In economics, inflation refers to the general increase in the prices of goods and services within an economy. It is commonly measured using the Consumer Price Index (CPI). When the general price level rises, each unit of currency buys fewer goods and services. Therefore, inflation represents a decrease in the purchasing power of money. The opposite of inflation is deflation, which is a decrease in the general price level.
Inflation is measured as a percentage change in a price index, such as the CPI. Since prices of goods and services do not all increase at the same rate, the CPI is often used to gauge overall inflation.
Inflation can result from various factors, including fluctuations in demand for goods and services (demand shocks), changes in supply (supply shocks), or shifts in inflation expectations. Moderate inflation can have both positive and negative effects. On the positive side, it can help reduce unemployment, provide more flexibility for monetary policy, and encourage investment. On the negative side, it can increase the cost of holding money, create uncertainty about future inflation, and potentially lead to shortages if consumers hoard goods.
Most economists today prefer a low and steady rate of inflation. This helps prevent economic recessions and avoids the complications of high inflation or deflation. Central banks typically manage inflation by setting interest rates and conducting open market operations.
Related Post:
• Pros and Cons of Gold Ira Rollover
• Broker
• Platinum
Terminology
The term “inflation” comes from the Latin word inflatus, meaning “to blow up.” It describes a general trend in rising prices, rather than changes in specific prices. For example, if cucumbers become more expensive relative to tomatoes due to a change in consumer preferences, this is not considered inflation.
Historically, inflation was linked to changes in the value of currency. For instance, when money was backed by gold, discovering new gold deposits would reduce the value of gold and, consequently, increase the prices of other goods.
Classical Economics
In the 19th century, economists identified three main factors causing price changes: changes in the value or production costs of goods, changes in the value of money due to fluctuations in metal content, and currency depreciation from an oversupply of money. The term “inflation” initially referred to currency devaluation rather than a general rise in prices. Early economists like David Hume and David Ricardo studied how currency devaluation affected prices.
Related Concepts
Several economic concepts are related to inflation:
- Deflation: A decrease in the general price level.
- Disinflation: A reduction in the rate of inflation.
- Hyperinflation: Extremely high inflation rates.
- Stagflation: A combination of inflation, slow economic growth, and high unemployment.
- Reflation: Efforts to increase the general price level to combat deflation.
- Asset Price Inflation: An increase in the prices of financial assets without a corresponding rise in the prices of goods or services.
- Agflation: A significant increase in food and agricultural prices compared to the general price rise.
History
Inflation has been present throughout history whenever money has been used. One of the earliest documented inflations occurred in Alexander the Great’s empire around 330 BCE. Historically, large increases in the supply of money, such as during the Roman Empire or in more recent times during hyperinflation episodes, have led to significant inflationary periods. Since the 1980s, many countries have managed to keep inflation low and stable, reducing economic volatility.
Measures
There are several ways to measure inflation:
- Consumer Price Index (CPI): Measures the average change in prices paid by consumers for goods and services.
- Producer Price Index (PPI): Measures changes in prices received by domestic producers.
- Personal Consumption Expenditures Price Index (PCEPI): Measures price changes in goods and services consumed by households.
- GDP Deflator: Measures the price change of all goods and services included in GDP.
Inflation rates are often calculated based on price indices, with methods and baskets of goods being updated to reflect changes in consumer behavior and market conditions.
Causes of Inflation
Historical Approaches
Theories about the causes of inflation have been discussed since at least the 16th century. Two major theories, the Quantity Theory of Money and the Real Bills Doctrine, have been debated for centuries regarding central bank policies. In the 20th century, Keynesian, Monetarist, and New Classical (or Rational Expectations) theories dominated discussions. By the end of the century, these theories were somewhat integrated.
Before 1936
Quantity Theory of Money (QTM) The price revolution between approximately 1550 and 1700 led early thinkers to develop ideas that are now considered early forms of the Quantity Theory of Money (QTM). Some attributed rising prices to the debasement of coinages, but later research showed that increased output from Central European silver mines and advancements in payment technology, such as the use of bills of exchange, also played a role.
Real Bills Doctrine (RBD) The Real Bills Doctrine, first detailed in Adam Smith’s The Wealth of Nations, argues that banks should issue money only in exchange for short-term, valuable assets. If a bank issues money based on assets worth the same amount, the money maintains its value. If the bank fails to do this, the money loses value. This theory contrasts with the QTM, which suggests that inflation happens when the money supply grows faster than the economy’s production of goods.
In the 19th century, three main schools of thought debated these theories:
- The British Currency School supported the QTM, advocating that the Bank of England’s banknotes should match its gold reserves.
