What is Inflation?

Inflation and other related topics

Inflation rates around the world in 2007.
Annual inflation rates in the U.S., 1666-2004.Inflation is a rise in the general level of prices of goods and services over time. "Inflation" is also sometimes used to refer to a rise in the prices of some specific set of goods or services, as in "commodities inflation" or "core inflation". It is measured as the percentage rate of change of a price index.

Economists agree that high rates of inflation are caused by high rates of growth of the money supply.Views on the factors that determine moderate rates of inflation are more varied: changes in inflation are sometimes attributed to fluctuations in real demand for goods and services or in available supplies (i.e. changes in scarcity), and sometimes to changes in the supply or demand for money. In the mid-twentieth century, two camps disagreed strongly on the main causes of inflation at moderate rates: the "monetarists" argued that money supply dominated all other factors in determining inflation, while "Keynesians" argued that real demand was often more important than changes in the money supply.

There are many measures of inflation, because there are many different price indices relating to different sectors of the economy. Two widely known indices for which inflation rates are reported in many countries are the Consumer Price Index (CPI), which measures consumer prices, and the GDP deflator, which measures price variations associated with domestic production of goods and services.



Related definitions
Related economic concepts include: deflation, a general falling in price level; disinflation, a decrease in the rate of inflation; hyperinflation, an out-of-control inflationary spiral; stagflation, a combination of inflation and slow economic growth and rising unemployment; and reflation, which is an attempt to raise prices to counteract deflationary pressures.

In classical political economy, inflation meant increasing the money supply, while deflation meant decreasing it (see Monetary inflation). Economists from some schools of economic thought (including some Austrian economists) still retain this usage. In contemporary economic terminology, these would usually be referred to as expansionary and contractionary monetary policies.


Measures of inflation
Inflation is measured by calculating the percentage rate of change of a price index, which is called the inflation rate. This rate can be calculated for many different price indices, including:

Consumer price indices (CPIs) which measure the price of a selection of goods purchased by a "typical consumer."
Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes.
Producer price indices (PPIs) which measure the prices received by producers. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. Producer price inflation measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" as consumer inflation, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index.
Commodity price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee.
The GDP Deflator is a measure of the price of all the goods and services included in Gross Domestic Product (GDP). The US Commerce Department publishes a deflator series for US GDP, defined as its nominal GDP measure divided by its real GDP measure.
Capital goods price Index, although so far no attempt at building such an index has been made, several economists have recently pointed out the necessity of measuring capital goods inflation (inflation in the price of stocks, real estate, and other assets) separately.[citation needed] Indeed a given increase in the supply of money can lead to a rise in inflation (consumption goods inflation) and or to a rise in capital goods price inflation. The growth in money supply has remained fairly constant through since the 1970s however consumption goods price inflation has been reduced because most of the inflation has happened in the capital goods prices.
Other types of inflation measures include:

Regional Inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US.
Historical Inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology. This is equivalent to not adjusting the composition of baskets over time.

Issues in measuring inflation
Measuring inflation requires finding objective ways of separating out changes in nominal prices from other influences related to real activity. In the simplest possible case, if the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price change represents inflation. But we are usually more interested in knowing how the overall cost of living changes, and therefore instead of looking at the change in price of one good, we want to know how the price of a large 'basket' of goods and services changes. This is the purpose of looking at a price index, which is a weighted average of many prices. The weights in the Consumer Price Index, for example, represent the fraction of spending that typical consumers spend on each type of goods (using data collected by surveying households).

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 excluding food and energy, which is often called “core inflation”.


Effects of inflation
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 by Keynesians because of the downward adjustments in wages and output that are associated with it.

With inflation, the price of any given good is likely to increase over time, therefore both consumers and businesses may choose to make purchases sooner rather than later. This effect tends to keep an economy active in the short term by encouraging spending and borrowing, and in the long term by encouraging investments. But inflation can also reduce incentives to save, so the effect on gross capital formation in the long run is ambiguous.

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 systemic risk, in order to gain returns that will stay ahead of expected inflation.[citation needed]

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. As central banks are controlled by governments, there is also often political pressure to increase the money supply to pay government services, this has the added effect of creating inflation and decreasing the net money owed by the government in previously negotiated contractual agreements and in debt.

In general, high or unpredictable inflation rates are regarded as bad:

Uncertainty about future inflation may discourage investment and saving.
Redistribution
Rent Seeking - happens when resources are used to merely transfer wealth rather than produce it. e.g. a company tries to gauge and combat the costs of inflation.
inflation redistributes 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.
Debtors may be helped by inflation due to reduction of the real value of debt burden.
A particular form of inflation as a tax is Bracket Creep (also called fiscal drag). By allowing inflation to move upwards, certain sticky aspects of the tax code are met by more and more people. For example, income tax brackets, where the next dollar of income is taxed at a higher rate than previous dollars, tend to become distorted. 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.
International trade: Where fixed exchange rates are imposed, higher inflation than in trading partners' economies will make exports more expensive and tend toward a weakening balance of trade.
Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral.[citation needed] In a sense, inflation begets further inflationary expectations.

Hoarding: people buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.
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.

Causes of inflation
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.[3] 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. 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 seller 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 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 caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion. The failing value of money, however, may encourage spending rather than saving and so reduce the funds available for investment.
Cost-push inflation: presently termed "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.
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 is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively, often leading to hyperinflation, a condition where prices can double in a month or less. Another cause can be a rapid decline in the demand for money, as happened in Europe during the Black Plague.

The money supply is also thought to play a major role in determining 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 emphasize 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. Some economists consider this a 'hocus pocus' approach: They disagree with the notion that central banks control the money supply, arguing that central banks have little control because the money supply adapts to the demand for bank credit issued by commercial banks. This is the theory of endogenous money. Advocated strongly by post-Keynesians as far back as the 1960s, it has today become a central focus of Taylor rule advocates. But this position is not universally accepted. Banks create money by making loans. But the aggregate volume of these loans diminishes as real interest rates increase. Thus, it is quite likely that central banks influence the money supply by making money cheaper or more expensive, and thus increasing or decreasing its production.

A fundamental concept in Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment. The Phillips 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 British Prime Minister Margaret Thatcher might 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. 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
Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:


P=Dc/Sc

where P is the general price level of consumer goods, DC is the aggregate demand for consumer goods and SC is the aggregate supply of consumer goods. The idea is that the general price level of consumer goods will rise only if the aggregate supply of consumer goods falls relative to aggregate demand for consumer goods, or if aggregate demand increases relative to aggregate supply. Based on the idea that total spending is based primarily on the total amount of money in existence, the economists calculate aggregate demand for consumers' goods based on the total quantity of money. Therefore, they posit that as the quantity of money increases, total spending increases and aggregate demand for consumer goods increases too. For this reason, economists who believe in the Quantity Theory of Money also believe that the only cause of rising prices in a growing economy (this means the aggregate supply of consumer goods is increasing) is an increase of the quantity of money in existence, which is a function of monetary policies, generally set by central banks that have a monopoly on the issuance of currency, which is not pegged to a commodity, such as gold. The central bank of the United States is the Federal Reserve; the central bank backing the euro is the European Central Bank.


Rational expectations
Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.

A core assertion of rational expectations theory is that actors will seek to “head off” central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession.


Other theories about the causes of inflation

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 unanimously favor a gold standard.)


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.[citation needed]


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 boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of the Federal Reserve 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 [1] 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 control 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 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.[citation needed] 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 by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed.