![UK and US 1989-present monthly CPI](https://upload.wikimedia.org/wikipedia/commons/0/02/UK_and_US_1989-present_monthly_CPI.svg)
In
economics
Economics () is the social science that studies the production, distribution, and consumption of goods and services.
Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics analyzes ...
, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of
currency
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general ...
buys fewer goods and services; consequently, inflation corresponds to a reduction in the
purchasing power
Purchasing power is the amount of goods and services that can be purchased with a unit of currency. For example, if one had taken one unit of currency to a store in the 1950s, it would have been possible to buy a greater number of items than would ...
of money. The opposite of inflation is
deflation
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflatio ...
, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general
price index.
As prices do not all increase at the same rate, the
consumer price index (CPI) is often used for this purpose. The
employment cost index is also used for wages in the United States.
Most economists agree that high levels of inflation as well as
hyperinflation
In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as t ...
—which have severely disruptive effects on the real economy—are caused by persistent excessive growth in the
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circul ...
. Views on low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in
real
Real may refer to:
Currencies
* Brazilian real (R$)
* Central American Republic real
* Mexican real
* Portuguese real
* Spanish real
* Spanish colonial real
Music Albums
* ''Real'' (L'Arc-en-Ciel album) (2000)
* ''Real'' (Bright album) (2010) ...
demand
In economics, demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given time. The relationship between price and quantity demand is also called the demand curve. Demand for a specific item ...
for goods and services, or changes in available supplies such as during
scarcities
In economics, scarcity "refers to the basic fact of life that there exists only a finite amount of human and nonhuman resources which the best technical knowledge is capable of using to produce only limited maximum amounts of each economic good. ...
. Moderate inflation affects economies in both positive and negative ways. The negative effects would include an increase in the
opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation were rapid enough, shortages of
goods
In economics, goods are items that satisfy human wants
and provide utility, for example, to a consumer making a purchase of a satisfying product. A common distinction is made between goods which are transferable, and services, which are not t ...
as consumers begin
hoarding
Hoarding is a behavior where people or animals accumulate food or other items.
Animal behavior
''Hoarding'' and ''caching'' are common in many bird species as well as in rodents. Most animal caches are of food. However, some birds will a ...
out of concern that prices will increase in the future. Positive effects include reducing
unemployment
Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work during the refere ...
due to
nominal wage rigidity, allowing the central bank greater freedom in carrying out
monetary policy
Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
, encouraging loans and investment instead of money hoarding, and avoiding the inefficiencies associated with deflation.
Today, most economists favour a low and steady rate of inflation.
[Hummel, Jeffrey Rogers. "Death and Taxes, Including Inflation: the Public versus Economists" (January 2007]
p. 56 Low (as opposed to zero or
Deflation, negative) inflation reduces the severity of economic
recessions
In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
by enabling the labor market to adjust more quickly in a downturn and reduces the risk that a
liquidity trap prevents
monetary policy
Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
from stabilizing the economy, while avoiding the costs associated with high inflation.
[Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others]
Lars E.O. Svensson, ''Journal of Economic Perspectives'', Volume 17, Issue 4 Fall 2003, pp. 145–166 The task of keeping the rate of inflation low and stable is usually given to
monetary authorities. Generally, these monetary authorities are the
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central b ...
s that control monetary policy through the setting of
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...
s, by carrying out
open market operations and (more rarely) changing commercial bank
reserve requirements.
Terminology
The term originates from the Latin ''inflare'' (to blow into or inflate) and was initially used in America in 1838 with regard to inflating the currency.
The term was used "not in reference to something that happens to prices, but as something that happens to a paper currency".
[Bryan, Michael F.]
"On the Origin and Evolution of the Word Inflation"
''Federal Reserve Bank of Cleveland, Economic Commentary,'' 15 October 1997. The resulting imbalance between the quantity of money and the amount needed for trade caused prices to increase. Over time, the term ''inflation'' has evolved to refer to increases in the price level; an increase in the money supply may be called
monetary inflation to distinguish it from rising prices, which for clarity may be called "price inflation".
Conceptually, inflation refers to the general trend of prices, not changes in any specific price. For example, if people choose to buy more cucumbers than tomatoes, cucumbers consequently become more expensive and tomatoes cheaper. These changes are not related to inflation; they reflect a shift in tastes. Inflation is related to the value of currency itself. When currency was linked with gold, if new gold deposits were found, the price of gold and the value of currency would fall, and consequently, prices of all other goods would become higher.
Classical economics
By the nineteenth century, economists categorised three separate factors that cause a rise or fall in the price of goods: a change in the ''
value
Value or values may refer to:
Ethics and social
* Value (ethics) wherein said concept may be construed as treating actions themselves as abstract objects, associating value to them
** Values (Western philosophy) expands the notion of value beyo ...
'' or production costs of the good, a change in the ''price of money'' which then was usually a fluctuation in the
commodity price of the metallic content in the currency, and ''currency depreciation'' resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. Following the proliferation of private
banknote
A banknote—also called a bill (North American English), paper money, or simply a note—is a type of negotiable promissory note, made by a bank or other licensed authority, payable to the bearer on demand.
