Inflation: Difference between revisions
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Reverted to the version of September 1st. Monetary inflation has its own article. |
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{{for|increases in the money supply or debasement of the currency|monetary inflation}} |
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{{otheruses|Inflate}} |
{{otheruses|Inflate}} |
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[[Image:World Inflation rate 2007.PNG|thumb|Inflation rates around the world in 2007.]] |
[[Image:World Inflation rate 2007.PNG|thumb|Inflation rates around the world in 2007.]] |
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[[Image:US Historical Inflation Ancient.svg|thumb|Annual inflation rates in the U.S., 1666-2004.]] |
[[Image:US Historical Inflation Ancient.svg|thumb|Annual inflation rates in the U.S., 1666-2004.]] |
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In mainstream economics, '''inflation''' means a rise in the general [[price level|level of prices]] of goods and services over time.<ref>Michael Burda and Charles Wyplosz(1997), ''Macroeconomics: A European text'', 2nd ed., p. 579 (Glossary). ISBN 0-19-877468-0 See also: Olivier Blanchard (2000), ''Macroeconomics'', 2nd ed., Glossary. ISBN 013013306X and Robert Barro (1993), ''Macroeconomics'', 4th ed., Glossary. See also: Andrew Abel and Ben Bernanke (1995), ''Macroeconomics'', 2nd ed., Glossary. ISBN 0201543923.</ref> |
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This definition differs from that of [[monetary inflation]], in which inflation refers to the increase of the money supply, which is based on the earliest definition of inflation, which concerned [[debasement]] of the currency. |
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⚫ | Economists agree that high rates of inflation are caused by high rates of growth of the [[money supply]].<ref>Robert Barro and Vittorio Grilli (1994), ''European Macroeconomics'', Ch. 8, p. 139, Fig. 8.1. Macmillan, ISBN 0333577647.</ref> Views on the factors that determine moderate rates of inflation are more varied: changes in inflation are sometimes attributed to fluctuations in [[real versus nominal value|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 "[[monetarist]]s" argued that money supply dominated all other factors in determining inflation, while "[[Keynesian]]s" argued that real demand was often more important than changes in the money supply. |
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⚫ | In contrast to these two camps, the [[Austrian School]] maintains that there is no material distinction between monetary inflation and price inflation (price inflation being the inevitable and obvious result of monetary inflation). This "traditionalist" interpretation of inflation implies that, by the Austrian definition, inflation is always a distinct action taken by the state, meaning simply that the [[central government]] or [[central bank]] permits or allows an increase in the supply of monetary units either by its own actions or by its inaction in controlling the growth of bank [[credit (finance)|credit]] (i.e. the [[central bank]] allows the debasement of the [[means of exchange]] by inflating the [[money supply]]).<ref>Ludwig von Mises, ''The Theory of Money and Credit'', ISBN 0-913966-70-3[http://mises.org/books/Theory_Money_Credit/Contents.aspx] See also: Jesus Huerta de Soto, ''Money, Bank Credit, and Economic Cycles'', ISBN 0-945466-39-4 [http://mises.org/books/desoto.pdf]</ref> |
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==Original definition== |
==Original definition== |
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⚫ | Originally, inflation originated with the debasement of the currency, meaning that e.g. gold coins were collected by the government (usually the king or the ruler of the region), melted down, mixed with other metals (often lead) and reissued at the same nominal value. By mixing the gold coins with other metals, the total nominal value of coins in circulation, and thus the money supply, increased.<ref>Frank Shostak, ''Commodity Prices and Inflation: What's the connection [http://mises.org/story/3018]</ref> However, the "real" (or commodity) value of each unit of currency, i.e. gold coin, was decreased as it was no longer pure gold. This led to an increase in nominal prices, as a consumer had to pay more mixed coins in exchange for goods and services than they previously had to pay in pure gold coins. In the 19th century, the word ''inflation'' started to appear as a direct reference to the action of increasing the amount of currency units by the central bank.<ref>Michael F. Bryan, ''On the Origin and Evolution of the Word "Inflation" [http://www.clevelandfed.org/research/Commentary/1997/1015.pdf]</ref> |
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{{Economics sidebar}} |
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⚫ | Originally, inflation originated with the debasement of the currency, meaning that e.g. gold coins were collected by the government (usually the king or the ruler of the region), melted down, mixed with other metals (often |
