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Inflation
Economists have differing views on whether monetary expansion or the devaluing of money is true inflation. The reason for this difference between economic schools of thought is that some scientists see inflation as an economic process while others see it as an economic symptom, so the term "inflation" is often used to mean both. Economists that subscribe to the Austrian school of thought believe that inflation is an increase of the money supply (which causes prices to go up), but most others use inflation to describe price increases only.
Still, to the average person, inflation has more to do with the price of goods rising than any abstract process. It influences the cost of living, which is the comparison of the cost of certain goods between two time periods. Adjustments are then made based on this comparison. The cost of living comparison to account for inflation is not a true definition of raw inflation, because it allows for increased expectations along with actual prices. Raw inflation only looks at objective measurements of the change in prices.
Cost of living measurements to determine inflation are varied, as different groups measure inflation using different goods. There are, however, some common forms of inflation like consumer and producer inflation, GDP deflators, and price indexes (which measure overall inflation in the economy).
The term "inflation" will, from this point on, be used to describe general price increases unless noted otherwise.
Inflation v. Currency Devaluation
In
general, though, most people know inflation as the devaluation of the
market value of money in a single economy, though some people confuse
inflation with the devaluation of currency between economies. Though
the two are somewhat related, the latter is not inflation, it is currency
devaluation, which is based on perception and investor demand. The
two do have some similarities, though, in that they are both caused by
currency inflation, or the addition of printed or virtual currency to the
money supply. Yet, it can be noted that, due to a gradual change of
wealth through things like long-lasting items or technologies, currency
inflation does not always cause price inflation.
Understanding Inflation
Terminology
While there are differences among economists as to the
actual meaning of inflation, there are some general terms that arise to
describe certain aspects of it. It is important to understand the
meanings of these terms, because they relate closely to inflation
itself.
"Deflation" is basically the opposite of inflation, as it is characterized by a rise in the market value of money. Often prices become lower when deflation occurs.
"Disinflation" is when inflation slows down, so prices may go up, but not as quickly.
"Reflation" means that deflation has occurred, but now inflation has resumed to bring prices back up to the level prior to deflation.
"Hyperinflation" is when inflation occurs quickly and produces more inflation, meaning there is a lack of equilibrium.
How Inflation is Measured
There are
several measures of inflation, although Classical Monetary Theorists and
Neo-Keynesians have different views on its measurement. Classical
Monetary Theorists measure inflation by observing currency levels in the
economy while Neo-Keynesians use the price of goods as measurement of
inflation.
Still, there are some general measures of inflation like money supply as defined in M0, M1, M2, M3, and M4 measures. When there is more currency in the money supply, the value of that currency goes down. The measurement of the money supply is one of the more accurate ways of measuring inflation, because governments tend to have an accurate measurement of how much currency is in various types of bank accounts. This measurement allows economists to see inflation clearly, because banks are able to report money supply quickly and it encompasses all types of inflation, including the inflation in financial markets represented by increasing stock prices.
There is some concern by economists today about the stability of the U.S. dollar, because the Federal Reserve stopped reporting the M3 money supply as of March 2006. Banks have raised suspicion that the Federal Reserve is trying to hide something by no longer reporting the data, as the M3 measurement has been reported since 1959.
The price of gold and silver is also used to measure inflation. As two of the oldest forms of money, they have been held as valuable commodities for millennia, and they have outlasted all other forms of money like the Denarius and Pound. Due to the slow moving rate of inflation for gold, only about 2 percent, plus the cost of mining an refining labor involved, many countries no longer use a gold standard and issue fiat currency. Fiat currency is money that which is not backed by other assets but is socially acceptable.
Still, despite the creation and use of fiat currency in many societies, gold and silver are still used to mint coins worldwide. The gold standard was solidified by the Bretton Woods system, which created a specific exchange rate for currency. Per the Bretton Woods Agreement, gold is to be valued at 42.2222 per troy ounce. However, President Richard Nixon took issue with France when it made a run on the gold that represented the central bank of France's U.S. dollar supply. While President Nixon closed the gold window on France, there was a lot of concern at the time that the amount of dollars in circulation was too great to be backed by the gold held in reserves. Today the U.S. values the gold within the Bretton Woods Agreement.
Others use the value of labor to measure inflation. The idea of using labor as a measure for inflation began with Adam Smith's "The Wealth of Nations," in which he describes how labor is unchanging over time. It is this labor that determines the value of money, because money is defined by how much labor it commands. This is not as accurate a measure of inflation as those tied to metals or commodities due to the static values and historically poor documentation.
