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In Economics , inflation is a change in some important measure of money which says either real or apparent value is falling. The two most obvious versions of this, each held by some economists to be "real" inflation, are for prices of goods and services in the currency in question to rise, or for the government to increase the money supply, other than to replace old money it destroys. Price inflation is closely akin to "cost of living" measurement, where a "basket" of goods, and comparing the prices at two intervals, and adjusting for changes in the intrinsic basket. But, technically, this is not raw inflation; it is an attempt to determine real-life value of money compared to the members of the society in question, adding other factors like increased expectations. Raw inflation measurement does not adjust for expectations, but directly measures the change in the price of goods. There are different measurements of price inflation, depending on the basket of goods selected. The most common measures are of Consumer inflation, producer inflation and GDP deflators, or price indexes. The last measures inflation in the entire economy. General price inflation is a fall in the Purchasing Power of Money within an economy, as compared to Currency Devaluation which is the fall of the market value of a currency between economies. It 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, though the comparison of a currency to foreign currencies is based on investor demand for currencies, and therefore must at least partially be a matter of perception. Both of these are often caused by a government adding too much money to an economy, as by printing it or lending/selling virtual money to banks or other entities. This is called currency inflation, and is more often than not the cause of any severe price inflation or currency devaluation. But, because the general amount of wealth gradually increases in an economy (as long-lasting things are created, new technologies invented, et cetera), a small amount of currency inflation is actually necessary to keep prices stable, and need not cause price inflation. Some terms related to inflation:
In some contexts the word "inflation" is used to mean an increase in the money supply, which is seen as a 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 refer to inflation in the 1920s in the United States even though the prices of some baskets of goods were not increasing at the time. Below, the word "inflation" will be used to refer to a general increase in prices unless otherwise specified. MEASURING INFLATION Inflation is measured differently by those who follow classical monetary theory than by those who study Neo-Keynesian theory. Neo-Keynesians observe inflation indirectly through the rise in prices of goods and services while Monetary Theorists directly watch the amount of currency. Examples of common measures of inflation include:
Money supply The amount of currency in an economy (the Money Supply ) is stated as M0, M1, M2, M3 and M4 each more broad than the previous. As the amount of currency in circulation increases (inflation), its value decreases. This is the most direct way of measuring inflation as the amount of currency in bank accounts, bond, coins and paper notes, etc. is generally known to the government of each country. Observations of the money supply gives a much clearer picture of inflation because it responds quickly (as fast as banks report) and accounts for all inflation including that which occurs in finacial markets as rising stock prices. Gold There is a saying "Gold is money, period." and for very good reason. Gold and silver have been used as money since the invention of money. These two precious metals are the true benchmark of inflation and have held their value for millennia compared to the mere centuries of the Denarius and Pound Sterling both of which started out based on precious metal. Gold has experienced an historical inflation rate of about 2% as new supplies are mined and refined and it is this immutable rate which has prompted governments throughout history to turn to the creation of Fiat Currency . The discussion of inflation would be moot if not for fiat currency as it is only this form of money substitute that can can be easily inflated by governments. Prices Neo-Keynesians measure inflation 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, although labor unions and business magazines have also done this job). The prices of goods and services are combined to give a price index. When the CPI was first created, this was an " rate of inflation despite the fact that they are basic components of everyday living and go in to every good delivered to a store shelf. The Inflation Rate as measured by Neo-Keynesians 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 rate of ''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, as well as the extent of the economic region being examined. 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. Increasing the hedonic adjustments also helps to control government costs as many are linked to CPI such as union labour contracts, pensions and social security. This exposes a confilct of interest in the governments publication of these figures. 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 who's pensions are indexed to the CPI. The most often overlooked price increases are those in the stock market. Inflation can manifest itself in many places besides house and consumer prices, and in today's world of computer trading, the finacial markets are able to absorb massive amounts of inflation without causing the negative effects associated with an increase in the price of goods. This leads to an amplification of the negative effects over the long run as the problems can go unnoticed for long periods of time by the public at large; when the price of goods do start to rise, they do so under the huge pressure built up by the financial markets, like a dam holding back the flood. ECONOMIC ROLE One effect of small steady inflation is that it is difficult to renegotiate some prices, and particularly wages and contracts, 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, risking Bankruptcy for companies that do not react, ultimately resulting in 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 relatively low levels is generally considered 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 "vicious circle". To extremes this can become Hyperinflation .
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 Bank s define Price Stability as a central goal, with a perceptible, but low, rate of inflation as the target. Misery index In the 1970s a “ (possibly encouraged by Monetarist ideology).