- The British Banking School supported the RBD, arguing that banks should issue currency based on real bills from merchants.
- The Free Banking School believed that competitive private banks would not overissue currency, unlike a central bank which might.
The 19th-century debate between these schools set the stage for modern discussions on money credibility. The Banking Schools had more influence in the U.S. and Great Britain, while the Currency Schools influenced other countries, particularly in the Latin Monetary Union and the Scandinavian Monetary Union.
Bullionist Controversy During the Napoleonic Wars, David Ricardo argued that the Bank of England overissued banknotes, leading to increased commodity prices. In the late 19th century, Irving Fisher and other Quantity Theory supporters debated with proponents of bimetallism. Knut Wicksell later explained price movements as results of real shocks rather than changes in the money supply.
Keynes and Early Keynesians John Maynard Keynes, in his 1936 work The General Theory of Employment, Interest and Money, emphasized that wages and prices are “sticky” in the short run but adjust over time to changes in aggregate demand. Keynesian economics, which dominated post-World War II macroeconomic discussions, was based on the idea that economic policy affects demand through both monetary and fiscal measures. Alban William Phillips’s 1958 research showed a negative relationship between inflation and unemployment, known as the Phillips Curve, which suggested a trade-off between inflation and employment. This idea was central to Keynesian thought but failed to account for the 1970s stagflation.
Monetarism
In the 1960s, Monetarist theories, led by Milton Friedman, challenged Keynesian views. Friedman argued that “Inflation is always and everywhere a monetary phenomenon” and revived the Quantity Theory of Money. Monetarists believed that inflation results from changes in the money supply. They used the equation of exchange MV=PQMV = PQMV=PQ to illustrate this, where MMM is the money supply, VVV is the velocity of money, PPP is the price level, and QQQ is the quantity of output.
Monetarists assumed that changes in the money supply directly influence the price level, while fiscal policy was seen as less effective. Friedman and Edmund Phelps argued that the Phillips Curve trade-off between inflation and unemployment was only temporary. Over time, inflation expectations would adjust, making this trade-off unsustainable.
Rational Expectations Theory
In the early 1970s, Rational Expectations Theory, led by Robert Lucas, Thomas Sargent, and Robert Barro, transformed macroeconomic thought. This theory posits that people make rational decisions based on expectations of future economic conditions. Central banks must build credibility to control inflation. If people expect high inflation, it becomes a self-fulfilling prophecy. Conversely, if a central bank is seen as committed to controlling inflation, expectations will adjust, reducing inflationary pressures.
New Keynesians
By the 1970s, economists recognized that supply shocks and changing inflation expectations influenced inflation. New Keynesians accepted many concepts from Monetarists and Rational Expectations theories, such as the importance of monetary policy and the natural rate of unemployment. They also studied market imperfections and their effects on inflation. By the 2000s, a synthesis of these ideas emerged, known as the New Keynesian model or the New Consensus.
Post-2000 to Present
Since around 2000, modern views on inflation consider demand shocks, supply shocks, and inflation expectations as key determinants. For example, demand-pull inflation results from increased demand, while cost-push inflation arises from reduced supply. Inflation expectations can lead to a wage-price spiral, where higher wages drive up prices, which in turn can lead to further inflation.
Recent central banking practices focus on adjusting interest rates to target inflation rather than controlling the money supply directly. The Quantity Theory of Money remains influential among some economists, but the link between money supply and inflation has weakened in recent decades.
Housing Shortages and Climate Change
Housing shortages and climate change are also cited as significant drivers of inflation in the 21st century. Both factors can affect supply and prices, contributing to inflationary pressures.
2021–2022 Inflation Spike
In 2021–2022, many countries saw a sharp increase in inflation. This was due to a combination of demand and supply shocks, including fiscal and monetary policies related to the COVID-19 pandemic, supply chain disruptions, and rising energy prices following the Russian invasion of Ukraine. Price gouging and monopolistic practices also contributed to inflation. Despite a surge in money supply during the pandemic, recent studies suggest that the link between money supply and inflation has diminished.
Effects of Inflation
General Effect
Inflation is the decline in the purchasing power of money, meaning that as prices rise, each unit of currency buys fewer goods and services. The impact of inflation varies across different parts of the economy. For instance, individuals who own physical assets like property or stocks may benefit as the value of these assets increases. However, those with fixed incomes, such as certain workers and pensioners, may struggle because their earnings or benefits may not keep pace with rising prices. Similarly, individuals or institutions holding cash will see a decrease in the purchasing power of their money due to inflation.