The CLI uses the Consumer Price Index (CPI) to approximate the increase in the cost of living for an individual in a specific economy. Since the CLI is actually a theoretical measurement, there is still a lot of debate among economists as to whether CPIs give an accurate estimate of the CLI, because they feel there is too much bias in the measurements. Economists often make adjustments in the CLI to reflect purchasing power parity based on the differences in the cost of and land and commodities versus world prices.
Neo-Keynesian View
Neo-Keynesians use
data collected by government agencies regarding the change in prices of
goods and services within an economy to measure inflation. Sometimes
they will use data from labor unions and business periodicals, but the
government remains a primary source of data. The CPI is the price of
goods and services in the economy. Before Alan Greenspan, the CPI
was an arithmetic mean of the prices of goods and services, but as the
Chairman of the Federal Reserve it became a geometric
mean.
This change from arithmetic to geometric mean lowered the weighting of goods whose price is going up. Then there is a hedonic adjustment done to make an adjustment to account for changes in the goods being used. Using a car is a good example of hedonic adjustment. A base model of a car may go up in price, but the auto company may include air conditioning. Yet the price included in the CPI calculation will be adjusted downward in consideration of the improved model. This adjustment will occur whether the air conditioning has value or not, in spite of the fact that the person has to pay for it. There is still a question of what percentage of the price increase is actually inflation-related rather than based upon the added feature.
Neo-Keynesians often omit volatile goods from their calculations, because they desire a core calculation. These volatile goods, like energy and fuel, are still a part of daily life and part of every product available to consumers. However, they do not allow Neo-Keynesians to get to that core value. Therefore, the rate of inflation for Neo-Keynesians is actually a percentage rate of increase in the index. Neo-Keynesians see the price level as the size of a balloon, but they see the inflation rate as the increase in the size of the balloon. They do not see the measure of inflation as an exact measure, because the value of inflation is dependent on the weight of each good in the index and the specific economic region.
Neo-Keynesians assert that there can be an overall increase in the money supply without any inflation. An example of the theory is the current increase in the U.S. money supply that is increasing at a greater pace than the inflation rate (as measured by the CPI). The worldwide demand for the U.S. dollar and increased exchange of goods has caused the phenomenon. The U.S. dollar has become a global currency that can be used to buy a wider range of goods, and if the dollar was not able to expand the price of goods would fall.
Much of this expansion has occurred to a change in the Federal Reserves monetary policy to print more money through open market operations. It has assisted in both preventing deflation and increasing inflation slightly. Without the dollar's increased demand, the inflation rate today would be similar to what the U.S. saw in the 1970's. Yet, monetary theorists do not adhere to the idea that inflation does not need to occur when money supply is increased, and they use oil and gold prices as a basis for their disagreement. They assert that the dollar has lost 95 percent of its value against gold since it was taken off the gold standard.
Bias in Measurement?
Economists argue
whether or not bias exists in the calculation of inflation, because each
measure of inflation is often based on another measure. In 1995, the
Boskin Commission asserted that the U.S. Department of Labor's Bureau of
Labor Statistics created a CPI that was biased. The commission
produced a quantitative analysis that demonstrated the bias by showing how
inflation was overstated since consumers were moving away from expensive
goods and technology was making rapid improvements. These movements
created a lowering of the CPI-U rate.
The Boskin Commission's findings were not the first time that the rate of inflation was estimated incorrectly. Early on in the 1980's, it was found that the rental component in the CPI-U and CPI-W failed to include vacant rental unit rent increases, so the inflation rate was understated. By 1982, the calculation was added into the calculations of the CPI.
Economists continue to argue about the level of hedonic adjustment and whether the housing part of the calculations is accurate. Some economists want to add in a hedonic adjustment for people that move to less expensive areas when they are priced out of more expensive ones. Other economists worry that the impact of home values on the cost of living is being underestimated when calculating the CPI as well as under-accounting for the cost of medications to senior citizens.
Some economists believe that hedonic adjustments are needed to assist the government in controlling costs. Items such as labor contracts, pensions, and social security are all linked to the CPI, so it raises some conflict of interest in the government's reporting of certain figures.
There are some areas in which inflation is present, but they are not included in determining the inflation rate. One of these areas is the stock market. The stock market absorbs large amounts of inflation without causing the same detrimental effects as increases in the prices of goods and homes, which are traditionally included in determining the inflation rate. The lack of attention paid to the stock market inflation rate can be costly in the end, because it builds up over time. Prices on goods then rise and they are holding back the flood of inflation within the stock markets.
