In economics, inflation is a sustained increase in the general price level of goods and services
in an economy over a period of time.When the price level rises, each unit of currency buys
fewer goods and services; consequently, inflation reflects a reduction in the purchasing power
per unit of money – a loss of real value in the medium of exchange and unit of account
within the economy. A chief measure of price inflation is the inflation rate, the annualized
percentage change in a general price index, usually the consumer price index, over time.
The opposite of inflation is deflation. Inflation affects economies in various positive
and negative ways. The negative effects of inflation include an increase in the opportunity
cost of holding money, uncertainty over future inflation which may discourage investment
and savings, and if inflation were rapid enough, shortages of goods as consumers begin hoarding
out of concern that prices will increase in the future. Positive effects include reducing
the real burden of public and private debt, keeping nominal interest rates above zero
so that central banks can adjust interest rates to stabilize the economy, and reducing
unemployment due to nominal wage rigidity. Economists generally believe that high rates
of inflation and hyperinflation are caused by an excessive growth of the money supply.Views
on which factors determine low to moderate rates of inflation are more varied. Low or
moderate inflation may be attributed to fluctuations in real demand for goods and services, or
changes in available supplies such as during scarcities. However, the consensus view is
that a long sustained period of inflation is caused by money supply growing faster than
the rate of economic growth. Inflation may also lead to an invisible tax in which the
value of currency is lowered in contrast with its actual reserve ultimately, leading individuals
to hold devalued legal tender. Today, most economists favor a low and steady
rate of inflation. Low (as opposed to zero or negative) inflation reduces the severity
of economic recessions by enabling the labor market to adjust more quickly in a downturn,
and reduces the risk that a liquidity trap prevents monetary policy from stabilizing
the economy. The task of keeping the rate of inflation low and stable is usually given
to monetary authorities. Generally, these monetary authorities are the central banks
that control monetary policy through the setting of interest rates, through open market operations,
and through the setting of banking reserve requirements.
Venezuela has the highest inflation in the world, with an annual inflation of around
536.2% as of October 2017. History:
Rapid increases in quantity of the money or in the overall money supply (or debasement
of the means of exchange) have occurred in many different societies throughout history,
changing with different forms of money used. For instance, when gold was used as currency,
the government could collect gold coins, melt them down, mix them with other metals such
as silver, copper, or lead, and reissue them at the same nominal value. By diluting the
gold with other metals, the government could issue more coins without also needing to increase
the amount of gold used to make them. When the cost of each coin is lowered in this way,
the government profits from an increase in seigniorage. This practice would increase
the money supply but at the same time the relative value of each coin would be lowered.
As the relative value of the coins becomes lower, consumers would need to give more coins
in exchange for the same goods and services as before. These goods and services would
experience a price increase as the value of each coin is reduced.
Song Dynasty China introduced the practice of printing paper money to create fiat currency.
During the Mongol Yuan Dynasty, the government spent a great deal of money fighting costly
wars, and reacted by printing more money, leading to inflation. Fearing the inflation
that plagued the Yuan dynasty, the Ming Dynasty initially rejected the use of paper money,
and reverted to using copper coins. Historically, large infusions of gold or silver
into an economy also led to inflation. From the second half of the 15th century to the
first half of the 17th, Western Europe experienced a major inflationary cycle referred to as
the "price revolution", with prices on average rising perhaps sixfold over 150 years. This
was largely caused by the sudden influx of gold and silver from the New World into Habsburg
Spain. The silver spread throughout a previously cash-starved Europe and caused widespread
inflation. Demographic factors also contributed to upward pressure on prices, with European
population growth after depopulation caused by the Black Death pandemic.
By the nineteenth century, economists categorized three separate factors that cause a rise or
fall in the price of goods: a change in the value or production costs of the good, a change
in the price of money which then was usually a fluctuation in the commodity price of the
metallic content in the currency, and currency depreciation resulting from an increased supply
of currency relative to the quantity of redeemable metal backing the currency. Following the
proliferation of private banknote currency printed during the American Civil War, the
term "inflation" started to appear as a direct reference to the currency depreciation that
occurred as the quantity of redeemable banknotes outstripped the quantity of metal available
for their redemption. At that time, the term inflation referred to the devaluation of the
currency, and not to a rise in the price of goods.
