Inflation is the rise in the general level of prices. This is equivalent to a fall in the value or purchasing power of money. It is the opposite of deflation. Measuring inflation Inflation is measured by observing the changes in prices of goods in the economy using econometric techniques. The rises in prices of the various goods are combined to give a price index that reflects the change in prices of these many goods, where the inflation rate is the rate of increase in this index. There is no single true measure of inflation, because the value of inflation will depend on the weight given to each good in the index.
Examples of common measures of inflation include: • consumer price indexes which measure the price of a selection of goods purchased by a “typical consumer”. In many industrial nations, annualised percentage changes in these indexes are the most commonly reported inflation figure. • producer price indexes which measure the price of a selection of inputs purchased by a “typical firm”. • wholesale price indexes which measure the change in price of a selection of goods at wholesale (i. e. , typically prior to sales taxes). • GDP deflator which is used to adjust measures of gross domestic product for inflation.
The role of inflation in the economy A great deal of economic literature concerns the question of what causes inflation and what effects it has. A small amount of inflation is often viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Inflation may also have negative effects on the economy: • Increasing uncertainty may discourage investment and saving. Redistribution o It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and profits which may keep pace with inflation. o Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax. International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade. • Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank. ) • Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
On balance many economists see moderate inflation as a benefit, and so there are a variety of fiscal policy arguments which favor moderate inflation. Central banks can affect inflation to a significant extent through setting the prime rate of lending and through other operations. This is due to the fact that most money in industrialised economies is based on debt (see money and credit money), and so controlling debt is thought to control the amount of money existing and so influence inflation. A government may find some level of inflation to be desirable, particularly in order to raise funds.
Causes of inflation Inflation may be caused by an increase in the quantity of money in circulation. This has been seen most graphically when governments have financed spending in a crisis by printing money, leading to hyperinflation where prices rise at extremely high rates. Another cause of inflation occurs when there are many people and organisations with enough market power to increase their prices. The money supply is also thought to play a role in determining levels of more 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 emphasise the role of aggregate demand in the economy rather than the money supply in determining inflation. A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggested that price stability was a trade off against employment. Therefore some level of inflation could be considered desirable in order to minimize unemployment.
The Philips curve model described the US 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. Stopping inflation There are a number of methods which have been suggested to stop inflation. One method is simply instituting wage and price controls, which were tried in the United States in the early 1970s. However, most economists regard price controls as counterproductive in that they tend to distort the functioning of the economy. Monetarists emphasize increasing interest rates in the hope of reducing the money supply.
Keynesians emphasize reducing demand, often through fiscal policy, using increased taxation or reduced government spending to reduce demand. In some cases of hyperinflation, confidence in the currency can be restored by pegging the value of the currency to a commodity such as gold or a stronger currency such as the U. S. dollar. Types of inflation: • Demand pull inflation • Cost push inflation • Inflation induced by adaptive expectations, often termed the “wage-price spiral” Historically, inflation meant an increase in the money supply, which was the cause of price increases.
Some economists still prefer this meaning of the term, rather than to mean the price increases themselves. Demand pull inflation arises where there is an increase in aggregate demand in an economy relative to aggregate supply. This is commonly described as “too much money chasing too few goods”. This would not be expected to persist over time due to increases in supply, unless the economy is already at a full employment level. Cost push is a type of inflation caused by arbitrary increases in the cost of goods or services where no suitable alternative is available.
A situation that has been often cited as of this was the oil crisis of the 1970s, which some economists attribute as the cause of the inflation experienced in the Western world in that decade. It is argued that this inflation resulted from increases in the cost of oil imposed by the member states of OPEC. Monetarist economists such as Milton Friedman argue against the concept of cost push inflation because they believe that increases in the cost of goods and services do not lead to inflation without the government cooperating in increasing the money supply.
The argument is that if the money supply is constant, increases in the cost of a good or service will decrease the money available for other goods and services, and therefore the price of some those goods will fall and offset the rise in price of those goods whose prices have increased. One consequence of this is that monetarist economists do not believe that the rise in the cost of oil was a direct cause of the inflation of the 1970’s. Hyperinflation is a form of economic inflation in which the general price level is increasing rapidly.