Banknotes were originally issued ...
currency printed during the
American Civil War
The American Civil War (April 12, 1861 – May 26, 1865; also known by other names) was a civil war in the United States. It was fought between the Union ("the North") and the Confederacy ("the South"), the latter formed by states ...
, the term "inflation" started to appear as a direct reference to the ''currency depreciation'' that occurred as the quantity of redeemable banknotes outstripped the quantity of metal available for their redemption. At that time, the term inflation referred to the
devaluation
In macroeconomics and modern monetary policy, a devaluation is an official lowering of the value of a country's currency within a fixed exchange-rate system, in which a monetary authority formally sets a lower exchange rate of the national curre ...
of the currency, and not to a rise in the price of goods.
This relationship between the over-supply of banknotes and a resulting
depreciation
In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the ...
in their value was noted by earlier classical economists such as
David Hume
David Hume (; born David Home; 7 May 1711 NS (26 April 1711 OS) – 25 August 1776) Cranston, Maurice, and Thomas Edmund Jessop. 2020 999br>David Hume" ''Encyclopædia Britannica''. Retrieved 18 May 2020. was a Scottish Enlightenment phil ...
and
David Ricardo
David Ricardo (18 April 1772 – 11 September 1823) was a British political economist. He was one of the most influential of the classical economists along with Thomas Malthus, Adam Smith and James Mill. Ricardo was also a politician, and a ...
, who would go on to examine and debate what effect a currency devaluation (later termed ''
monetary inflation'') has on the price of goods (later termed ''price inflation'', and eventually just ''inflation'').
Related concepts
Other economic concepts related to inflation include:
deflation
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflatio ...
a fall in the general price level;
disinflation
Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services in a nation's gross domestic product over time. It is the opposite of reflation.
If the inflation r ...
a decrease in the rate of inflation;
hyperinflation
In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as t ...
an out-of-control inflationary spiral;
stagflation
In economics, stagflation or recession-inflation is a situation in which the inflation rate is high or increasing, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since actio ...
a combination of inflation, slow economic growth and high unemployment;
reflation
Reflation is used to describe a return of prices to a previous rate of inflation. One usage describes an act of stimulating the economy by increasing the money supply or by reducing taxes, seeking to bring the economy (specifically the price level ...
an attempt to raise the general level of prices to counteract deflationary pressures; and
asset price inflation
Asset price inflation is the economic phenomenon whereby the price of assets rise and become inflated. A common reason for higher asset prices is low interest rates. When interest rates are low, investors and savers cannot make easy returns using l ...
a general rise in the prices of financial assets without a corresponding increase in the prices of goods or services;
agflationan advanced increase in the price for food and industrial agricultural crops when compared with the general rise in prices.
More specific forms of inflation refer to sectors whose prices vary semi-independently from the general trend. “House price inflation” applies to changes in the
house price index
A house price index (HPI) measures the price changes of residential housing as a percentage change from some specific start date (which has an HPI of 100). Methodologies commonly used to calculate an HPI are hedonic regression (HR), simple moving ...
while “energy inflation” is dominated by the costs of oil and gas.
History
![US Historical Inflation Ancient](https://upload.wikimedia.org/wikipedia/commons/2/20/US_Historical_Inflation_Ancient.svg)
Historically, when
commodity money
Commodity money is money whose value comes from a commodity of which it is made. Commodity money consists of objects having value or use in themselves (intrinsic value) as well as their value in buying goods.
This is in contrast to representat ...
was used, periods of inflation and deflation would alternate depending on the condition of the economy. However, when large prolonged infusions of gold or silver into an economy occurred, this could lead to long periods of inflation.
The adoption of
fiat currency by many countries, from the 18th century onwards, made much larger variations in the supply of money possible. Rapid increases in the
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circul ...
have taken place a number of times in countries experiencing political crises, producing
hyperinflation
In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as t ...
sepisodes of extreme inflation rates much higher than those observed in earlier periods of
commodity money
Commodity money is money whose value comes from a commodity of which it is made. Commodity money consists of objects having value or use in themselves (intrinsic value) as well as their value in buying goods.
This is in contrast to representat ...
. The
hyperinflation in the Weimar Republic
Hyperinflation affected the German Papiermark, the currency of the Weimar Republic, between 1921 and 1923, primarily in 1923. It caused considerable internal political instability in the country, the occupation of the Ruhr by France and Belgium, ...
of Germany is a notable example. Currently, the
hyperinflation
In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as t ...
in
Venezuela
Venezuela (; ), officially the Bolivarian Republic of Venezuela ( es, link=no, República Bolivariana de Venezuela), is a country on the northern coast of South America, consisting of a continental landmass and many islands and islets in th ...
is the highest in the world, with an annual inflation rate of 833,997% as of October 2018.
Historically, inflations of varying magnitudes have occurred from the price revolution of the 16th century, which was driven by the flood of gold and particularly silver seized and mined by the Spaniards in Latin America, to the largest paper money inflation of all time in Hungary after World War II.