This relationship between the over-supply of banknotes and a resulting depreciation
in their value was noted by earlier classical economists such as David Hume and David Ricardo,
who would go on to examine and debate what effect a currency devaluation (later termed
monetary inflation) has on the price of goods (later termed price inflation, and eventually
just inflation). The adoption of fiat currency by many countries,
from the 18th century onwards, made much larger variations in the supply of money possible.
Since then, huge increases in the supply of paper money have taken place in a number of
countries, producing hyperinflations – episodes of extreme inflation rates much higher than
those observed in earlier periods of commodity money. The hyperinflation in the Weimar Republic
of Germany is a notable example. Related definitions:
The term "inflation" originally referred to increases in the amount of money in circulation.
However, most economists today use the term "inflation" to refer to a rise in the price
level. An increase in the money supply may be called monetary inflation, to distinguish
it from rising prices, which may also for clarity be called "price inflation". Economists
generally agree that in the long run, inflation is caused by increases in the money supply.
Conceptually, inflation refers to the general trend of prices, not changes in any specific
price. For example, if people choose to buy more cucumbers than tomatoes, cucumbers consequently
become more expensive and tomatoes cheaper. These changes are not related to inflation,
they reflect a shift in tastes. Inflation is related to the value of currency itself.
When currency was linked with gold, if new gold deposits were found, the price of gold
and the value of currency would fall, and consequently prices of all other goods would
become higher. Other economic concepts related to inflation
include: deflation – a fall in the general price level; disinflation – a decrease in
the rate of inflation; hyperinflation – an out-of-control inflationary spiral; stagflation
– a combination of inflation, slow economic growth and high unemployment; reflation – an
attempt to raise the general level of prices to counteract deflationary pressures; and
Asset price inflation – a general rise in the prices of financial assets without a corresponding
increase in the prices of goods or services. Since there are many possible measures of
the price level, there are many possible measures of price inflation. Most frequently, the term
"inflation" refers to a rise in a broad price index representing the overall price level
for goods and services in the economy. The Consumer Price Index (CPI), the Personal consumption
expenditures price index (PCEPI) and the GDP deflator are some examples of broad price
indices. However, "inflation" may also be used to describe a rising price level within
a narrower set of assets, goods or services within the economy, such as commodities (including
food, fuel, metals), tangible assets (such as real estate), financial assets (such as
stocks, bonds), services (such as entertainment and health care), or labor. Although the values
of capital assets are often casually said to "inflate," this should not be confused
with inflation as a defined term; a more accurate description for an increase in the value of
a capital asset is appreciation. The Reuters-CRB Index (CCI), the Producer Price Index, and
Employment Cost Index (ECI) are examples of narrow price indices used to measure price
inflation in particular sectors of the economy. Core inflation is a measure of inflation for
a subset of consumer prices that excludes food and energy prices, which rise and fall
more than other prices in the short term. The Federal Reserve Board pays particular
attention to the core inflation rate to get a better estimate of long-term future inflation
trends overall. Measures:
The inflation rate is widely calculated by calculating the movement or change in a price
index, usually the consumer price index. The inflation rate is the percentage change of
a price index over time. The Retail Prices Index is also a measure of inflation that
is commonly used in the United Kingdom. It is broader than the CPI and contains a larger
basket of goods and services. To illustrate the method of calculation, in
January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080.
The formula for calculating the annual percentage rate inflation in the CPI over the course
of the year is: The resulting inflation rate for the CPI in this one-year period is 4.28%,
meaning the general level of prices for typical U.S. consumers rose by approximately four
percent in 2007. Other widely used price indices for calculating
price inflation include the following: Producer price indices (PPIs) which measures
average changes in prices received by domestic producers for their output. 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 eventual increase in the CPI. Producer price index measures
the pressure being put on producers by the costs of their raw materials. This could be
"passed on" to consumers, 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.