No single definition is universally accepted; one simplistic definition is a monthly inflation rate of 50%. Hyperinflation is just out-of-control inflation at an extremely high rate. Hyperinflation was rare before the 20th century, because past a certain level of inflation the economy would revert to either specie metals or barter. The widespread use of fiat money created the possibility for hyperinflation as governments often tended to print larger amounts of money to finance their expenses. Where such an increase in money supply is done without regard for the actual market demand for money then inflation results.
Rates of inflation of several hundred percent per month are often seen. Extreme examples include Germany in the early 1920s when the rate of inflation hit 3. 25 million percent per month, Greece in the mid-1940s with 8. 55 billion percent per month, and Hungary during the same approximate time period at 4. 19 quintillion percent per month. Other more moderate examples include Eastern European countries in the period of economic transition in the early 1990s and in Bolivia and Peru in 1985 and 1988, respectively.
Nations such as Ghana in North Western Africa continue to this day to have inflation in the order of 30% per annum. Hyperinflation produces some interesting banknotes. One type has a big long row of zeros on the number. (like this: “10,000,000,000”). Another type uses words for part or all of the number (like this: “10 Billion” or this: “Ten Billion”) Still others avoid the use of large numbers simply by declaring a new unit of currency (so, instead of 10,000,000,000 Dollars, you might set 1 New Dollar = 1,000,000,000 old Dollars, so your new banknote would read “10 New Dollars”. In countries experiencing hyperinflation it is common to see men and women bringing enormous grocery bags full of banknotes to the store, even for simple purchases like bread or milk. Stagflation is a portmanteau word used to describe a period with a high rate of inflation combined with an economic recession. The Phillips curve, which is associated with Keynesian economics suggests that stagflation is impossible because high unemployment lowers demand for goods and services which lowers prices. This results in low or no inflation.
By contrast, monetarism which argues that inflation is due to the money supply rather than to demand predicts that inflation can occur with high unemployment if the government increases the money supply. Stagflation occurred in the economies of the United Kingdom in the 1960s and 1970s and the United States in the late 1970s, and the difficulty in fitting its existence within a Keynesian framework led to a greater acceptance of monetarist theories in the 1970s and 1980s. But some still believe in Keynesian economics, saying that there was no recession at that time.
The coinage of the term has been claimed for the UK Finance Minister Iain Macleod who died in 1970. Adaptive expectations In economics, adaptive expectations means that people base their expectations of what will happen in the future based on what has happened in the past. For example, if inflation has been high in the past, people would expect it to be high in the future. In the theory of inflation, demand pull inflation and cost push inflation are usually one off shocks. However, a series of such shocks may lead people to assume that inflation is a permanent feature of the economy, in which case they will modify their economic behaviour ccordingly, based on their expectation of future inflation rates. For instance, they may begin demanding larger pay raises – this in itself acts as a cost push, leading firms to push their prices higher, and thus to another round of pay-raises. This “wage-price spiral” builds some inflation directly into the economy! The theory of adaptive expectations was popular in the 1980s, as an explanation of some aspects of the economic crisis that the West went through after the 1970s oil shock.
The fact that some countries, particularly the UK, took until the 1990s to achieve stable low inflation rates again suggests there may well be something in the idea. An alternative theory of how expectations are formed is rational expectations. Effects of Inflation: Regardless of whether inflation is demand pull or cost-push, the failure to correctly anticipate it results in unintended consequences. These unintended consequences impose costs in both labor markets and capital markets. Let’s examine these costs. Unanticipated Inflation in Labor Market Unanticipated inflation has two main consequences for the operation of the labor market: Redistribution of income • Departure from full employment Redistribution of Income Unanticipated inflation redistributes income between employers and workers. Sometimes employers gain at the expense of workers, and sometimes they lose. If an unexpected increase in aggregate demand increases [he inflation- rate, [hen wages will not have been set high enough. Profits will be higher than expected, and wages will buy fewer goods than expected. In this case, employers gain at the expense of workers. But if aggregate demand is expected to increase at a rapid rate and it fails to do so, workers gain at the expense of employers.