Measuring Inflation Over Time
Measuring
inflation over long periods of time is no easy task. Many of the
goods used today to calculate the GDP did not exist ten, twenty, or
especially a hundred years ago. It makes the long-term measurement
of inflation very difficult. While goods like agricultural and a
small percentage of consumer products did exist, they will not allow for
an accurate picture of inflation over time.
What Causes Inflation?
There are two
main schools of thought when it comes to defining the causes of inflation:
Neo-Classical Theory and Neo-Keynesian Theory. The Neo-Classical
Theory asserts that inflation is caused by the increase in the money
supply while Neo-Keynesians see it being caused by the lowering returns of
productivity.
Monetary, or Neo-Classical, theory remains one of the oldest and most widely understood of the assertions as to what causes inflation. Before fiat currency, there was a limit on the inflation rate, because the value of gold and silver was limited by their supply. There was a limit on the amount of the precious metals that could be mined and minted. The fiat currency metals like copper were only valued by the silver and gold that made up the coins. Hence, gold is not just a currency, but it is also considered money.
The Roman Empire recognized these limits and created debasement, because there was a greater need for currency. Copper become a fiat currency, so as the money supply increased inflation also increased. Yet this inflation also caused many Romans to hoard the gold coins. Today a comparison can be made between gold coins being replaced by copper and the current replacement of the copper penny by the zinc penny.
There are several misconceptions about monetary theory, which is really a simplistic theory that pre-dates the central bank, GNP, and GDP. Yet, people still believe that monetary theory links inflation to the increase of the GDP and interest rates. Also it is important to understand that those who adhere to the monetary theory school of thought do not believe that prices are inflation. Instead, monetary theorists believe in the idea of "too much money chasing too many goods," or that it is the lack of currency and the increase of that money that then causes prices to increase.
Effects of Inflation
Inflation causes a
number of things to happen in an economy, one of which is that it makes
renegotiating prices downward a more difficult process. Wages and
contracts are especially difficult to renegotiate. However, items
with relative prices adjust more easily. It is not uncommon for
efforts to maintain a zero inflation rate to cause falling prices,
profits, and employment difficulties in certain areas, because often
prices have a tendency to gradually move up. Too much emphasis on
trying to keep prices stable can cause deflation. The falling prices can
lead to a recession as businesses file for bankruptcy. In extreme
cases a depression can occur. Therefore, many businesspeople and
economists see inflation as a way to encourage commerce and avoid
recessions and depressions.
The positive view of inflation by people in the business world is also reflected in the attitudes of those who work in the financial sector. The idea of inflation itself encourages people to invest instead of saving wealth. To the people in the financial sector, there is the questionable value of the dollar in the future that defines inflation. People do not know if the dollar will be worth more or less in the future, so inflation ends up defined as the time value of money.
While most professionals understand that low levels of inflation are a necessary part of an economy, higher levels can be rather detrimental, especially when previous economic activity is discounted. Some economists see inflation as a tax on holding currency, so it encourages spending. When the government increases the supply of money, it works as that tax, and thus increases the velocity of money. The velocity increases and causes the inflationary environment to increase, and the cycle continues on and on. In extreme circumstances the cycle can result in hyperinflation. This is why central banks tend to use price stability as a goal, but often maintain low inflation as a target.
If levels of inflation grow, it can have a direct impact on the distribution of money in an economy. Most commonly inflation will move wealth toward people living off incomes from salaries or company dividends, basically incomes that are based on market conditions. The market condition-based incomes usually increase at the same rate as inflation. As market-condition-based incomes gain more money, it moves away from those on fixed incomes.
The redistribution of money is not just for people making money, but also those who are lending it. Inflation will move from the lenders, especially those who do not make the necessary adjustments for inflation, to those who borrow the money. An example of this movement is when the government becomes the net debtor. As the net debtor, inflation will lower the burden of debt toward to benefit and increase the wealth of the government (also known as the "inflation tax").
It should be noted that sometimes the total money supply can be increased without inflation also causing a redistribution of wealth. Finite and non-renewable commodities like fossil fuel and real estate would increase in value while commodities that are increasing (like money) would decrease in value. The reason the value of money would decrease is that often the measure of inflation does not take into account the increase in prices of essential commodities and assets like energy and real estate. In these situations, the greater money supply moves wealth from people who hold money to those who hold finite assets and commodities despite inflation.