Core price indices: because food and oil prices can change quickly due to changes in
supply and demand conditions in the food and oil markets, it can be difficult to detect
the long run trend in price levels when those prices are included. Therefore, most statistical
agencies also report a measure of 'core inflation', which removes the most volatile components
(such as food and oil) from a broad price index like the CPI. Because core inflation
is less affected by short run supply and demand conditions in specific markets, central banks
rely on it to better measure the inflationary impact of current monetary policy.
Other common measures of inflation are: 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. ∴
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.
Asset price inflation is an undue increase in the prices of real or financial assets,
such as stock (equity) and real estate. While there is no widely accepted index of this
type, some central bankers have suggested that it would be better to aim at stabilizing
a wider general price level inflation measure that includes some asset prices, instead of
stabilizing CPI or core inflation only. The reason is that by raising interest rates when
stock prices or real estate prices rise, and lowering them when these asset prices fall,
central banks might be more successful in avoiding bubbles and crashes in asset prices.
Issues in measuring: Measuring inflation in an economy requires
objective means of differentiating changes in nominal prices on a common set of goods
and services, and distinguishing them from those price shifts resulting from changes
in value such as volume, quality, or performance. For example, 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 difference represents inflation. This single price change would not, however,
represent general inflation in an overall economy. To measure overall inflation, the
price change of a large "basket" of representative goods and services is measured. This is the
purpose of a price index, which is the combined price of a "basket" of many goods and services.
The combined price is the sum of the weighted prices of items in the "basket". A weighted
price is calculated by multiplying the unit price of an item by the number of that item
the average consumer purchases. Weighted pricing is a necessary means to measuring the impact
of individual unit price changes on the economy's overall inflation. The Consumer Price Index,
for example, uses data collected by surveying households to determine what proportion of
the typical consumer's overall spending is spent on specific goods and services, and
weights the average prices of those items accordingly. Those weighted average prices
are combined to calculate the overall price. To better relate price changes over time,
indexes typically choose a "base year" price and assign it a value of 100. Index prices
in subsequent years are then expressed in relation to the base year price. While comparing
inflation measures for various periods one has to take into consideration the base effect
as well. Inflation measures are often modified over
time, either for the relative weight of goods in the basket, or in the way in which goods
and services from the present are compared with goods and services from the past. Over
time, adjustments are made to the type of goods and services selected to reflect changes
in the sorts of goods and services purchased by 'typical consumers'. New products may be
introduced, older products disappear, the quality of existing products may change, and
consumer preferences can shift. Both the sorts of goods and services which are included in
the "basket" and the weighted price used in inflation measures will be changed over time
to keep pace with the changing marketplace. Inflation numbers are often seasonally adjusted
to differentiate expected cyclical cost shifts. For example, home heating costs are expected
to rise in colder months, and seasonal adjustments are often used when measuring for inflation
to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged
or otherwise subjected to statistical techniques to remove statistical noise and volatility
of individual prices. When looking at inflation, economic institutions
may focus only on certain kinds of prices, or special indices, such as the core inflation
index which is used by central banks to formulate monetary policy.
Most inflation indices are calculated from weighted averages of selected price changes.
This necessarily introduces distortion, and can lead to legitimate disputes about what
the true inflation rate is. This problem can be overcome by including all available price
changes in the calculation, and then choosing the median value. In some other cases, governments
may intentionally report false inflation rates; for instance, during the presidency of Cristina
Kirchner (2007–2015) the government of Argentina was criticised for manipulating economic data,
such as inflation and GDP figures, for political gain and to reduce payments on its inflation-indexed
debt. Causes:
Historically, a great deal of economic literature was concerned with the question of what causes
inflation and what effect it has. There were different schools of thought as to the causes
of 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 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 quantity equation of money that relates the money supply, its velocity, and
the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory
of inflation for money, and a quality theory of inflation for production.