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In classical [[political economy]], inflation meant increasing the money supply, while deflation meant decreasing it (see ''[[Monetary inflation]]'').{{Fact|date=August 2008}} Economists from some schools of economic thought still retain this usage. Classical political economists from Hume to Ricardo did distinguish between and debate the cause and effect: the Bullionists, for example, argued that the Bank of England had overissued banknotes (increased the money supply) and caused 'the depreciation of banknotes' (inflation).<ref>[http://books.google.com/books?id=4nd6alor2goC&pg=PA127&lpg=PA127&dq=bullionist+inflation&source=web&ots=mG3_PT_O6q&sig=ViD-klPJPpaZxCBjdcPKh9zlwyU&hl=en&sa=X&oi=book_result&resnum=5&ct=result#PPA128,M1 Mark Blaug], Economic Theory in Retrospect, pg. 129: "...this was the cause of inflation, or, to use the language of the day, 'the depreciation of banknotes.'</ref> |
In classical [[political economy]], inflation meant increasing the money supply, while deflation meant decreasing it (see ''[[Monetary inflation]]'').{{Fact|date=August 2008}} Economists from some schools of economic thought still retain this usage. Classical political economists from Hume to Ricardo did distinguish between and debate the cause and effect: the Bullionists, for example, argued that the Bank of England had overissued banknotes (increased the money supply) and caused 'the depreciation of banknotes' (inflation).<ref>[http://books.google.com/books?id=4nd6alor2goC&pg=PA127&lpg=PA127&dq=bullionist+inflation&source=web&ots=mG3_PT_O6q&sig=ViD-klPJPpaZxCBjdcPKh9zlwyU&hl=en&sa=X&oi=book_result&resnum=5&ct=result#PPA128,M1 Mark Blaug], Economic Theory in Retrospect, pg. 129: "...this was the cause of inflation, or, to use the language of the day, 'the depreciation of banknotes.'</ref> |
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Today, increases and decreases in the money supply mainly result from actions by central banks |
Today, increases and decreases in the money supply mainly result from actions by central banks<ref>Murray Rothbard, ''The Case Against the Fed'', ISBN 978-0945466178 [http://mises.org/books/fed.pdf]</ref>, and the effects of increasing the money supply are magnified by credit expansion, as a result of the [[fractional-reserve banking]] system employed in most economic and financial systems in the world.<ref>Murray Rothbard, ''What Has Government Done to Our Money?'', ISBN 978-0945466444 [http://mises.org/rothbard/rothmoney.pdf]</ref> In contemporary economic terminology, these would usually be referred to as expansionary and contractionary [[monetary policy|monetary policies]]. |
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⚫ | Mainstream economists maintain that inflation is a measure of changes in the general level of prices. Thus the difference is that [[Austrian economists]] claim that inflation is the very action of producing more units of money, whereas mainstream economists regard inflation as the effect rather than the cause.<ref>[http://www.econlib.org/library/Enc/Inflation.html David Ranson], "Inflation" in The Concise Encyclopedia of Economics: "Still more difficult than measuring inflation is the problem of identifying its root causes."</ref> While most schools of economics agree that price levels are affected by changes in the money supply relative to the level of economic activity, the link with the [[Quantity theory of money|quantity of money]] is not direct: for example, changes in price levels are affected by the [[velocity of money]], and inflation can occur with a substantial lag between the increase in the quantity of money and the increase in the general price level. |
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==Related definitions== |
==Related definitions== |
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where <math>P</math> is the general price level of consumer goods, <math>D_C</math> is the aggregate demand for consumer goods and <math>S_C</math> 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 bank]]s that have a monopoly on the issuance of currency, which is not pegged to a commodity, such as gold. |
where <math>P</math> is the general price level of consumer goods, <math>D_C</math> is the aggregate demand for consumer goods and <math>S_C</math> 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 bank]]s that have a monopoly on the issuance of currency, which is not pegged to a commodity, such as gold. |
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⚫ | |||
⚫ | [[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. |
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⚫ | 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. |
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⚫ | |||
===Austrian School=== |
===Austrian School=== |
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⚫ | |||