In opposition to the deadweight loss argument against the redistributive nature of inflation it has been argued that, in economies where the rate vs capital gains tax is low or nil, inflation acts as an important “wealth tax”, and that low inflation societies will tend to see Wealth Condensation . CAUSES There are different schools of thought as to what causes inflation. The two most prevalent theories are the neo-classical theory that inflation is driven by increases in the money supply, often used to finance government spending and the neo-Keynesian view that inflation is the result of diminishing returns of productivity. Monetary theory One of the oldest and most widespread theories of inflation is also the most straightforward: inflation is an increase in the supply of money. Before the invention of Fiat Currency metals such as Copper , Silver and Gold were made in to Coins and used as currency. This placed a physical limit on the rate of inflation as the increase in metal for coinage was limited by the rate at which it could be mined and is why gold is considered money and not just currency. Historically, gold has seen a very constant inflation rate of 2% without regard to the GDP of any country or even the world. The limits of gold supplies lead to the invention of Debasement by the Roman Empire . As the empire's need for currency rose, the gold content of the coins minted was replaced by base metals such as copper. This lead to an increase in the supply of currency and inflation. As a result of this debasement, the population began hoarding the coins made of gold. Misunderstandings of monetary theory have lead to the belief that inflation is related to the growth of GDP or to interest rates but this belies the simplicity of monetary theory which predates the Central Bank or economic measures like GDP and GNP . Another misconception which monetary theory rejects is that prices are inflation and stems from the confusion between cause and effect. Prices are based upon the Scarcity of the currency being used and when the supply of the currency increased (the cause), the amount of currency needed to pay for a good or services rises (the effect). This is classically expressed as "Too much money chasing too few goods". Neo-Keynesian theory According to Neo- Keynesian economic theory there are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":
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. 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 increasing the amount of currency in circulation to avoid the results of economic collapse, sometimes during wartime conditions. This has led to Hyperinflation where prices rise at extremely high rates in short periods of time in extreme cases. A fundamental concept in such Keynesian analysis is the relationship between Inflation and Unemployment , called the Phillips Curve . In classical Keynesian economics 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, and suggests that trade offs between inflation and employment are based on the change in the rate of inflation, rather than the inflation rate itself. In this model, increases in aggregate demand drive prices upwards, as suppliers are aware that they have pricing power, which leads to more people working, which leads to increased aggregate demand. 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):
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. Productivity For these reasons neo-Keynesian theory focuses on productivity, because it is falling productivity which signals diminishing returns of production, and therefore inflationary pressures from overheating and output above "potential". From the neo-Keynesian perspective budget balancing and restraints on spending do not control inflation, and persistent budget deficits do not cause inflation. What causes inflation is an increase in the velocity of money, and the reduction in efficiency caused by excessive present consumption versus investment. That is, a savings rate that is too low to fund the improvements in production required to keep pace with increases in aggregate demand. Consequently neo-Keynesians such as Franco Modigliani warned that it is an insufficient savings rate which is the better predictor of future inflation. Indexing and inertial inflation In the 1980s several industrialized nations experienced persistent inflation, and attempted to address it by cutting budgets and engaging in IMF backed austerity plans. These plans had the paradoxical effect of causing people to flee the main currency, and pushing up the inflation rate. The next round of programs were targeted at reducing budget deficits, but they focused on ending wage indexing and on cutting government subsidies for commodities, instead of simply reducing government spending in the aggregate. Neo-Keynesians argue that the experience of Israel, Argentina, Bolivia and Brazil in dealing with inflation and hyperinflation shows that government budget deficits are exogenous to money supply growth, and that therefore central banks which are accommodating them may not have the autonomy to constrict the money supply. Thus it is fiscal, not monetary policy, which is the main agent for driving inflation where governments use Seigniorage as an active source of revenue where the market for money clears. Other theories of inflation Austrian Economics The Austrian School of Economics defines inflation as "an inflation of the supply of money". All other things being equal, inflation can be expected to cause an increase in prices, but exactly which prices are affected when and how much will depend on how the newly created money was introduced to the system, and how the new money spreads throughout the economy. Therefore, in the Austrian view, it is possible that changes in productivity (or other factors) will drive down the price of any arbtirarily chosen basket of goods, even in the presence of inflation (of the money supply). Thus fighting inflation is very simple in Austrian framework: just stop creating new money. Increasing prices can have many causes, and inflation (of the money supply) is but one. Austrian theory would dispute the idea that mild "deflation" (in the non-Austrian sense, i.e. a decline in the general price level) is something to be avoided. Instead, this is seen as a natural way of passing on productivity gains to those who have deferred consumption. Sudden contractions in the money supply can undoubtedly disrupt business plans which depended on continuous injections of new money, and bank runs are certainly unhealthy, but that doesn't mean all decreases in prices are inherently bad, or that continuing to inflate just to maintatin inflation-dependent enterprises is the correct policy. See http://www.mises.org/journals/qjae/pdf/qjae6_4_8.pdf. Supply-side economics Supply-side Economics asserts that inflation is always caused by either an increase in the supply of base money or a decrease in the demand for base money (or both). 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 as the volume of production and trade fell, while 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 at the same rate. 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 inflationary forces. An expanding economy can be seen as frequently leading to an increased demand for money, and, all else being equal, an increase in the value of money. In international currency markets this principle is mostly undisputed, however, supply side economists argue that economic expansion increases the domestic valuation of money and not just the international valuation. Welfare economics Welfare Economics takes the concept that the real purchasing power of an individual is measured in the basket of commodities that they can command. Therefore, it measures standard of living differently from GDP and price level, and instead uses the concept of "welfare" or happiness grounded in other measures. Neoclassical Economics defines utility as being related to price, and therefore does not need to look at separate components of general welfare individually, only their aggregate price. This view is used by Marxian economists to argue that production and not consumption should be central to the definition of inflation. This view stands outside that of mainstream economic thought, but is influential in Political Economy . Measures of well being are used by NGOs in arguing for greater aid, and Bhutan has adopted a happiness, rather than product based measure of standard of living. STOPPING INFLATION There are a number of methods which have been suggested to stop inflation. Monetary policy Central Bank s such as the U.S. Federal Reserve System 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 ways 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. The European Central Bank has come under some criticism for following the latter practice, especially in the face of high unemployment.