Currently, the quantity theory of money is widely accepted as an accurate model of inflation
in the long run. Consequently, there is now broad agreement among economists that in the
long run, the inflation rate is essentially dependent on the growth rate of money supply
relative to the growth of the economy. However, in the short and medium term inflation may
be affected by supply and demand pressures in the economy, and influenced by the relative
elasticity of wages, prices and interest rates. The question of whether the short-term effects
last long enough to be important is the central topic of debate between monetarist and Keynesian
economists. In monetarism prices and wages adjust quickly enough to make other factors
merely marginal behavior on a general trend-line. 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. Keynesian view:
Keynesian economics proposes that changes in money supply do not directly affect prices,
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 is caused by increases in aggregate demand due to increased private
and government spending, etc. Demand inflation encourages economic growth since the excess
demand and favourable market conditions will stimulate investment and expansion.
Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate
supply (potential output). This may be due to natural disasters, or increased prices
of inputs. For example, a sudden decrease in the supply of oil, leading to increased
oil prices, can cause cost-push inflation. Producers for whom oil is a part of their
costs could then pass this on to consumers in the form of increased prices. Another example
stems from unexpectedly high Insured losses, either legitimate (catastrophes) or fraudulent
(which might be particularly prevalent in times of recession).
Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage
spiral". It involves workers trying to keep their wages up with prices (above the rate
of inflation), and firms passing these higher labor costs on to their customers as higher
prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and
so might be seen as hangover inflation. Demand-pull theory states that inflation accelerates
when aggregate demand increases beyond the ability of the economy to produce (its potential
output). Hence, any factor that increases aggregate demand can cause inflation. However,
in the long run, aggregate demand can be held above productive capacity only by increasing
the quantity of money in circulation faster than the real growth rate of the economy.
Another (although much less common) cause can be a rapid decline in the demand for money,
as happened in Europe during the Black Death, or in the Japanese occupied territories just
before the defeat of Japan in 1945. The effect of money on inflation is most obvious
when governments finance spending in a crisis, such as a civil war, by printing money excessively.
This sometimes leads to hyperinflation, a condition where prices can double in a month
or less. 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 economists, 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 Keynesian economists also disagree with
the notion that central banks fully control the money supply, arguing that central banks
have little control, since the money supply adapts to the demand for bank credit issued
by commercial banks. This is known as the theory of endogenous money, and has been advocated
strongly by post-Keynesians as far back as the 1960s. It has today become a central focus
of Taylor rule advocates. 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, central banks can influence the money supply by making money cheaper or
more expensive, thus increasing or decreasing its production.
A fundamental concept in inflation analysis is the relationship between inflation and
unemployment, called the Phillips curve. This model suggests that there is a trade-off between
price stabilityand employment. Therefore, some level of inflation could be considered
desirable to minimize unemployment. The Phillips curve model described the U.S. experience
well in the 1960s but failed to describe the stagflation experienced in the 1970s. Thus,
modern macroeconomics describes inflation using a Phillips curve that is able to shift
due to such matters as supply shocks and structural inflation. The former refers to such events
like the 1973 oil crisis, while the latter refers to the price/wage spiral and inflationary
expectations implying that inflation is the new normal. Thus, the Phillips curve represents
only the demand-pull component of the triangle model.
Another concept of note 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. Unemployment:
A connection between inflation and unemployment has been drawn since the emergence of large
scale unemployment in the 19th century, and connections continue to be drawn today. However,
the unemployment rate generally only affects inflation in the short-term but not the long-term.
In the long term, the velocity of money is far more predictive of inflation than low
unemployment. In Marxian economics, the unemployed serve
as a reserve army of labor, which restrain wage inflation. In the 20th century, similar
concepts in Keynesian economics include the NAIRU (Non-Accelerating Inflation Rate of
Unemployment) and the Phillips curve. Monetarist view:
Monetarists believe the most significant factor influencing inflation or deflation is how
fast the money supply grows or shrinks. They consider fiscal policy, or government spending
and taxation, as ineffective in controlling inflation. The monetarist economist Milton
Friedman famously stated, "Inflation is always and everywhere a monetary phenomenon."
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
any change in the amount of money in a system will change the price level.
Monetarists assume that the velocity of money is unaffected by monetary policy (at least
in the long run), and the real value of output is determined in the long run by the productive
capacity of the economy. Under these assumptions, the primary driver of the change in the general
price level is changes in the quantity of money. With exogenous velocity (that is, velocity
being determined externally and not being influenced by monetary policy), the money
supply determines the value of nominal output (which equals final expenditure) in the short
run. In practice, velocity is not exogenous in the short run, and so the formula does
not necessarily imply a stable short-run relationship between the money supply and nominal output.