However, since the 1980s, inflation has been held low and stable in countries with independent
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central b ...
s. This has led to a moderation of the
business cycle
Business cycles are intervals of expansion followed by recession in economic activity. These changes have implications for the welfare of the broad population as well as for private institutions. Typically business cycles are measured by examin ...
and a reduction in variation in most macroeconomic indicatorsan event known as the
Great Moderation
The Great Moderation is a period in the United States of America starting from the mid-1980s until at least 2007 characterized by the reduction in the volatility of business cycle fluctuations in developed nations compared with the decades befor ...
.
Historical inflationary periods
Rapid increases in the quantity of money or in the overall
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circul ...
have occurred in many different societies throughout history, changing with different forms of money used. For instance, when silver was used as currency, the government could collect silver coins, melt them down, mix them with other metals such as copper or lead and reissue them at the same
nominal value
In economics, nominal value is measured in terms of money, whereas real value is measured against goods or services. A real value is one which has been adjusted for inflation, enabling comparison of quantities as if the prices of goods had not c ...
, a process known as
debasement
A debasement of coinage is the practice of lowering the intrinsic value of coins, especially when used in connection with commodity money, such as gold or silver coins. A coin is said to be debased if the quantity of gold, silver, copper or nick ...
. At the ascent of
Nero
Nero Claudius Caesar Augustus Germanicus ( ; born Lucius Domitius Ahenobarbus; 15 December AD 37 – 9 June AD 68), was the fifth Roman emperor and final emperor of the Julio-Claudian dynasty, reigning from AD 54 unti ...
as Roman emperor in AD 54, the
denarius
The denarius (, dēnāriī ) was the standard Roman silver coin from its introduction in the Second Punic War to the reign of Gordian III (AD 238–244), when it was gradually replaced by the antoninianus. It continued to be minted in very ...
contained more than 90% silver, but by the 270s hardly any silver was left. By diluting the silver with other metals, the government could issue more coins without increasing the amount of silver used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in
seigniorage
Seigniorage , also spelled seignorage or seigneurage (from the Old French ''seigneuriage'', "right of the lord (''seigneur'') to mint money"), is the difference between the value of money and the cost to produce and distribute it. The term can be ...
. This practice would increase the money supply but at the same time the relative value of each coin would be lowered. As the relative value of the coins becomes lower, consumers would need to give more coins in exchange for the same goods and services as before. These goods and services would experience a price increase as the value of each coin is reduced.
Ancient China
Song Dynasty
The Song dynasty (; ; 960–1279) was an imperial dynasty of China that began in 960 and lasted until 1279. The dynasty was founded by Emperor Taizu of Song following his usurpation of the throne of the Later Zhou. The Song conquered the rest ...
China introduced the practice of printing paper money to create
fiat currency.
During the Mongol
Yuan Dynasty
The Yuan dynasty (), officially the Great Yuan (; xng, , , literally "Great Yuan State"), was a Mongol-led imperial dynasty of China and a successor state to the Mongol Empire after its division. It was established by Kublai, the fift ...
, the government spent a great deal of money fighting
costly wars, and reacted by printing more money, leading to inflation.
Fearing the inflation that plagued the Yuan dynasty, the
Ming Dynasty
The Ming dynasty (), officially the Great Ming, was an imperial dynasty of China, ruling from 1368 to 1644 following the collapse of the Mongol-led Yuan dynasty. The Ming dynasty was the last orthodox dynasty of China ruled by the Han peo ...
initially rejected the use of paper money, and reverted to using copper coins.
Medieval Egypt
During the
Malian king
Mansa Musa
Mansa Musa ( ar, منسا موسى, Mansā Mūsā; ) was the ninth ''mansa'' of the Mali Empire, which reached its territorial peak during his reign. Musa is known for his wealth and generosity. He has been subject to popular claims that he is ...
's
hajj to
Mecca
Mecca (; officially Makkah al-Mukarramah, commonly shortened to Makkah ()) is a city and administrative center of the Mecca Province of Saudi Arabia, and the holiest city in Islam. It is inland from Jeddah on the Red Sea, in a narrow ...
in 1324, he was reportedly accompanied by a
camel train
A camel train or caravan is a series of camels carrying passengers and goods on a regular or semi-regular service between points. Despite rarely travelling faster than human walking speed, for centuries camels' ability to withstand harsh condi ...
that included thousands of people and nearly a hundred camels. When he passed through
Cairo
Cairo ( ; ar, القاهرة, al-Qāhirah, ) is the Capital city, capital of Egypt and its largest city, home to 10 million people. It is also part of the List of urban agglomerations in Africa, largest urban agglomeration in Africa, List of ...
, he spent or gave away so much gold that it depressed its price in Egypt for over a decade, reducing its purchasing power. A contemporary Arab historian remarked about Mansa Musa's visit:
"Price revolution" in Western Europe
From the second half of the 15th century to the first half of the 17th, Western Europe experienced a major inflationary cycle referred to as the "
price revolution
The Price Revolution, sometimes known as the Spanish Price Revolution, was a series of economic events that occurred between the second half of the 15th century and the first half of the 17th century, and most specifically linked to the high rate o ...