Not only does inflation influence wealth distribution, but it also impacts trade. The balance of trade can be weakened by inflation, because inflation undermines the exchange rate. Also, as uncertainty surrounding inflation grows, investments and savings decrease. People spend much more in a panic that prices will soon increase. This spending moves the inflationary cycle along much faster. The sudden increase in spending also causes economic bubbles. These bubbles significantly increase prices and demand greatly, and they cause even bigger issues when they "pop."
Inflation has a great effect on investments, because interest rates rise. It costs banks more to make loans, so they pass the cost onto the consumer with higher interest rates, which discourage net investment.
Real costs also end up impacted by rising inflation. Economists refer to shoe leather costs increasing with inflation. The term "shoe leather costs" refers to the wearing out of shoe leather from walking frequently to the bank. During times of great inflation, people hold less cash and have to make more frequent trips to the bank, so real costs are impacted. There is also the term "menu costs" that refer to the cost of reprinting menus for restaurants that is used to describe the effect of inflation on the re-pricing of goods. It costs money for stores having to re-price the products they offer. Also, due to the justification inflation offers, companies are not encouraged to be innovative so that prices do not need to go up.
Hyperinflation ends up being the result if the inflation rate increases out of control. It causes resources to be used less efficiently, because people do not know if prices increased due to all prices increasing or if it is due to a scarcity of resources. This confusion means that the economy will not function in a normal manner.
Sometimes economies will only index certain sectors for inflation, so that there will be a redistribution of inflation toward the indexed sectors. It sometimes acts as a tax on "liquidity preference" and hoarding. It discourages saving, but it also distorts the expectations of inflation by allowing people to invest in inflation, causing the inflationary cycle to continue. The use of indexing is often a policy choice of certain economies.
How to Stop Inflation
Economists offer
several ways to stop or limit inflation. The methods are primarily
through setting monetary policy and price controls, though there are some
less popular theories on stopping inflation.
Those who suggest using monetary policy to stop inflation place an emphasis on the role of the central bank, like the U.S. Federal Reserve System, in setting that policy. The Federal Reserve can use traditional methods such as setting high interest rates, using unemployment and declining production to slow or stop rising prices.
Even among those that believe monetary policy should be used to stop inflation, various theories abound as to how the policy should be wielded. For instance, those who subscribe to Neo-Classical monetary theory want to see the money supply decreased, while Neo-Keynesians would rather reduce the overall demand through fiscal policy like higher taxes or lower government spending. Neo-Keynesians focus on monetary policy's role, especially as it relates to basic commodities inflation as outlined by Robert Solow. Finally, supply-side economists believe that the exchange rate needs to be fixed so that the exchange rate is tied to a reference currency (gold, for instance). They also believe that, in a floating currency regime, that there can be a reduction in marginal tax rates to that capital formation is promoted.
Yet there is even a philosophical difference between those running the various central banks. For instance, at the European Central Bank, the target is to control inflation when it gets too high rather than using symmetrical inflation as other central banks do. The result is that the European Central Bank has come under great criticism for increasingly high unemployment rates.
While some believe that changing monetary policy is the way to control or stop inflation, a few others subscribe to the idea that controlling prices is the best method. Also, price supports are used to set minimum prices. The price supports help to prevent deflation and to allow for the continued production of certain goods. However, not many economists subscribe to the idea of using price controls as a way to control inflation, as there are many counterproductive effects.
Using price controls to stop or control inflation means that shortages are created. When shortages happen, the quality of production decreases and black market operations increase. Also, price controls only work as long as they are in place, and when they are removed inflation often moves at an accelerated rate.
The exception to the criticisms of price controls is during times of war, when shortages are bound to happen anyhow. The government needs to borrow more money at lower rates during wartime, and profiteering needs to be discouraged. In World War II, price controls were used effectively both during and after the war to control inflation. Yet sometimes the wartime price controls are continued too long after the end of the war, so people will over-consume the things that have price controls imposed.
A common example of price controls is rent controlled buildings. These rent-controlled areas tend to remain so for decades, which allows owners to control the new building rate. It maintains capital parity, and since inflation lowers the burden of a fixed rental price, allows renters to gain a net reduction in rental costs.
However, sometimes price controls do make a
recession more efficient. The recession and prices controls both
complement one another, because the recession prevents the distortion of
high demand while price controls lower the need to increase
unemployment.