However, in the long run, changes in velocity are assumed to be determined by the evolution
of the payments mechanism. If velocity is relatively unaffected by monetary policy,
the long-run rate of increase in prices (the inflation rate) is equal to the long-run growth
rate of the money supply plus the exogenous long-run rate of velocity growth minus the
long run growth rate of real output. Rational expectations theory:
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 economic
actors will make bets that the central bank will expand the money supply rapidly enough
to prevent recession, even at the expense of exacerbating inflation. Thus, if a central
bank has a reputation as being "soft" on inflation, when it announces a new policy of fighting
inflation with restrictive monetary growth economic agents will not believe that the
policy will persist; their inflationary expectations will remain high, and so will inflation. On
the other hand, if the central bank has a reputation of being "tough" on inflation,
then such a policy announcement will be believed and inflationary expectations will come down
rapidly, thus allowing inflation itself to come down rapidly with minimal economic disruption.
Austrian view: The Austrian School stresses that inflation
is not uniform over all assets, goods, and services. Inflation depends on differences
in markets and on where newly created money and credit enter the economy. Ludwig von Mises
said that inflation should refer to an increase in the quantity of money that is not offset
by a corresponding increase in the need for money, and that price inflation will necessarily
follow. Real bills doctrine:
The real bills doctrine asserts that banks should issue their money in exchange for short-term
real bills of adequate value. As long as banks only issue a dollar in exchange for assets
worth at least a dollar, the issuing bank's assets will naturally move in step with its
issuance of money, and the money will hold its value. Should the bank fail to get or
maintain assets of adequate value, then the bank's money will lose value, just as any
financial security will lose value if its asset backing diminishes. The real bills doctrine
(also known as the backing theory) thus asserts that inflation results when money outruns
its issuer's assets. The quantity theory of money, in contrast, claims that inflation
results when money outruns the economy's production of goods.
Currency and banking schools of economics argue the RBD, 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."
The debate between currency, or quantity theory, and the banking schools during the 19th century
prefigures current questions about the credibility of money in the present. In the 19th century
the banking schools had greater influence in policy in the United States and Great Britain,
while the currency schools had more influence "on the continent", that is in non-British
countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary
union. Effects:
General: An increase in the general level of prices
implies a decrease in the purchasing power of the currency. That is, when the general
level of prices rise, each monetary unit buys fewer goods and services. The effect of inflation
is not distributed evenly in the economy, and as a consequence there are hidden costs
to some and benefits to others from this decrease in the purchasing power of money. For example,
with inflation, those segments in society which own physical assets, such as property,
stock etc., benefit from the price/value of their holdings going up, when those who seek
to acquire them will need to pay more for them. Their ability to do so will depend on
the degree to which their income is fixed. For example, increases in payments to workers
and pensioners often lag behind inflation, and for some people income is fixed. Also,
individuals or institutions with cash assets will experience a decline in the purchasing
power of the cash. Increases in the price level (inflation) erode the real value of
money (the functional currency) and other items with an underlying monetary nature.
Debtors who have debts with a fixed nominal rate of interest will see a reduction in the
"real" interest rate as the inflation rate rises. The real interest on a loan is the
nominal rate minus the inflation rate. The formula R = N-I approximates the correct answer
as long as both the nominal interest rate and the inflation rate are small. The correct
equation is r = n/i where r, n and i are expressed as ratios (e.g. 1.2 for +20%, 0.8 for −20%).
As an example, when the inflation rate is 3%, a loan with a nominal interest rate of
5% would have a real interest rate of approximately 2% (in fact, it's 1.94%). Any unexpected increase
in the inflation rate would decrease the real interest rate. Banks and other lenders adjust
for this inflation risk either by including an inflation risk premium to fixed interest
rate loans, or lending at an adjustable rate. Negative:
High or unpredictable inflation rates are regarded as harmful to an overall economy.