", with prices on average rising perhaps sixfold over 150 years. This is often attributed to the influx of gold and silver from the
New World
The term ''New World'' is often used to mean the majority of Earth's Western Hemisphere, specifically the Americas."America." ''The Oxford Companion to the English Language'' (). McArthur, Tom, ed., 1992. New York: Oxford University Press, p. ...
into
Habsburg Spain, with wider availability of
silver
Silver is a chemical element with the symbol Ag (from the Latin ', derived from the Proto-Indo-European ''h₂erǵ'': "shiny" or "white") and atomic number 47. A soft, white, lustrous transition metal, it exhibits the highest electrical ...
in previously
cash-starved Europe causing widespread inflation. European population rebound from the
Black Death began before the arrival of New World metal, and may have began a process of inflation that New World silver compounded later in the 16th century.
Measures
![Inflation data](https://upload.wikimedia.org/wikipedia/commons/5/56/Inflation_data.webp)
Given that there are many possible measures of the price level, there are many possible measures of price inflation. Most frequently, the term "inflation" refers to a rise in a broad price index representing the overall price level for goods and services in the economy. The
Consumer Price Index (CPI), the
Personal consumption expenditures price index
The PCE price index (PePP), also referred to as the PCE deflator, PCE price deflator, or the Implicit Price Deflator for Personal Consumption Expenditures (IPD for PCE) by the Bureau of Economic Analysis (BEA) and as the Chain-type Price Inde ...
(PCEPI) and the
GDP deflator
In economics, the GDP deflator (implicit price deflator) is a measure of the money price of all new, domestically produced, final goods and services in an economy in a year relative to the real value of them. It can be used as a measure of the va ...
are some examples of broad price indices. However, "inflation" may also be used to describe a rising price level within a narrower set of assets, goods or services within the economy, such as
commodities (including food, fuel, metals),
tangible asset
In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...
s (such as real estate), services (such as entertainment and health care), or
labor
Labour or labor may refer to:
* Childbirth, the delivery of a baby
* Labour (human activity), or work
** Manual labour, physical work
** Wage labour, a socioeconomic relationship between a worker and an employer
** Organized labour and the la ...
. Although the values of capital assets are often casually said to "inflate," this should not be confused with inflation as a defined term; a more accurate description for an increase in the value of a capital asset is appreciation. The FBI (CCI), the
Producer Price Index
A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.
Its importance is being undermined by the steady decline in manufactured goods as a share of spending.
...
, and
Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy.
Core inflation
Core inflation represents the long run trend in the price level. In measuring long run inflation, transitory price changes should be excluded. One way of accomplishing this is by excluding items frequently subject to volatile prices, like foo ...
is a measure of inflation for a subset of consumer prices that excludes food and energy prices, which rise and fall more than other prices in the short term. The
Federal Reserve Board
The Board of Governors of the Federal Reserve System, commonly known as the Federal Reserve Board, is the main governing body of the Federal Reserve System. It is charged with overseeing the Federal Reserve Banks and with helping implement the m ...
pays particular attention to the core inflation rate to get a better estimate of long-term future inflation trends overall.
The inflation rate is most widely calculated by determining the movement or change in a price index, typically the
consumer price index.
The inflation rate is the percentage change of a price index over time. The
Retail Prices Index
In the United Kingdom, the Retail Prices Index or Retail Price Index (RPI) is a measure of inflation published monthly by the Office for National Statistics. It measures the change in the cost of a representative sample of retail final good, goods ...
is also a measure of inflation that is commonly used in the United Kingdom. It is broader than the CPI and contains a larger basket of goods and services.
Given the recent high inflation, the RPI is indicative of the experiences of a wide range of household types, particularly low-income households.
To illustrate the method of calculation, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of the year is:
The resulting inflation rate for the CPI in this one-year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007.
Other widely used price indices for calculating price inflation include the following:
*
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
The Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods. Some countries (like the Philippines) use WPI changes as a central measure of inflation. But now India has adopted new CPI to measure inflation. However, ...
.
*
Commodity price indices A commodity price index is a fixed-weight index or (weighted) average of selected commodity prices, which may be based on spot or futures prices. It is designed to be representative of the broad commodity asset class or a specific subset of commodit ...
, 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.
*
Core price indices: because food and oil prices can 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 those prices are included. Therefore, most
statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a broad price index like the CPI. Because core inflation is less affected by short run supply and demand conditions in specific markets,
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central b ...
s rely on it to better measure the inflationary effect of current
monetary policy
Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
.
Other common measures of inflation are:
*
GDP deflator
In economics, the GDP deflator (implicit price deflator) is a measure of the money price of all new, domestically produced, final goods and services in an economy in a year relative to the real value of them. It can be used as a measure of the va ...
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.
∴
* 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
Asset price inflation is the economic phenomenon whereby the price of assets rise and become inflated. A common reason for higher asset prices is low interest rates. When interest rates are low, investors and savers cannot make easy returns using l ...
is an undue increase in the prices of real assets, such as real estate.