With a high inflation rate anticipated, wages are set too high and profits are squeezed. Redistribution between employers and workers creates an incentive for both firms and workers to try to forecast inflation correctly. Departures from Full Employment Redistribution brings gains to some and losses to others. But departures from full employment impose costs on everyone. To see why, let’s return to the soda-bottling plant in Kalamazoo. If the bottling plant and its workers do not anticipate inflation, but inflation occurs, the money wage rate does not rise to keep up with inflation.
The real wage rate falls, and the firm tries to hire more labor and increase production. But because the real wage rate has fallen, the firm has a hard time attracting the labor it wants to employ. It pays overtime rates to its existing work force, and because it runs its plant at a faster pace, it incurs higher plant maintenance and parts replacement costs. But also, because the real wage rate has fallen, workers begin to quit the bottling plant to find jobs that pay a real wage rate that is closer to one that prevailed before the outbreak of inflation. This Labor turnover imposes “additional costs on the firm.
So even though its production increases, the firm incurs additional costs, and its profits do not increase as much as they other- wise would. The workers incur additional costs of job search, and those who remain at the bottling plant wind up feeling cheated. They’ve worked overtime to produce the extra output, and when they come to spend their wages, they discover that prices have increased, so their wages buy a smaller quantity of goods and services than expected. If the bottling plant and its workers anticipate a high inflation rate that does not occur, they increase the money wage rate by too much, and the real wage rate rises.
At the higher real wage rate, the firm lays off some workers and the unemployment rate increases. Those workers who keep their jobs gain, but those who become unemployed lose. Also, the bottling plant loses because its output and profits fall. Unanticipated Inflation in the Capital Market Unanticipated inflation has two consequences for the operation of the capital market. They are: • Redistribution of income • Too much or too little lending and borrowing Redistribution of Income Unanticipated inflation redistributes income between borrowers and lenders.
Sometimes borrowers gain at the expense of lenders, and sometimes they lose. When inflation is unexpected, interest rates are not set high enough to compensate lenders for the falling value of money. In this case, borrowers gain at the expense of lenders. But if inflation is expected and then fails to occur, interest rates are set too high. In this case, lenders gain at the expense of borrowers. Redistributions of income between borrowers and lenders create an incentive for both groups to try to forecast inflation correctly.
Too Much or Too Little Lending and Borrowing If the inflation rate turns out to be either higher or lower than expected, the interest rate does not incorporate a correct allowance for the falling value of money and the real interest rate is either lower or higher than it otherwise would be. When the real interest rate turns out to be too low, which occurs when inflation is higher than expected, borrowers wish they had borrowed more and lenders wish they had lent less-: Both groups would have made different lending and borrowing decisions with greater fore- sight about the inflation rate.
When the real interest rate turns out to be too high, which occurs when inflation is lower than expected, borrowers wish they had borrowed less and lenders wish they had lent more. Again, both groups would have made different lending and borrowing decisions with greater fore- sight about the inflation rate. So unanticipated inflation imposes costs regard- less of whether the inflation turns out to be higher or lower than anticipated. The presence of these costs gives everyone an incentive to forecast inflation correctly. Let’s see how people go about this task.
Forecasting Inflation: Inflation is difficult to forecast. The reasons are, first, there are several sources of inflation–the demand-pull and cost-push sources you’ve just studied. Second, the speed with which a change in either aggregate demand or aggregate supply translates into a change in the price level varies. This speed of response also depends, as you will see below, on the extent to which the inflation is anticipated. Because inflation is costly and difficult to forecast, people devote considerable resources to improving inflation forecasts.
Some people specialize in forecasting, and others buy forecasts from specialists. The specialist forecasters are economists who work for public and private macroeconomic forecasting agencies and for banks, insurance companies, labor unions, and large corporations. The returns these specialists make depend on the quality of their forecasts, so they have a strong incentive to forecast as accurately as possible. The most accurate forecast possible is the one that is based on all the relevant information and is called a rational expectation.
