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Inflation is the persistent rise in the general price level as measured against a standard level of Purchasing Power . There are many varying measures of inflation in use because different prices affect different people. The most widely known indices are the Consumer Price Index (CPI) which measures the change in nominal consumer prices and the GDP Deflator which measures inflation in new products and services created. Mainstream economists' views of the causes of inflation can be broadly divided into two camps: the " Monetarist s" who believe that monetary effects dominate all others in setting the rate of inflation, and the " Keynesian s" who believe that the interaction of money, interest and output dominate over 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 is caused by an increase in the supply of money by central banking authorities. Related concepts include: Deflation , a general falling level of prices; 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. In classical Political Economy , “inflation” means increasing the money supply, while “deflation” means decreasing it. The purpose of this increase in money supply is to accommodate any increase in real GDP. Some economists in a few schools of economic thought, generally described as libertarian, classical liberal, or ultra-conservative, still retain this usage. In mainstream economic terms these would be referred to as expansionary and contractionary monetary policies. Econometrics Measuring Inflation is a question of Econometrics , finding objective ways of comparing nominal prices to real activity. In many places in economics, "real" variables need to be compared. For example, in order to calculate GDP, effective interest rate and improvements in productivity are the "real variables" used in the calculations. Each inflationary measure takes a "basket" of goods and services, then the prices of the items in the basket are compared to a previous time, then adjustments are made for the changes in the goods in the basket itself. For example, a month ago canned corn was sold in 10 oz. jars for $9, and this month it is sold for $10. Assuming the quality of the product does not change (e.g. a different metal in the can, a new type of corn), the resulting price change is attributed to inflation. Economists analyze the aforementioned factors when calculating inflation for a product. For example, if that same can of corn was sold in 9 oz. jars for $9, and this month is sold in 10 oz jars for $10, and there are no other economic factors, then an economist would analyze the product as undergoing no inflation. MEASURES OF INFLATION Examples of common measures of inflation include:
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 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 ”. 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. ''Federal Reserve Board's semiannual Monetary Policy Report to the Congress'' Roundtable ''Introductory statement by Jean-Claude Trichet on 1 July 2004 '' The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian schools. In Monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trendline. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy. A great deal of economic literature concerns the question of what causes inflation and what effect it has. A small amount of inflation is often viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are "sticky downward" and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Efforts to attain complete price stability can also lead to Deflation , which is generally viewed as a negative outcome because of the significant downward adjustments in wages and output that are associated with it. Inflation is also viewed as a hidden risk pressure that provides an incentive for those with savings to invest them, rather than have the purchasing power of those savings erode through inflation. In investing, inflation risks often cause investors to take on more Systematic Risk , in order to gain returns that will stay ahead of expected inflation. Inflation is also used as an index for cost of living adjustments and as a peg for some bonds. In effect, inflation is the rate at which previous economic transactions are Discounted economically. Inflation also gives central banks room to maneuver, since their primary tool for controlling the money supply and Velocity Of Money is by setting the lowest interest rate in an economy - the discount rate at which banks can borrow from the central bank. Since borrowing at negative interest is generally ineffective, a positive inflation rate gives central bankers "ammunition", as it is sometimes called, to stimulate the economy. However, in general, inflation rates above the nominal amounts required to give monetary freedom, and investing incentive, are regarded as negative, particularly because in current economic theory, inflation begets further inflationary expectations.
As noted, some economists see moderate inflation as a benefit; some business executives see mild inflation as "greasing the wheels of commerce." A very few economists have advocated reducing inflation to zero as a monetary policy goal - particularly in the late 1990s at the end of a long disinflationary period, when the policy seemed within reach. CAUSES There are different schools of thought as to what causes inflation. Most can be divided into two broad areas: quality theories of inflation, and quantity theories of inflation. Many theories of inflation combine the two. The quality theory of inflation rests on the expectation of a buyer accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the equation of the money supply, its velocity, and exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production. Keynesian economic theory proposes that money are 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":
A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of Money in circulation relative to the ability of the economy to supply (its Potential Output ). This has been seen most graphically when governments have financed spending in a crisis by printing money excessively (from war or civil war conditions), often leading to Hyperinflation where prices rise at extremely high rates (such as, doubling every month). Another cause can be a rapid decline in the ''demand'' for money as happened in Europe during the black plague. The s. A fundamental concept in such Keynesian analysis is the relationship between inflation and Unemployment , called the Phillips Curve . This model suggested that price stability was a Trade-off against employment. Therefore some level of inflation could be considered desirable in order to minimize unemployment. The Philips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as '' Stagflation '') experienced in the 1970s. Thus, modern macroeconomics describes inflation using a Phillips curve that ''shifts'' (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the Price/wage Spiral and Inflationary Expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the Demand-pull 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 Non-Accelerating Inflation Rate of Unemployment, NAIRU , or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will ''accelerate'' as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will ''decelerate'' as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation. However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under Prime Minister Margaret Thatcher in the UK may have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as Structurally Unemployed (also see Unemployment ), unable to find jobs that fit their skills in the British economy. