Inflation

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In economics, the term inflation is used to denote a continuing series of increases in the general level of prices. It has effects that are generally considered to be undesirable, and a variety of measures have been adopted for the purpose of controlling it.

Measurement of inflation

The principal measure of inflation is usually taken to be the consumer price index, which is an index of the price of a typical "basket" of goods, collected mainly by surveys of prices charged at retail outlets, and (usually) corrected for quality changes. The term "cost of living index" has often been applied to consumer price indexes, but has sometimes been more broadly interpreted to include the effects upon household welfare of such matters as changes in social security payments. Price indexes of investment goods, imports and exports are also compiled and an average of those indexes, weighted according to their proportions in national income, is used as a "gdp deflator" - and incidentally provides the most comprehensive of the inflation measures. There are also indexes of commodity prices and producer prices.

Causes of inflation

Cost-push and demand-pull

The first-round effect of an external cost shock, such as a sudden increase in the oil price, is a single increase in a range of domestic prices. That results in an unavoidable reduction in domestic purchasing power , but it does not in itself constitute inflation. Attempts to restore the previous standard of domestic purchasing power by wage increases may be expected to lead to a second round of price increases, however; and expectations of further price increases may be expected to prompt an inflationary succession of repetitions of that sequence. If the general level of demand increases to a level that tends to exceed the productive capacity of the economy, it, too, has the first-round effect of bidding-up prices, which may be expected to generate similar second-round and subsequent effects.

Monetary causes

According to the proponents of monetarism, "inflation is always and everywhere a monetary phenomenon", As propounded by the late Professor Milton Friedman [1], that theory depends upon the correlations that he discovered in a study of an American business cycle. It is conventionally explained in terms of the stimulation of spending that may be expected to result from the reduction of interest rates which follows an increase in the money supply, and upon the consequent price increases and expectations of price increases.

Effects of inflation

There is evidence to suggest that inflation hampers economic growth by reducing business investment and the efficiency with which it is used [2]. It results in transfers from lenders to borrowers and from the poor to the rich [3], and most people believe that it makes them worse off [4].

Control of inflation

In the 1970s, indexation of payments was advocated, both as a means of mitigating the ill-effects of inflation and as a means of combating it, by Milton Friedman and Herbert Giersch in 1974, [5]. [6], but the experiences of countries that adopted it have been mixed [7]. After unsuccessful attempts in the 1970s and 1980s to control inflation by incomes policies and by controlling the money supply in Britain [8], the United States [9] and elsewhere, a consensus has emerged that it can best be attempted by regulating the interest rate [10]. Those attempts have generally been moderately successful during the period 1985 to 2005, but with significant inter-country variations [11].

History of inflation

There were many inflationary episodes before the twentieth century, notably in ancient Rome, during the black death and in the course of the French, American and Russian revolutions [12], but all were exclusively national phenomena. The German hyperinflation of the 1920s had few repercussions elsewhere, and it was not until the second half of the twentieth century that inflation acquired a significantly international character. [13]. The 1973 oil price shock raised inflation rates in most developed countries to over 15 per cent, the 2007 oil and food price shocks increased their inflation rates to similar extents, and between those events they experienced broadly similar patterns of of lower rates.

References

  1. Milton Friedman, "The Role of Monetary Policy", American Economic Review, 1968: p.12
  2. Javier Andres and Ignacio Hernando: Does Inflation Harm Economic Growth?, NBER Working Paper No 6062, 1997
  3. [1] William Easterly, and Stanley Fischer: Inflation and the Poor, World Bank Policy Research Working Paper No. 2335 May 2000]
  4. Robert Shiller: Why do People Dilke Inflation?, March 1946
  5. Milton Friedman: "Monetary Correction", in Essays on Inflation and Indexation, American Enterprise Institute 1974
  6. Herbert Giersch: "Index Clauses and the Fight against Inflation", in Essays on Inflation and Indexation, American Enterprise Institute, 1974
  7. Paul McNelis: Indexation and Experience: Theory and Experience, Research Observer 3, no. 2 July 1988
  8. Nick Gardner: Decade of Discontent, Blackwell 1987
  9. Bradford deLong: America's Only Peacetime Inflation - the 1970s, NBER December 1995
  10. For the current method of control see the article on macroeconomics.
  11. Thorarinn Petursson: How Hard Can It Be? Inflation Control Around the World, Working Paper No 40, Central Bank of Iceland August 2008
  12. Don Paarlberg An Analysis and History of Inflation. Praeger Publishers. 1993
  13. Bryan Taylor: The Century of Inflation