Issues in measuring
Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. For example, if the price of a can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price difference represents inflation. This single price change would not, however, represent general inflation in an overall economy. To measure overall inflation, the price change of a large "basket" of representative goods and services is measured. This is the purpose of a
price index, which is the combined price of a "basket" of many goods and services. The combined price is the sum of the weighted prices of items in the "basket". A weighted price is calculated by multiplying the
unit price
A product's average price is the result of dividing the product's total sales revenue by the total units sold. When one product is sold in variants, such as bottle sizes, managers must define "comparable" units. Average prices can be calculated b ...
of an item by the number of that item the average consumer purchases. Weighted pricing is a necessary means to measuring the effect of individual unit price changes on the economy's overall inflation. The
Consumer Price Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price.
While comparing inflation measures for various periods one has to take into consideration the
base effect as well.
Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Basket weights are updated regularly, usually every year, to adapt to changes in consumer behavior. Sudden changes in consumer behavior can still introduce a weighting bias in inflation measurement. For example, during the COVID-19 pandemic it has been shown that the basket of goods and services was no longer representative of consumption during the crisis, as numerous goods and services could no longer be consumed due to government containment measures (“lock-downs”).
Over time, adjustments are also made to the type of goods and services selected to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time to keep pace with the changing marketplace. Different segments of the population may naturally consume different "baskets" of goods and services and may even experience different inflation rates. It is argued that companies have put more innovation into bringing down prices for wealthy families than for poor families.
Inflation numbers are often
seasonally adjusted
Seasonal adjustment or deseasonalization is a statistical method for removing the seasonal component of a time series. It is usually done when wanting to analyse the trend, and cyclical deviations from trend, of a time series independently of the ...
to differentiate expected cyclical cost shifts. For example, home heating costs are expected to rise in colder months, and seasonal adjustments are often used when measuring for inflation to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical techniques to remove
statistical noise and
volatility of individual prices.
When looking at inflation, economic institutions may focus only on certain kinds of prices, or ''special indices'', such as the
core inflation
Core inflation represents the long run trend in the price level. In measuring long run inflation, transitory price changes should be excluded. One way of accomplishing this is by excluding items frequently subject to volatile prices, like foo ...
index which is used by central banks to formulate
monetary policy
Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
.
Most inflation indices are calculated from weighted averages of selected price changes. This necessarily introduces distortion, and can lead to legitimate disputes about what the true inflation rate is. This problem can be overcome by including all available price changes in the calculation, and then choosing the
median value. In some other cases, governments may intentionally report false inflation rates; for instance, during the presidency of
Cristina Kirchner
Cristina is a female given name, and it is also a surname. Notable people with the name include:
Given name
*Cristina (daughter of Edward the Exile), 11th-century English princess
*Cristina (singer), Cristina Monet-Palaci (1956–2020), American s ...
(2007–2015) the
government of Argentina was criticised for manipulating economic data, such as inflation and GDP figures, for political gain and to reduce payments on its inflation-indexed debt.
Inflation expectations
Inflation expectations or expected inflation is the rate of inflation that is anticipated for some time in the foreseeable future. There are two major approaches to modeling the formation of inflation expectations.
Adaptive expectations
In economics, adaptive expectations is a hypothesized process by which people form their expectations about what will happen in the future based on what has happened in the past. For example, if people want to create an expectation of the inflatio ...
models them as a weighted average of what was expected one period earlier and the actual rate of inflation that most recently occurred.
Rational expectations
In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" and on average take the model's predictions as valid. Rational expectations ensure internal consistency i ...
models them as unbiased, in the sense that the expected inflation rate is not systematically above or systematically below the inflation rate that actually occurs.
A long-standing survey of inflation expectations is the University of Michigan survey.
Inflation expectations affect the economy in several ways. They are more or less built into
nominal interest rate In finance and economics, the nominal interest rate or nominal rate of interest is the rate of interest stated on a loan or investment, without any adjustments or fees. Examples of adjustments or fees
# An adjustment for inflation(in contrast with ...
s, so that a rise (or fall) in the expected inflation rate will typically result in a rise (or fall) in nominal interest rates, giving a smaller effect if any on
real interest rate
The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approxi ...
s. In addition, higher expected inflation tends to be built into the rate of wage increases, giving a smaller effect if any on the changes in
real wages. Moreover, the response of inflationary expectations to monetary policy can influence the division of the effects of policy between inflation and unemployment (see
Monetary policy credibility).
Causes
Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation; most historical theories can be divided into two broad areas: ''quality'' theories of inflation and ''quantity'' theories of inflation. 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 they desire as a buyer. The
quantity theory of inflation rests on the quantity equation of money that relates the money supply, its
velocity
Velocity is the directional speed of an object in motion as an indication of its rate of change in position as observed from a particular frame of reference and as measured by a particular standard of time (e.g. northbound). Velocity i ...
, and the nominal value of exchanges.
Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of the money supply relative to the growth of the economy. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.
The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In
monetarism
Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on nation ...
prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the
Keynesian
Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output an ...
view, interest rates, 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.