⚫ | Mainstream economists maintain that inflation is a measure of changes in the general level of prices. Thus the difference is that [[Austrian economists]] claim that inflation is the very action of producing more units of money, whereas mainstream economists regard inflation as the effect rather than the cause.<ref>[http://www.econlib.org/library/Enc/Inflation.html David Ranson], "Inflation" in The Concise Encyclopedia of Economics: "Still more difficult than measuring inflation is the problem of identifying its root causes."</ref> While most schools of economics agree that price levels are affected by changes in the money supply relative to the level of economic activity, the link with the [[Quantity theory of money|quantity of money]] is not direct: for example, changes in price levels are affected by the [[velocity of money]], and inflation can occur with a substantial lag between the increase in the quantity of money and the increase in the general price level. |
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Because inflation, by the [[Austrian School]] definition, means debasement of the commercial [[means of exchange]], or increasing the [[money supply]] through the creation of new units of money, Austrians regard the [[central bank]] itself as the main cause of inflation, being the institution which controls the growth of bank [[credit (finance)|credit]]. When newly created bank [[credit (finance)|credit]] is injected into the [[fractional-reserve banking]] system through new borrowing from the banks, the total volume of [[credit (finance)|credit]] (and [[money supply|money]]) expands, thus exacerbating the inflationary effect of the increase in the [[money supply]].<ref>Charles T. Hatch, ''Inflationary Deception'' [http://mises.org/journals/scholar/hatch.pdf]</ref> |
Because inflation, by the [[Austrian School]] definition, means debasement of the commercial [[means of exchange]], or increasing the [[money supply]] through the creation of new units of money, Austrians regard the [[central bank]] itself as the main cause of inflation, being the institution which controls the growth of bank [[credit (finance)|credit]]. When newly created bank [[credit (finance)|credit]] is injected into the [[fractional-reserve banking]] system through new borrowing from the banks, the total volume of [[credit (finance)|credit]] (and [[money supply|money]]) expands, thus exacerbating the inflationary effect of the increase in the [[money supply]].<ref>Charles T. Hatch, ''Inflationary Deception'' [http://mises.org/journals/scholar/hatch.pdf]</ref> |
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Because the fiat money/fractional-reserve banking system enables the state to create new money "[[William Paterson (banker)|out of nothing]]" at the expense of the integrity of the monetary system, Austrians tend to be against paper currency and unfettered [[fractional-reserve banking]], and instead strongly advocate the [[gold standard]] or [[silver standard]] or [[bimetallism]].<ref>Hans-Hermann Hoppe, ''The Devolution of Money and Credit'' [http://mises.org/journals/rae/pdf/RAE7_2_3.pdf]</ref><ref>Andrew Dickinson White, ''Fiat Money in France'' [http://mises.org/books/inflationinfrance.pdf]</ref> |
Because the fiat money/fractional-reserve banking system enables the state to create new money "[[William Paterson (banker)|out of nothing]]" at the expense of the integrity of the monetary system, Austrians tend to be against paper currency and unfettered [[fractional-reserve banking]], and instead strongly advocate the [[gold standard]] or [[silver standard]] or [[bimetallism]].<ref>Hans-Hermann Hoppe, ''The Devolution of Money and Credit'' [http://mises.org/journals/rae/pdf/RAE7_2_3.pdf]</ref><ref>Andrew Dickinson White, ''Fiat Money in France'' [http://mises.org/books/inflationinfrance.pdf]</ref> |
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⚫ | |||
⚫ | [[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. |
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⚫ | 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. |
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⚫ | |||
===Supply-side economics=== |
===Supply-side economics=== |
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[[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 system|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.{{Fact|date=August 2007}} |
[[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 system|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.{{Fact|date=August 2007}} |
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[[Category:Basic financial concepts]] |
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[[Category:Economic problems]] |
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Revision as of 08:03, 6 September 2008
In mainstream economics, inflation means a rise in the general level of prices of goods and services over time.[1]
This definition differs from that of monetary inflation, in which inflation refers to the increase of the money supply, which is based on the earliest definition of inflation, which concerned debasement of the currency.