A rational expectation is not a correct forecast. 1t is simply the best forecast available. It will often turn out to be wrong, but no ocher forecast that could have been made with the information available could be predicted to be better. You’ve seen the effects of inflation when people fail to anticipate it. And you’ve seen why it pays to try to anticipate inflation. Let’s now see what happens if inflation is correctly anticipated. Anticipated Inflation: In the demand-pull and cost-push inflations that we studied earlier in this chapter, money wages are sticky.
When aggregate demand increases, either to set off a demand-pull inflation or to accommodate cost-push inflation, the money wage does not change immediately. But if people correctly anticipate increases in aggregate demand, they will adjust money wage rates so as to keep up with anticipated inflation. In this case, inflation proceeds with real GDP equal to potential GDP and unemployment equal to the natural rate. Figure 32. 7 explains why. Suppose that last year the price level was 110 and real GDP was $7 trillion, which is also potential GDP. The. aggregate demand curve. as ADo; the aggregate supply curve was SASo, and the long-run aggregate supply curve was LAS. Suppose that potential GDP does not change, so the LAS curve does not shift. Also suppose that aggregate demand is expected to increase and that the expected aggregate demand curve for this year is ADl’ In anticipation of this increase in aggregate demand, money wage rates rise and the short-run aggregate supply curve shifts leftward. If the money wage rate rises by the same percentage as the price level rises, the short-run aggregate supply curve for next year is SASl.
If aggregate demand turns out to be the same as expected, the aggregate demand curve is ADl and with the short-run aggregate supply curve SASl the actual price level is 121. Between last year and this year, the price level increased from 110 to 121 and the economy experienced an inflation rate of 10 percent, the same as the inflation rate that was anticipated. If this anticipated inflation is ongoing, in the following year aggregate demand increases (as anticipated) and the aggregate demand curve shifts to AD2. The money wage rate rises to reflect the anticipated inflation, and the short-run aggregate supply curve shifts to SAS2.
The price level rises by a further 10 percent to 133. What has caused this inflation? The immediate answer is that because people expected inflation, wages were increased and prices increased. But the expectation was correct. Aggregate demand was expected to increase, and it did increase. Because aggregate demand was expected to increase from ADo to ADl, the short-run aggregate supply curve shifted from SASo to SASl. Because aggregate demand actually did increase by the amount that was expected, the actual aggregate demand curve shifted from ADo to ADl.
The combination of the anticipated and actual increases in aggregate demand produced an increase in the price level that was anticipated. Only if aggregate demand growth is correctly forecasted does the economy follow the course described in Fig. 32. 7. If the expected growth rate of aggregate demand is different from its actual growth rate, the expected aggregate demand curve shifts by an amount that is different from the actual aggregate demand curve. The inflation rate departs from its expected level, and to some extent, there is unanticipated inflation.
Page 348 figure 15. 7 Unanticipated Inflation: When aggregate demand increases by more than expected, there is some unanticipated-inflation that looks just like the demand-pull inflation that you studied earlier. Some inflation is expected, and the money wage rate is set to reflect that expectation. The SAS curve intersects the LAS curve at the expected price level. Aggregate demand then increases, but by more than expected. So the AD curve intersects the SAS curve at a level of real GDP that exceeds potential GDP.
With real GDP above potential GDP and unemployment below the natural rate, the money wage rate rises. So the price level rises further. , If aggregate demand increases again, a: demand-pull inflation spiral unwinds. When aggregate demand increases by less than expected, there is some unanticipated inflation that looks like the cost-push inflation that you studied earlier. Again, some inflation is expected, and the money wage rate is set to reflect that expectation. The SAS curve intersects the LAS curve at the expected price level.
Aggregate demand then- increases, but by less than expected. So the AD curve intersects the SAS curve at a level of real GDP-below potential GDP. Aggregate demand increases to restore full employment. But if aggregate demand is expected to increase by more than it actually does, wages again rise, short-run aggregate supply again decreases, and a cost push spiral unwinds We’ve seen that only when inflation is unanticipated does real GDP depart from potential GDP. When inflation is anticipated, real GDP remains at potential GDP. Does this mean that an anticipated inflation has no costs?