Keynesian view
Keynesian economics
Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output a ...
proposes that changes in the money supply do not directly affect prices in the short run, and that visible inflation is the result of demand pressures in the economy expressing themselves in prices.
There are three major sources of inflation, as part of what
Robert J. Gordon calls the "
triangle model
A triangle is a polygon with three edges and three vertices. It is one of the basic shapes in geometry. A triangle with vertices ''A'', ''B'', and ''C'' is denoted \triangle ABC.
In Euclidean geometry, any three points, when non-collinear ...
":
* ''
Demand-pull inflation
Demand-pull inflation is asserted to arise when aggregate demand in an economy is more than aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips c ...
'' is caused by increases in aggregate demand due to increased private and government spending,
etc. Demand inflation encourages economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
* ''
Cost-push inflation'', also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, war or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Another example stems from unexpectedly high insured losses, either legitimate (catastrophes) or fraudulent (which might be particularly prevalent in times of recession). High inflation can prompt employees to demand rapid wage increases, to keep up with consumer prices. In the cost-push theory of inflation, rising wages in turn can help fuel inflation. In the case of collective bargaining, wage growth will be set as a function of inflationary expectations, which will be higher when inflation is high. This can cause a
wage spiral. In a sense, inflation begets further inflationary expectations, which beget further inflation.
*
Built-in inflation
Built-in inflation is a type of inflation that results from past events and persists in the present.
Built-in inflation is one of three major determinants of the current inflation rate. In Robert J. Gordon's triangle model of inflation, the curr ...
is induced by
adaptive expectations
In economics, adaptive expectations is a hypothesized process by which people form their expectations about what will happen in the future based on what has happened in the past. For example, if people want to create an expectation of the inflatio ...
, and is often linked to the "
price/wage spiral
In macroeconomics, a wage-price spiral (also called a wage/price spiral or price/wage spiral) is a proposed explanation for inflation, in which wage increases cause price increases which in turn cause wage increases, in a positive feedback loop. Gr ...
". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a feedback loop. Built-in inflation reflects events in the past, and so might be seen as
hangover inflation.
Demand-pull theory
In economics, the demand-pull theory is the theory that inflation occurs when demand for goods and services exceeds existing supplies. According to the demand pull theory, there is a range of effects on innovative activity driven by changes in exp ...
states that inflation accelerates when
aggregate demand increases beyond the ability of the economy to produce (its
potential output
In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real gross domestic product (potential output) that can be sustained over the long term. Actual output happens in real life while ...
). Hence, any factor that increases aggregate demand can cause inflation. However, in the long run, aggregate demand can be held above productive capacity only by increasing the quantity of money in circulation faster than the real growth rate of the economy. Another (although much less common) cause can be a rapid decline in the ''demand'' for money, as happened in Europe during the
Black Death, or in the
Japanese occupied territories just before the defeat of Japan in 1945.
The effect of money on inflation is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively. This sometimes leads to
hyperinflation
In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as t ...
, a condition where prices can double in a month or even daily. 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 economists, 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 Keynesian economists also disagree with the notion that central banks fully control the money supply, arguing that central banks have little control, since the money supply adapts to the demand for bank credit issued by commercial banks. This is known as the theory of
endogenous money
Endogenous money is an economy’s supply of money that is determined endogenously—that is, as a result of the interactions of other economic variables, rather than exogenously (autonomously) by an external authority such as a central bank.
T ...
, and has been advocated strongly by
post-Keynesian
Post-Keynesian economics is a school of economic thought with its origins in '' The General Theory'' of John Maynard Keynes, with subsequent development influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor, Sidney ...
s as far back as the 1960s. This position is not universally acceptedbanks create money by making loans, but the aggregate volume of these loans diminishes as real interest rates increase. Thus, central banks can influence the money supply by making money cheaper or more expensive, thus increasing or decreasing its production.
A fundamental concept in inflation analysis is the relationship between inflation and unemployment, called the
Phillips curve
The Phillips curve is an economic model, named after William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did not state a linked relationship ...
. This model suggests that there is a
trade-off
A trade-off (or tradeoff) is a situational decision that involves diminishing or losing one quality, quantity, or property of a set or design in return for gains in other aspects. In simple terms, a tradeoff is where one thing increases, and anot ...
between
price stability Price stability is a goal of monetary and fiscal policy aiming to support sustainable rates of economic activity. Policy is set to maintain a very low rate of inflation or deflation. For example, the European Central Bank (ECB) describes price s ...
and employment. Therefore, some level of inflation could be considered desirable to minimize unemployment. The Phillips curve model described the U.S. experience well in the 1960s but failed to describe the
stagflation experienced in the 1970s. Thus, modern
macroeconomics describes inflation using a Phillips curve that is able to shift due to such matters as supply shocks and structural inflation. The former refers to such events like the
1973 oil crisis, while the latter refers to the
price/wage spiral
In macroeconomics, a wage-price spiral (also called a wage/price spiral or price/wage spiral) is a proposed explanation for inflation, in which wage increases cause price increases which in turn cause wage increases, in a positive feedback loop. Gr ...
and
inflationary expectations implying that inflation is the new normal. Thus, the Phillips curve represents only the demand-pull component of the triangle model.