Economists agree that high rates of inflation are caused by high rates of growth of the money supply.[2] 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.
In contrast to these two camps, the Austrian School maintains that there is no material distinction between monetary inflation and price inflation (price inflation being the inevitable and obvious result of monetary inflation). This "traditionalist" interpretation of inflation implies that, by the Austrian definition, inflation is always a distinct action taken by the state, meaning simply that the central government or central bank permits or allows an increase in the supply of monetary units either by its own actions or by its inaction in controlling the growth of bank credit (i.e. the central bank allows the debasement of the means of exchange by inflating the money supply).[3]
Original definition
Originally, inflation originated with the debasement of the currency, meaning that e.g. gold coins were collected by the government (usually the king or the ruler of the region), melted down, mixed with other metals (often lead) and reissued at the same nominal value. By mixing the gold coins with other metals, the total nominal value of coins in circulation, and thus the money supply, increased.[4] However, the "real" (or commodity) value of each unit of currency, i.e. gold coin, was decreased as it was no longer pure gold. This led to an increase in nominal prices, as a consumer had to pay more mixed coins in exchange for goods and services than they previously had to pay in pure gold coins. In the 19th century, the word inflation started to appear as a direct reference to the action of increasing the amount of currency units by the central bank.[5]
In classical political economy, inflation meant increasing the money supply, while deflation meant decreasing it (see Monetary inflation).[citation needed] Economists from some schools of economic thought still retain this usage. Classical political economists from Hume to Ricardo did distinguish between and debate the cause and effect: the Bullionists, for example, argued that the Bank of England had overissued banknotes (increased the money supply) and caused 'the depreciation of banknotes' (inflation).[6]
Today, increases and decreases in the money supply mainly result from actions by central banks[7], and the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.[8] In contemporary economic terminology, these would usually be referred to as expansionary and contractionary monetary policies.
Mainstream economists maintain that inflation is a measure of changes in the general level of prices. Thus the difference is that Austrian economists claim that inflation is the very action of producing more units of money, whereas mainstream economists regard inflation as the effect rather than the cause.[9] While most schools of economics agree that price levels are affected by changes in the money supply relative to the level of economic activity, the link with the quantity of money is not direct: for example, changes in price levels are affected by the velocity of money, and inflation can occur with a substantial lag between the increase in the quantity of money and the increase in the general price level.
Related definitions
While "inflation" usually refers to a rise in some broad price index like the consumer price index that indicates the overall level of prices, it is also used to refer to a rise in the prices of some specific set of goods or services, as in "commodities inflation",[10][11] "food inflation",[12] or "house price inflation"[13] or core inflation (a measure of inflation of some sub-set of the broader index, usually excluding goods with higher volatility or strong seasonality).
Related economic concepts 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 and slow economic growth and rising unemployment; and reflation, which is an attempt to raise the general level of prices to counteract deflationary pressures.
Measures of inflation
Inflation is measured by calculating the inflation rate, which means the percentage rate of change of a price index, such as the Consumer Price Index.[14][15][16]
For example, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. Therefore, using these numbers, we can calculate that the annual percentage rate of CPI inflation over the course of 2007 was
That is, the general level of prices for typical U.S. consumers rose by approximately four per cent in 2007.[17]
Price indices include the following.