Debtors and Lenders
Debtors with loans at fixed nominal interest rates benefit when inflation rises, as the real interest rate (nominal rate minus inflation rate) decreases. For example, if the nominal interest rate is 5% and inflation is 3%, the real interest rate is about 2%. Unexpected increases in inflation further lower the real interest rate. Lenders and banks adjust for inflation risks by adding an inflation risk premium to fixed interest rate loans or offering adjustable rates.
Negative Effects
High or unpredictable inflation is harmful to the economy. It creates market inefficiencies, makes long-term planning difficult for businesses, and can lower productivity as companies focus on managing inflation rather than improving their products and services. Inflation can also reduce asset prices and lead to higher interest rates as central banks respond. Additionally, inflation can act as a hidden tax, pushing taxpayers into higher income brackets if tax brackets are not adjusted for inflation.
Inflation redistributes purchasing power, often from those with fixed incomes to those with variable incomes. It can also affect international trade by making a country’s exports more expensive and impacting the balance of trade. High inflation can create economic instability, causing currency value fluctuations and affecting global trade.
Hoarding and Social Unrest
People may hoard goods to protect their wealth from inflation, leading to shortages. Inflation can also cause social unrest and revolts, as seen in the 2010–2011 Tunisian and Egyptian revolutions. High inflation can lead to a severe devaluation of currency, making people abandon it in favor of more stable currencies, a situation known as hyperinflation.
Corruption and Economic Impact
High inflation can increase corruption and undermine trust in financial institutions. Studies show that the costs of unemployment during high inflation can be significantly higher than those of inflation itself. This distrust can hinder economic recovery and lead to a decline in investments, potentially causing economic crashes.
Allocative Efficiency
Inflation distorts price signals, making it harder for buyers and sellers to respond to genuine changes in market conditions. This loss of efficiency can result in misallocated resources and slower economic responses to market changes.
Shoe Leather Cost
High inflation raises the cost of holding cash, leading people to keep their assets in interest-bearing accounts. This results in increased banking transactions, metaphorically wearing out “shoe leather” as people make more trips to the bank.
Menu Cost
Frequent price changes due to inflation increase the cost of adjusting prices, whether through reprinting menus or other administrative efforts. This ongoing adjustment can be costly for businesses.
Tax
Inflation acts as a hidden tax by eroding the real value of currency holdings.
Positive Effects
Moderate inflation can be beneficial. It allows for labor market adjustments by reducing real wages even if nominal wages remain constant, which can help the labor market reach equilibrium faster. Inflation also provides room for monetary policy adjustments, especially during recessions.
Mundell–Tobin Effect
The Mundell–Tobin effect suggests that moderate inflation can lead to increased capital investment and economic growth. As inflation encourages people to invest rather than hold cash, it can lower real interest rates and stimulate borrowing and investment.
Instability with Deflation
Deflation can cause instability as people hoard money, fearing future price increases. This behavior can lead to economic disruptions and hinder investment, making moderate inflation a preferable alternative.
Cost-of-Living Allowance
To mitigate the effects of inflation on fixed incomes, many employment contracts, pensions, and government benefits are adjusted based on a cost-of-living index. This adjustment helps maintain the real value of these payments.
Controlling Inflation
Monetary policy, managed by central banks, aims to keep inflation low and stable. Various methods have been used historically, including the gold standard, fixed exchange rates, and inflation targeting. Since 1990, many countries have adopted inflation targeting to manage their monetary policy effectively.
Inflation Targeting
Inflation targeting involves central banks adjusting interest rates to keep inflation within a set range. This method has been widely adopted and helps stabilize the economy by making monetary policy more predictable.
Fixed Exchange Rates
A fixed exchange rate system ties a country’s currency to another currency or a basket of currencies. This can help control inflation if the reference currency maintains low inflation, but it limits the government’s ability to use domestic monetary policy for economic stability.
Gold Standard
The gold standard links a currency’s value to a fixed quantity of gold. While it provided stability historically, it was eventually abandoned due to its limitations in addressing economic fluctuations and employment levels.
Wage and Price Controls
Wage and price controls have been used in various contexts to combat inflation. While they can be effective in certain situations, economists generally view them as temporary measures that should be accompanied by policies addressing the root causes of inflation.
Conclusion
Inflation is a crucial economic concept that impacts the purchasing power of money and the overall health of an economy. While moderate inflation can support economic growth and stability, high inflation or deflation can create significant challenges. Understanding and measuring inflation accurately helps policymakers and economists make informed decisions to maintain economic stability and growth.