Another concept of note is the
potential output
In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real gross domestic product (potential output) that can be sustained over the long term. Actual output happens in real life while ...
(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
Non-accelerating inflation rate of unemployment (NAIRU) is a theoretical level of unemployment below which inflation would be expected to rise. , or the "natural" rate of
unemployment
Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work during the refere ...
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. It can change because of policy: for example, high unemployment under British Prime Minister
Margaret Thatcher
Margaret Hilda Thatcher, Baroness Thatcher (; 13 October 19258 April 2013) was Prime Minister of the United Kingdom from 1979 to 1990 and Leader of the Conservative Party from 1975 to 1990. She was the first female British prime ...
might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as
structurally unemployed, 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.
Unemployment
A connection between inflation and unemployment has been drawn since the emergence of large scale unemployment in the 19th century, and connections continue to be drawn today. However, the
unemployment rate
Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work during the refere ...
generally only affects inflation in the short-term but not the long-term.
[Chang, R. (1997]
"Is Low Unemployment Inflationary?"
''Federal Reserve Bank of Atlanta Economic Review'' 1Q97:4–13 In the long term, the
velocity of money
image:M3 Velocity in the US.png, 300px, Similar chart showing the logged velocity (green) of a broader measure of money M3 that covers M2 plus large institutional deposits. The US no longer publishes official M3 measures, so the chart only runs thr ...
is far more predictive of inflation than low unemployment.
[Oliver Hossfeld (2010]
"US Money Demand, Monetary Overhang, and Inflation Prediction"
''International Network for Economic Research'' working paper no. 2010.4
In
Marxian economics, the unemployed serve as a
reserve army of labor
Reserve army of labour is a concept in Karl Marx's critique of political economy. It refers to the unemployed and underemployed in capitalist society. It is synonymous with "industrial reserve army" or "relative surplus population", except that t ...
, which restrain wage inflation. In the 20th century, similar concepts in Keynesian economics include the
NAIRU
Non-accelerating inflation rate of unemployment (NAIRU) is a theoretical level of unemployment below which inflation would be expected to rise. (Non-Accelerating Inflation Rate of Unemployment) and the
Phillips curve
The Phillips curve is an economic model, named after William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did not state a linked relationship ...
.
Profiteering under consolidation
![USprofitsVsCPIchange](https://upload.wikimedia.org/wikipedia/commons/7/79/USprofitsVsCPIchange.png)
Keynesian price inelasticity can contribute to inflation when
firms consolidate, tending to support
monopoly
A monopoly (from Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situation where a speci ...
or
monopsony
In economics, a monopsony is a market structure in which a single buyer substantially controls the market as the major purchaser of goods and services offered by many would-be sellers. The microeconomic theory of monopsony assumes a single entity ...
conditions anywhere along the
supply chain for goods or services. When this occurs, firms can provide greater
shareholder value
Shareholder value is a business term, sometimes phrased as shareholder value maximization. It became prominent during the 1980s and 1990s along with the management principle value-based management or "managing for value".
Definition
The term "shar ...
by taking a larger proportion of
profits than by investing in providing greater volumes of their outputs.
![OilVsGasoline1Q22](https://upload.wikimedia.org/wikipedia/commons/c/cf/OilVsGasoline1Q22.png)
Examples include the rise in gasoline and other fossil fuel prices in the first quarter of 2022. Shortly after initial energy price shocks caused by the
2022 Russian invasion of Ukraine
On 24 February 2022, in a major escalation of the Russo-Ukrainian War, which began in 2014. The invasion has resulted in tens of thousands of deaths on both sides. It has caused Europe's largest refugee crisis since World War II. ...
subsided, oil companies found that supply chain constrictions, already exacerbated by the ongoing global
COVID-19 pandemic
The COVID-19 pandemic, also known as the coronavirus pandemic, is an ongoing global pandemic of coronavirus disease 2019 (COVID-19) caused by severe acute respiratory syndrome coronavirus 2 (SARS-CoV-2). The novel virus was first identi ...
, supported price inelasticity, i.e., they began lowering prices to match the
price of oil
The price of oil, or the oil price, generally refers to the spot price of a barrel () of benchmark crude oil—a reference price for buyers and sellers of crude oil such as West Texas Intermediate (WTI), Brent Crude, Dubai Crude, OPEC ...
when it fell much more slowly than they had increased their prices when costs rose. California's five largest gasoline companies,
Chevron Corporation,
Marathon Petroleum,
Valero Energy
Valero Energy Corporation is a Fortune 500 international manufacturer and marketer of transportation fuels, other petrochemical products, and power. It is headquartered in San Antonio, Texas, United States. Throughout the United States and Ca ...
,
PBF Energy, and
Phillips 66, responsible for 96% of transportation fuel sold in the state, all participated in this behavior, reaping first quarter profits much larger than any of their quarterly results in the previous several years. On May 19, 2022, the U.S. House of Representatives passed a bill to prevent such "
price gouging
Price gouging is a pejorative term used to describe the situation when a seller increases the prices of goods, services, or commodities to a level much higher than is considered reasonable or fair. Usually, this event occurs after a demand or ...