- Consumer price index (CPI) which measure the price of a selection of goods and services 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 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.
- 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.
- Core inflation Because food and oil prices 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 looking at those prices. Therefore most national statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a wider price index like the CPI. Since core inflation is less affected by short run supply and demand conditions in specific markets, it helps central banks better measure the inflationary impact of current monetary policy.
- 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 An undue increase in the prices of real or financial assets, such as stock (equity) and real estate, can be called 'asset price inflation'.
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.
- True Money Supply (TMS)
Following their definition, Austrian economists measure the inflation by calculating the growth of the money supply, i.e. how many new units of money that are available for immediate use in exchange, that have been created over time.[18][19][20]
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. This single price change does not, however, demonstrate how overall cost of living changes, and instead of looking at the change in price of one good, the price of a large "basket" of goods and services is measured. 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 "reweighting" as well as using chained measures of inflation. These adjustments are necessary because the type of goods purchased by 'typical consumers' changes over time, and the quality of some types of goods may change, and new types of goods may be invented.
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".
In keeping with their definition and understanding of inflation, Austrian economists track increases in the money supply to measure inflation (or debasement of the means of exchange).
Effects of inflation
Since inflation, according to the mainstream definition, is an increase in the general level of prices over time, it means a decline in the real value of money. That is, when the general level of prices rises, each monetary unit buys fewer goods and services.[21]
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.
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.[citation needed]
- 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 current profits which may keep pace with inflation. The real value of retained profits are eroded by inflation as the historical cost balances stay fixed like pensioners´ fixed income.
- 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.
As noted, this definition of inflation is rejected by the Austrian School, which maintains that inflation is an excessive increase of the money supply, which in turn leads to a higher nominal price level, as the real value of each monetary unit is eroded and thus buys fewer goods and services. Austrian economists also believe that inflation sets off the business cycle (see Austrian Business Cycle Theory) and hold this to be the most damaging effect of inflation as artificially low interests rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they show their underlying unsustainability.[22]
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.[23] 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. According to the Austrian School, inflation is a distinctive action taken by central bank, meaning the creation of new units of money. This newly created credit is then expanded due to the multiplying effect of the fractional-reserve banking system.
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":[24]
- 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.
- Cost-push inflation: also called "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 Death.
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:
where is the general price level of consumer goods, is the aggregate demand for consumer goods and 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.
Austrian School
Because inflation, by the Austrian School definition, means debasement of the commercial means of exchange, or increasing the money supply through the creation of new units of money, Austrians regard the central bank itself as the main cause of inflation, being the institution which controls the growth of bank credit. When newly created bank credit is injected into the fractional-reserve banking system through new borrowing from the banks, the total volume of credit (and money) expands, thus exacerbating the inflationary effect of the increase in the money supply.[25]
Austrians claim that the state uses inflation as one of the three means by which it can fund its activities, the other two being taxing and borrowing.[26] Therefore, they often seek to identify the reasons for why the state needs to create new money, and what the new money is used for. Various forms of military spending is often cited as a reason for resorting to inflation and borrowing, as this can be a short term way of acquiring marketable resources and is often favored by desperate, indebted governments.[27] In other cases, the central bank may try avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions or depressions by artificially trying to "stimulate" the economy through "encouraging" money supply growth and further borrowing via artificially low interest rates.[28]
Given that in almost all modern economies the central government "borrows" money from the central bank to fund deficit spending, in reality there are only two ways a modern government can fund its activities: taxing the populace, or borrowing (either from the central bank, private savers or overseas investors).[29] The issuance of debt-free money from the central government ended in the United States with the cessation of silver certificates.[30]
Because the fiat money/fractional-reserve banking system enables the state to create new money "out of nothing" at the expense of the integrity of the monetary system, Austrians tend to be against paper currency and unfettered fractional-reserve banking, and instead strongly advocate the gold standard or silver standard or bimetallism.[31][32]
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
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[33] 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
Today most central banks are tasked with keeping inflation at a low level, normally 2 to 3% per annum within the targeted low inflation range which could range from 2 to 6% per annum.