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation. Problems If inflation is high in an economy there are three main problems it can cause: #People on a fixed income (e.g. pensioners, students) will be worse off in real terms due to higher prices and equal income as before; this will lead to a reduction in the purchasing power of their income. This has a great effect on the GDP of a country. #Rising inflation can encourage trade unions to demand higher wages, as wages have to be adjusted to keep up with inflation. In the case of collective bargaining the wages will be set as a factor of price expectations (Pe). Pe will be higher when inflation has an upward trend. This can cause a Wage Spiral . Also if strikes occur in an important industry which has a comparative advantage the nation may see a decrease in productivity and suffer. #If inflation is relatively higher in one country, and that country maintains fixed exchange rates with other countries, then the country's exports will become more expensive for other countries to purchase, creating a deficit on its current account. Monetarism One of the most influential schools of economic thinking rests on the quantity theory of money, devised by Milton Friedman , the "high priest" of monetarism. This way of thinking about inflation was suddenly given credence once more by the stagflation of the 1970s. Monetarists assert that empirical study of monetary history shows that "inflation is always and everywhere a monetary phenomenon." Modern mainstream central banking practice still adheres closely to this concept, as shown by Ben Bernanke's speech on the occasion of Friedman's 90th birthday, in which he said, "Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." The Quantity Theory of Money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created: where is the general price level of consumers' goods, is the aggregate demand for consumers' goods and is the aggregate supply of consumers' goods. The idea behind this formula is that the general price level of consumers' goods will rise only if the aggregate supply of consumers' goods goes down relative to the aggregate demand for consumers' goods, or if the aggregate demand increases relative to the aggregate supply of consumers' goods. Based on the idea that total spending is based primarily on the total amount of money in existence, the economists calculate aggregate demand for consumers' goods based on the total quantity of money. Therefore, they posit that as the quantity of money increases, total spending increases and the aggregate demand for consumers' goods increases as well. For this reason the economists who believe in the Quantity Theory of Money also believe that the only cause for rising prices in a growing economy (this means aggregate supply of consumers' goods is increasing), is an increase of the total quantity of money in existence, which is caused by monetary policies, generally of Central Bank s where there is a monopoly on currency issue and the lack of a commodity peg to currency. The Central Bank of the United States is the Federal Reserve ; the central bank backing the Euro is the European Central Bank . No-one denies that inflation is associated with an excessive supply of money, but opinions differ as to whether the excessive money supply is the causal factor. Rational expectations Rational expectations theory is a view of macroeconomics that states that economic actors look rationally into the future and try and maximize their general sense of future states of well-being, and do not simply respond to the immediate opportunity cost and pressures of the present. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well. One core assertion of rational expectations theory is that actors will seek to “head off” central bank decisions, by acting preemptively and in ways that may themselves fulfill the predictions that drive them. 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 bank will not allow it. OTHER THEORIES Austrian School Austrian School economics falls within the general tradition of the quantity theory of money, but is notable for providing a theory of the process whereby, upon an increase of the money supply, a new equilibrium is pursued. More specifically, possessors of the additional money are held to react to their new purchasing power by changing their buying habits in a way that generally increases demand for goods and for services. Austrian School economists do not believe that production will simply rise to meet all this new demand, so that prices increase and the new purchasing power erodes. The Austrian School emphasizes that this process is not instantaneous, and that the changes in demand are not distributed uniformly, so that the process does not ultimately lead to an equilibrium identical to the old except for some proportionate increase in prices; that “nominal” values thus have real effects. Austrian economists tend to view fiat increases in the money supply as particularly pernicious in their real effects. This view typically leads to the support for a Commodity standard of a very strict variety where all notes are convertible on demand to some commodity or basket of commodities. (The more popular of the Austrian economists tend to favor a Gold Standard .) Marxist theory In Marxist Economics value is based on the labor required to extract a given commodity versus the demand for that commodity by those with money. The fluctuations of price in money terms are inconsequential compared to the rise and fall of the labor cost of a commodity, since this determines the true cost of a good or service. In this, Marxist economics is related to other "classical" economic theories that argue that monetary inflation is caused solely by printing notes in excess of the basic quantity of gold. However, Marx argues that the real kind of inflation is in the cost of production measured in labor. Because of the classical labor theory of value, the only factor that is important is whether more or less labor is required to produce a given commodity at the rate it is demanded. Supply-side economics Supply-side Economics asserts that inflation is caused by either an increase in the supply of money or a decrease in the demand for balances of money. Thus the inflation experienced during the Black Plague in medieval Europe is seen as being caused by a decrease in the demand for money, the money stock used was gold coin and it was relatively fixed, while inflation in the 1970s is regarded as initially caused by an increased supply of money that occurred following the U.S. exit from the Bretton Woods Gold Standard . Supply-side Economics asserts that the money supply can grow without causing inflation as long as the demand for balances of 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. 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 19th century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the Federal Reserve . In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as Currency Board s. It is generally held in ill repute today, with Frederic Mishkin going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with Libertarian principles of laissez-faire, even though almost all libertarian economists are opposed to the RBD. The debate between currency, or quantity theory, and banking schools in Britain during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union 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 {Link without Title} argues that the value of money is determined by the assets and liabilities of the issuing agency. Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions. CONTROLLING INFLATION There are a number of methods that have been suggested to stop inflation, although a 0% inflation rate has never been achieved over any sustained period of time in the past. Central Bank s such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations (that is, using Monetary Policy ). High Interest Rate s and slow growth of the money supply are the traditional 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 overconsumed, and that the distortions that occur will force adjustments in supply. For example, if the official price of bread is too low, there will be too little bread at official prices. Temporary controls may ''complement'' a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase Unemployment ), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls, but to liberalize prices, assuming that the economy will adjust, abandoning unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated, and is thus often very unpopular with the people whose livelihoods are destroyed.See Creative Destruction SEE ALSO
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