They add inefficiencies in the market, and make it difficult for companies to budget
or plan long-term. Inflation can act as a drag on productivity as companies are forced
to shift resources away from products and services to focus on profit and losses from
currency inflation. Uncertainty about the future purchasing power of money discourages
investment and saving. Inflation can also impose hidden tax increases. For instance,
inflated earnings push taxpayers into higher income tax rates unless the tax brackets are
indexed to inflation. With high inflation, purchasing power is redistributed
from those on fixed nominal incomes, such as some pensioners whose pensions are not
indexed to the price level, towards those with variable incomes whose earnings may better
keep pace with the inflation. This redistribution of purchasing power will also occur between
international trading partners. Where fixed exchange rates are imposed, higher inflation
in one economy than another will cause the first economy's exports to become more expensive
and affect the balance of trade. There can also be negative impacts to trade from an
increased instability in currency exchange prices caused by unpredictable inflation.
Cost-push inflation: High inflation can prompt employees to demand
rapid wage increases, to keep up with consumer prices. In the cost-push theory of inflation,
rising wages in turn can help fuel inflation. In the case of collective bargaining, wage
growth will be set as a function of inflationary expectations, which will be higher when inflation
is high. This can cause a wage spiral. In a sense, inflation begets further inflationary
expectations, which beget further inflation. Hoarding:
People buy durable and/or non-perishable commodities and other goods as stores of wealth, to avoid
the losses expected from the declining purchasing power of money, creating shortages of the
hoarded goods. Social unrest and revolts:
Inflation can lead to massive demonstrations and revolutions. For example, inflation and
in particular food inflation is considered as one of the main reasons that caused the
2010–11 Tunisian revolution and the 2011 Egyptian revolution, according to many observers
including Robert Zoellick, president of the World Bank. Tunisian president Zine El Abidine
Ben Ali was ousted, Egyptian President Hosni Mubarak was also ousted after only 18 days
of demonstrations, and protests soon spread in many countries of North Africa and Middle
East. Hyperinflation:
If inflation becomes too high, it can cause people to severely curtail their use of the
currency, leading to an acceleration in the inflation rate. High and accelerating inflation
grossly interferes with the normal workings of the economy, hurting its ability to supply
goods. Hyperinflation can lead to the abandonment of the use of the country's currency (for
example as in North Korea) leading to the adoption of an external currency (dollarization).
Allocative efficiency: A change in the supply or demand for a good
will normally cause its relative price to change, signaling the buyers and sellers that
they should re-allocate resources in response to the new market conditions. But when prices
are constantly changing due to inflation, price changes due to genuine relative price
signals are difficult to distinguish from price changes due to general inflation, so
agents are slow to respond to them. The result is a loss of allocative efficiency.
Shoe leather cost: High inflation increases the opportunity cost
of holding cash balances and can induce people to hold a greater portion of their assets
in interest paying accounts. However, since cash is still needed to carry out transactions
this means that more "trips to the bank" are necessary to make withdrawals, proverbially
wearing out the "shoe leather" with each trip. Menu costs:
With high inflation, firms must change their prices often to keep up with economy-wide
changes. But often changing prices is itself a costly activity whether explicitly, as with
the need to print new menus, or implicitly, as with the extra time and effort needed to
change prices constantly. Positive:
Labour-market adjustments: Nominal wages are slow to adjust downwards.
This can lead to prolonged disequilibrium and high unemployment in the labor market.
Since inflation allows real wages to fall even if nominal wages are kept constant, moderate
inflation enables labor markets to reach equilibrium faster.
Room to maneuver: The primary tools for controlling the money
supply are the ability to set the discount rate, the rate at which banks can borrow from
the central bank, and open market operations, which are the central bank's interventions
into the bonds market with the aim of affecting the nominal interest rate. If an economy finds
itself in a recession with already low, or even zero, nominal interest rates, then the
bank cannot cut these rates further (since negative nominal interest rates are impossible)
to stimulate the economy – this situation is known as a liquidity trap.