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. 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 breadmaking 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.
Austrian economists view inflation simply as an action taken by the state to fund its own growth and expenditure (or, viewed from a different angle, as the inevitable by-product of lax oversight of "fraudulent" fractional-reserve banking by the government-sponsored central bank).[34] Accordingly, many Austrian economists support the abolition of the central banks and the fractional-reserve banking system, and advocate instead a return to a 100 percent gold standard, or, less frequently, free banking.[35][36] Money could only be created by finding and putting into circulation more gold under a gold standard. This would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth (and inflation) would never spiral out of control.[37][38]
Some more radical monetary reformers such as Social Credit advocates Michael Rowbotham and Stephen Zarlenga support the complete abolition and outlawing of privately-owned fractional reserve banking, and argue that the controlled issuance of debt-free money from the Treasury (when combined with progressive taxation such as a land tax) would actually be less inflationary and disruptive than the present fractional-reserve banking-based monetary system.
See also
- Classification of Individual Consumption by Purpose
- Depreciation
- Disinflation
- Devaluation
- Economics
- Inflation accounting
- Inflation adjustment
- Macroeconomics
- Price revolution
- Rule of 72
- Seignorage
- United Nations Statistics Division
- 1920s German inflation
- World petroleum inflation
- World food inflation
- 2007-2008 world food price crisis
References
- ^ Michael Burda and Charles Wyplosz(1997), Macroeconomics: A European text, 2nd ed., p. 579 (Glossary). ISBN 0-19-877468-0 See also: Olivier Blanchard (2000), Macroeconomics, 2nd ed., Glossary. ISBN 013013306X and Robert Barro (1993), Macroeconomics, 4th ed., Glossary. See also: Andrew Abel and Ben Bernanke (1995), Macroeconomics, 2nd ed., Glossary. ISBN 0201543923.
- ^ Robert Barro and Vittorio Grilli (1994), European Macroeconomics, Ch. 8, p. 139, Fig. 8.1. Macmillan, ISBN 0333577647.
- ^ Ludwig von Mises, The Theory of Money and Credit, ISBN 0-913966-70-3[1] See also: Jesus Huerta de Soto, Money, Bank Credit, and Economic Cycles, ISBN 0-945466-39-4 [2]
- ^ Frank Shostak, Commodity Prices and Inflation: What's the connection [3]
- ^ Michael F. Bryan, On the Origin and Evolution of the Word "Inflation" [4]
- ^ Mark Blaug, Economic Theory in Retrospect, pg. 129: "...this was the cause of inflation, or, to use the language of the day, 'the depreciation of banknotes.'
- ^ Murray Rothbard, The Case Against the Fed, ISBN 978-0945466178 [5]
- ^ Murray Rothbard, What Has Government Done to Our Money?, ISBN 978-0945466444 [6]
- ^ David Ranson, "Inflation" in The Concise Encyclopedia of Economics: "Still more difficult than measuring inflation is the problem of identifying its root causes."
- ^ "Capital Markets & Economic Analysis: Commodities Inflation". Thursday, November 03, 2005. Retrieved 2008-08-11.
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(help) - ^ "Econbrowser: Commodity price inflation". Retrieved 2008-08-11.
- ^ MATTHEW L. WALD (Published: August 7, 2008). "E.P.A. Declines to Reduce the Quota for Ethanol in Cars - NYTimes.com". Retrieved 2008-08-11.
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(help) - ^ "BBC NEWS". Last Updated:. Retrieved 2008-08-11.
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(help); Text "Business" ignored (help); Text "House price inflation easing off" ignored (help)CS1 maint: extra punctuation (link) - ^ Robert Hall and John Taylor (1986), Macroeconomics: Theory, Performance, and Policy, page 5. ISBN 039395398X.
- ^ Blanchard (2000), op. cit.
- ^ Barro (1993), op. cit.
