An economic situation of widespread and persistent increases in prices and wages. Common measures of inflation are the Retail Price Index, which covers a wide range of consumer goods, and the gross domestic product deflator, an index of all goods prices. Inflation is believed to be bad for both equity and efficiency. If interest rates do not rise, inflation injures savers; if interest rates do rise, the need for high payments early in the life of loans makes borrowing for business or for house ownership very risky. Economists differ over the cause of inflation: the main models blame excess demand and excessive rises in the money supply. Cost inflation, in which each price or wage rate rises because others have risen, or are expected to rise, does not explain how inflation starts, but does explain why it is so persistent once it has started. Under very rapid inflation, or hyperinflation (eg Germany in the 1920s and early 1930s, or some Latin-American countries in the 1970s and 1980s), money becomes useless and the economy is forced back to barter, with great losses of efficiency. Governments have often tried to cure inflation, frequently incurring unemployment in the process, without much success.
The prevailing view in mainstream economics is that inflation is caused by the interaction of the supply of money with output and interest rates. 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, monetarists, and those who believe that the interaction of money, interest and output dominate over other effects, or broadly speaking Keynesians.
Related terms include: 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 counter act deflationary pressures.
Measures of inflation
Measuring inflation is a question of econometrics, that is, finding objective ways of comparing nominal prices to real activity. The result is the amount of increase in price which is attributed to "inflation" and not to improvements in productivity.
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.
Examples of common measures of inflation include:
consumer price indexes (CPIs) which measure the price of a selection of goods purchased by a "typical consumer". Producer price inflation measures the pressure being put on producers by the costs of their raw materials.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. 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, while deflation meant decreasing it.
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. 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.
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. 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. 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. 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. If there is higher inflation, firms that do not adjust their prices will have much lower prices relative to firms that do adjust them. 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 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.
As noted, some economists see moderate inflation as a benefit; 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. 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 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 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).
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. Keynesian economics by contrast typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation.
A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. 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.
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. (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. 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." 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:
where 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. 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 banks where there is a monopoly on currency issue and the lack of a commodity peg to currency. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well. 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 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. 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.
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.
Marxist theory
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. 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.
Supply-side economics
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. 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 banking, velocity of money, price levels and division of the economy into production and consumption.
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.
Anti-Classical or Backing Theory
Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory". 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.
Stopping inflation
There are a number of methods that 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 (that is, 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 rises above a target, whether express or implied.
Monetarists emphasize increasing interest rates (reducing the money supply, monetary policy) to fight inflation. Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. 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.
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. (See Creative destruction)
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