). For example, they were tried in the United States in the early 1970s (under President Nixon). One of the main problems with these controls was that they were used at the same time as demand-side stimulus was applied, so that supply-side limits (the controls, potential output) were in conflict with demand growth. In general, most economists regard price controls as counterproductive in that they tend to distort the functioning of the economy because they encourage shortages, decreases in the quality of products, etc. However, this cost may be "worth it" if it avoids a serious recession, which can have even greater costs, or in the case of fighting war time inflation.

In fact, 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.

See also

Hyperinflation
Stagflation
Deflation
Devaluation
Central bank
Macroeconomics
Monetarism
Money Supply
Economics
Price revolution
Rule of 72 (a rule of thumb for calculating the period for inflation to halve the purchasing value of a fixed amount)