- ^ The numbers reported here refer to the US Consumer Price Index for All Urban Consumers, All Items, series CPIAUCNS, from base level 100 in base year 1982. They were downloaded from the FRED database at the Federal Reserve Bank of St. Louis on August 8, 2008.
- ^ Ludwig von Mises Institute, True Money Supply [7]
- ^ Joseph T. Salerno, (1987), Austrian Economic Newsletter, The "True" Money Supply: A Measure of the Medium of Exchange in the U.S. Economy [8]
- ^ Frank Shostak, (2000), The Mystery of the Money Supply Definition [9]
- ^ N. Gregory Mankiw, (2004), Principles of Economics, 3rd edition, International Student Edition. Chapter 30, page 659. ISBN 0324203098.
- ^ Thorsten Polleit, Inflation Is a Policy that Cannot Last [10]
- ^ Federal Reserve Board's semiannual Monetary Policy Report to the CongressRoundtableIntroductory statement by Jean-Claude Trichet on 1 July 2004
- ^ Robert J. Gordon (1988), Macroeconomics: Theory and Policy, 2nd ed., Chap. 22.4, 'Modern theories of inflation'. McGraw-Hill.
- ^ Charles T. Hatch, Inflationary Deception [11]
- ^ Lew Rockwell, interview on NOW with Bill Moyers [12]
- ^ Lew Rockwell, War and Inflation [13]
- ^ Thorsten Polleit, Manipulating the Interest Rate, 13 December 2007
- ^ Joseph T. Salerno, An Introduction to Austrian Economic Analysis, lecture 10 "Banking and the Business Cycle", [14]
- ^ Mike Hewitt, The Forgotten War
- ^ Hans-Hermann Hoppe, The Devolution of Money and Credit [15]
- ^ Andrew Dickinson White, Fiat Money in France [16]
- ^ "www.econ.ucla.edu/workingpapers/wp830.pdf" (PDF).
- ^ Murray Rothbard, The Mystery of Banking
- ^ Ludwig von Mises Institute, The Gold Standard [17]
- ^ Ron Paul, The Case for Gold, [18]
- ^ Murray Rothbard, The Case for a 100 Percent Gold Dollar [19]
- ^ Ludwig von Mises Institute, Money, Banking and the Federal Reserve [20]
Further reading
- George Reisman, Capitalism: A Treatise on Economics (Ottawa : Jameson Books, 1990), 503-506 & Chapter 19 ISBN 0-915463-73-3
- Henry Hazlitt, What You Should Know About Inflation [21]
- Juan de Mariana, On the debasement of money (De Mutatione Monetae)
- Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, New York, Harper Collins, 1995.
- Baumol, William J. and Alan S. Blinder, Macroeconomics: Principles and Policy, Tenth edition. Thomson South-Western, 2006. ISBN 0-324-22114-2
- Federal Reserve Bank of Boston, "Understanding Inflation and the Implications for Monetary Policy: A Phillips Curve Retrospective", Conference Series 53, June 9–11, 2008, Chatham, Massachusetts. (Also cf. Phillips curve article)
External links
Statistical sources
- Inflation Data - up-to-date US inflation data
- United States Bureau of Labor Statistics Consumer Price Index homepage
- Shadow Government Statistics - Current U.S. figures calculated using older official methodologies to allow more accurate comparison of current vs. historic figures
- US Consumer Price Index Over Time - A time-series chart of U.S. Consumer Price Index.
- Current Value of Old Money - discusses changes in the value of money over time.
- Various inflation calculators - US Dollars (1790-2006), UK pounds (1830-2006), price of gold (1257-2006)
- Inflation 1290-2006 - Based on the historical Consumer Price Index of the Swedish Riksbank
- Inflation Calculator - Based on CPI (1913-2008)
- US Inflation calculator - Based on consumer price indices (1800-2006)
- Cost-of-Living Calculator from American Institute for Economic Research (AIER)
- Up-to-date monthly inflation rates for the UK