Mundell–Tobin effect: The Nobel laureate Robert Mundell noted that
moderate inflation would induce savers to substitute lending for some money holding
as a means to finance future spending. That substitution would cause market clearing real
interest rates to fall. The lower real rate of interest would induce more borrowing to
finance investment. In a similar vein, Nobel laureate James Tobin noted that such inflation
would cause businesses to substitute investment in physical capital (plant, equipment, and
inventories) for money balances in their asset portfolios. That substitution would mean choosing
the making of investments with lower rates of real return. (The rates of return are lower
because the investments with higher rates of return were already being made before.)
The two related effects are known as the Mundell–Tobin effect. Unless the economy is already overinvesting
according to models of economic growth theory, that extra investment resulting from the effect
would be seen as positive. Instability with deflation:
Economist S.C. Tsiang noted that once substantial deflation is expected, two important effects
will appear; both a result of money holding substituting for lending as a vehicle for
saving.The first was that continually falling prices and the resulting incentive to hoard
money will cause instability resulting from the likely increasing fear, while money hoards
grow in value, that the value of those hoards are at risk, as people realize that a movement
to trade those money hoards for real goods and assets will quickly drive those prices
up. Any movement to spend those hoards "once started would become a tremendous avalanche,
which could rampage for a long time before it would spend itself." Thus, a regime of
long-term deflation is likely to be interrupted by periodic spikes of rapid inflation and
consequent real economic disruptions. Moderate and stable inflation would avoid such a seesawing
of price movements. Financial market inefficiency with deflation:
The second effect noted by Tsiang is that when savers have substituted money holding
for lending on financial markets, the role of those markets in channeling savings into
investment is undermined. With nominal interest rates driven to zero, or near zero, from the
competition with a high return money asset, there would be no price mechanism in whatever
is left of those markets. With financial markets effectively euthanized, the remaining goods
and physical asset prices would move in perverse directions. For example, an increased desire
to save could not push interest rates further down (and thereby stimulate investment) but
would instead cause additional money hoarding, driving consumer prices further down and making
investment in consumer goods production thereby less attractive. Moderate inflation, once
its expectation is incorporated into nominal interest rates, would give those interest
rates room to go both up and down in response to shifting investment opportunities, or savers'
preferences, and thus allow financial markets to function in a more normal fashion.
Controlling inflation: A variety of methods and policies have been
proposed and used to control inflation. Monetary policy:
Governments and central banks primarily use monetary policy to control inflation. Central
banks such as the U.S. Federal Reserve increase the interest rate, slow or stop the growth
of the money supply, and reduce the money supply. Some banks have a symmetrical inflation
target while others only control inflation when it rises above a target, whether express
or implied. Most central banks are tasked with keeping
their inter-bank lending rates at low levels, normally to a target annual rate of about
2% to 3%, and within a targeted annual inflation range of about 2% to 6%. Central bankers target
a low inflation rate because they believe deflation endangers the economy.
Higher interest rates reduce the amount of money because fewer people seek loans, and
loans are usually made with new money. When banks make loans, they usually first create
new money, then lend it. A central bank usually creates money lent to a national government.
Therefore, when a person pays back a loan, the bank destroys the money and the quantity
of money falls. In the early 1980s, when the federal funds rate exceeded 15 percent, the
quantity of Federal Reserve dollars fell 8.1 percent, from US$8.6 trillion down to $7.9
trillion. Monetarists emphasize a steady growth rate
of money and use monetary policy to control inflation by slowing the rise in the money
supply. Keynesiansemphasize reducing aggregate demand during economic expansions and increasing
demand during recessions to keep inflation stable. Control of aggregate demand can be
achieved using both monetary policy and fiscal policy (increased taxation or reduced government
spending to reduce demand). Fixed exchange rates:
Under a fixed exchange rate currency regime, a country's currency is tied in value to another
single currency or to a basket of other currencies (or sometimes to another measure of value,
such as gold). A fixed exchange rate is usually used to stabilize the value of a currency,
vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation.