All of these policies are achieved in practice through a process of Open Market Operations . Price controls Another method attempted is simply instituting wage and price controls (see " Incomes Policies "). They are related to Price Supports , which set minimum prices to prevent deflation, or to maintain a particular good or service in production. Price controls and their aftermath 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 or the use of "black market" exchanges. The only exception is during war time, when shortages are expected, and the purpose is to allow the government to borrow money at a lower rate of interest than could be obtained normally, as well as prevent war profiteering of various kinds. The price controls used during World War II in the United States were effective not only at controlling inflation during the war, but after the war as well. Another criticism of price controls is that they work only so long as they are in force, removal tends to produce more inflation than would have been obtained without them. War time price controls are criticized because they are often maintained long after the war has ended, because they act as a transfer of wealth from some producers to others, and to consumers who then overconsume the price controlled commodity. Controls on rent, for example, often remain in force for decades, because it allows property owners to limit the rate of new building, making it possible to maintain capital parity more easily, and renters to stay in one place for a long period of time with a net reduction in the cost of rent, since inflation reduces the burden of a fixed rental price. 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. Inflation and money supply Neo-Keynsians would say that the money supply may increase without inflation occurring. One example is the U.S. money supply, which has been increasing at a much faster rate than inflation as measured by the CPI. This phenomenon occurs because there has been a trend of rising global demand for the U.S. dollar, which has become a global currency for the exchange of goods. More goods are available to be purchased by the dollar, if there were no expansion in the supply of the dollar, the price of goods would drop. However, the expansionary policy of the FED (the "printing of more money out of the thin air" through the Open Market Operations) has not only stopped deflation, it also has created slight inflation. It must be noted though that if there had been no increase in the demand for the dollar, the increase in the supply of money would surely have meant high inflation as seen in the 1970s. Monetary theorists would point to the price of both oil and gold as disproving this assertion. Since the U.S. dollar was taken off the gold standard, it has lost 95% of its value against gold. Wealth redistribution effect of increased money supply If the total money supply has increased, even if there were no inflation (similar to the low inflation environment in the US. in the early 2000's), what would be the wealth redistribution effect if any? The assets and commodities that would go up in value are those whose supply are finite or non-renewable (such as fossile fuel and real estate near areas of centers of trades). The assets and commodities whose supply are increasing would see its value to fall (including money). How can the value of money to fall when there is no inflation? This is because inflation has a very narrow definition. Some popular attempts to measure do not take into account the rise in price of essential commodities (such as energy) and the price of essential assets (such as real estate). These essential commodities and assets can become more expensive when the money supply increases but they are not measured by the standard measures of inflation. In scenarios like this, increased money supply redistributes wealth from the holders of money to the holders of finite assets and commodity regardless of inflation. SEE ALSO REFERENCES # Barro, Robert J. Macroeconomics # Brown, A. World Inflation Since 1950 # Case, Karl E. and Fair, Ray C. Principles of Macroeconomics # Bureau of Labor Statistics # Kieler, Mads The ECB's Inflation Objective # Marx, Karl Wages, Profits and Prices, # Puplava, Jim, '' The GREAT inflation '' # Reisman, George ''Capitalism: A Treatise on Economics'' (Ottawa : Jameson Books, 1990), 503-506 & Chapter 19 ISBN 0915463733 # 's view on money, inflation etc. # Sobel, Robert ''The Worldly Economists'' ( 1980 ). EXTERNAL LINKS
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