However, as the value of the reference currency rises and falls, so does the currency pegged
to it. This essentially means that the inflation rate in the fixed exchange rate country is
determined by the inflation rate of the country the currency is pegged to. In addition, a
fixed exchange rate prevents a government from using domestic monetary policy to achieve
macroeconomic stability. Under the Bretton Woods agreement, most countries
around the world had currencies that were fixed to the U.S. dollar. This limited inflation
in those countries, but also exposed them to the danger of speculative attacks. After
the Bretton Woods agreement broke down in the early 1970s, countries gradually turned
to floating exchange rates. However, in the later part of the 20th century, some countries
reverted to a fixed exchange rate as part of an attempt to control inflation. This policy
of using a fixed exchange rate to control inflation was used in many countries in South
America in the later part of the 20th century (e.g. Argentina (1991–2002), Bolivia, Brazil,
and Chile). Gold standard:
The gold standard is a monetary system in which a region's common media of exchange
are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The
standard specifies how the gold backing would be implemented, including the amount of specie
per currency unit. The currency itself has no innate value, but is accepted by traders
because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example,
could be redeemed for an actual piece of silver. The gold standard was partially abandoned
via the international adoption of the Bretton Woods system. Under this system all other
major currencies were tied at fixed rates to the dollar, which itself was tied to gold
at the rate of US$35 per ounce. The Bretton Woods system broke down in 1971, causing most
countries to switch to fiat money – money backed only by the laws of the country.
Under a gold standard, the long term rate of inflation (or deflation) would be determined
by the growth rate of the supply of gold relative to total output.Critics argue that this will
cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially
be determined by gold mining. Wage and price controls:
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. More successful
examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in
the Netherlands. In general, wage and price controls are regarded
as a temporary and exceptional measure, 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. They often have perverse effects, due to the
distorted signals they send to the market. Artificially low prices often cause rationing
and shortages and discourage future investment, resulting in yet further shortages. The usual
economic analysis is that any product or service that is under-priced is overconsumed. For
example, if the official price of bread is too low, there will be too little bread at
official prices, and too little investment in bread making by the market to satisfy future
needs, thereby exacerbating the problem in the long term.
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 (see creative
destruction). Effect of economic growth:
If economic growth matches the growth of the money supply, inflation should not occur when
all else is equal. A large variety of factors can affect the rate of both. For example,
investment in market production, infrastructure, education, and preventive health care can
all grow an economy in greater amounts than the investment spending.
Cost-of-living allowance: The real purchasing power of fixed payments
is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many
countries, employment contracts, pension benefits, and government entitlements (such as social
security) are tied to a cost-of-living index, typically to the consumer price index. A cost-of-living
adjustment (COLA) adjusts salaries based on changes in a cost-of-living index. It does
not control inflation, but rather seeks to mitigate the consequences of inflation for
those on fixed incomes. Salaries are typically adjusted annually in low inflation economies.
During hyperinflation they are adjusted more often. They may also be tied to a cost-of-living
index that varies by geographic location if the employee moves.
Annual escalation clauses in employment contracts can specify retroactive or future percentage
increases in worker pay which are not tied to any index. These negotiated increases in
pay are colloquially referred to as cost-of-living adjustments ("COLAs") or cost-of-living increases
because of their similarity to increases tied to externally determined indexes.
Inflation expectations: Inflation expectations, inflationary expectations,
or expected inflation is the rate of inflation that is anticipated for some period of time
in the foreseeable future. There are two major approaches to modeling the formation of inflation
expectations. Adaptive expectations models them as a weighted average of what was expected
one period earlier and the actual rate of inflation that most recently occurred. Rational
expectations models them as unbiased, in the sense that the expected inflation rate is
not systematically above or systematically below the inflation rate that actually occurs.
A long-standing survey of inflation expectations is the University of Michigan survey.
Inflation expectations affect the economy in several ways. They are more or less built
into nominal interest rates, so that a rise (or fall) in the expected inflation rate will
typically result in a rise (or fall) in nominal interest rates, giving a smaller effect if
any on real interest rates. In addition, higher expected inflation tends to be built into
the rate of wage increases, giving a smaller effect if any on the changes in real wages.
Moreover, the response of inflationary expectations to monetary policy can influence the division
of the effects of policy between inflation and unemployment (see Monetary policy credibility).
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