" by addressing the resulting
windfall profits
A windfall gain is an unusually high or abundant income, that is sudden and/or unexpected.
Types
Examples of windfall gains include, but are not limited to:
*Gains from demutualization - this example can lead to especially large windfall gains. ...
, but it is unlikely to prevail against the minority filibuster challenge in the Senate.
Similarly in the first quarter of 2022, meatpacking giant
Tyson Foods
Tyson Foods, Inc. is an American multinational corporation, based in Springdale, Arkansas, that operates in the food industry. The company is the world's second-largest processor and marketer of chicken, beef, and pork after JBS S.A. It annually ...
relied on downward price inelasticity in packaged chicken and related products to increase their profits to about $500 million, responding to a $1.5 billion increase in their costs with almost $2 billion in price hikes. Tyson's three main competitors, having essentially no ability to compete on lower prices because supply chain constriction would not support an increase in volumes, followed suit. Tyson's quarter was one of their most profitable, expanding their
operating margin In business, operating margin—also known as operating income margin, operating profit margin, EBIT margin and return on sales (ROS)—is the ratio of operating income ("operating profit" in the UK) to net sales, usually expressed in percent.
...
38%.
Effect of economic growth
If economic growth matches the growth of the money supply, inflation should not occur when all else is equal. A large variety of factors can affect the rate of both. For example, investment in market production, infrastructure, education, and
preventive health care
Preventive healthcare, or prophylaxis, consists of measures taken for the purposes of disease prevention.Hugh R. Leavell and E. Gurney Clark as "the science and art of preventing disease, prolonging life, and promoting physical and mental hea ...
can all grow an economy in greater amounts than the investment spending.
Monetarist view
![M2 and Inflation USA](https://upload.wikimedia.org/wikipedia/commons/1/15/M2_and_Inflation_USA.svg)
Monetarists believe the most significant factor influencing inflation or deflation is how fast the money supply grows or shrinks. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation. The monetarist economist
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
famously stated, ''"Inflation is always and everywhere a monetary phenomenon."''
Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The
quantity theory of money
In monetary economics, the quantity theory of money (often abbreviated QTM) is one of the directions of Western economic thought that emerged in the 16th-17th centuries. The QTM states that the general price level of goods and services is directly ...
, simply stated, says that any change in the amount of money in a system will change the price level. This theory begins with the
equation of exchange:
:
where
:
is the nominal quantity of money;
:
is the
velocity of money
image:M3 Velocity in the US.png, 300px, Similar chart showing the logged velocity (green) of a broader measure of money M3 that covers M2 plus large institutional deposits. The US no longer publishes official M3 measures, so the chart only runs thr ...
in final expenditures;
:
is the general price level;
:
is an index of the
real value of final expenditures;
In this formula, the general price level is related to the level of real economic activity (''Q''), the quantity of money (''M'') and the velocity of money (''V''). The formula is an identity because the velocity of money (''V'') is defined to be the ratio of final nominal expenditure (
) to the quantity of money (''M'').
Monetarists assume that the velocity of money is unaffected by monetary policy (at least in the long run), and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With exogenous velocity (that is, velocity being determined externally and not being influenced by monetary policy), the money supply determines the value of nominal output (which equals final expenditure) in the short run.
In practice, velocity is not exogenous in the short run, and so the formula does not necessarily imply a stable short-run relationship between the money supply and nominal output. However, in the long run, changes in velocity are assumed to be determined by the evolution of the payments mechanism. If velocity is relatively unaffected by monetary policy, the long-run rate of increase in prices (the inflation rate) is equal to the long-run growth rate of the money supply plus the exogenous long-run rate of velocity growth minus the long run growth rate of real output.
Rational expectations theory
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 economic actors will make bets that the central bank will expand the money supply rapidly enough to prevent recession, even at the expense of exacerbating inflation. Thus, if a central bank has a reputation as being "soft" on inflation, when it announces a new policy of fighting inflation with restrictive monetary growth economic agents will not believe that the policy will persist; their inflationary expectations will remain high, and so will inflation. On the other hand, if the central bank has a reputation of being "tough" on inflation, then such a policy announcement will be believed and inflationary expectations will come down rapidly, thus allowing inflation itself to come down rapidly with minimal economic disruption.
Heterodox views
Additionally, there are theories about inflation accepted by economists outside of the
mainstream
Mainstream may refer to:
Film
* ''Mainstream'' (film), a 2020 American film
Literature
* ''Mainstream'' (fanzine), a science fiction fanzine
* Mainstream Publishing, a Scottish publisher
* ''Mainstream'', a 1943 book by Hamilton Basso
Mu ...
.
Austrian view
The
Austrian School
The Austrian School is a heterodox school of economic thought that advocates strict adherence to methodological individualism, the concept that social phenomena result exclusively from the motivations and actions of individuals. Austrian schoo ...
stresses that inflation is not uniform over all assets, goods, and services. Inflation depends on differences in markets and on where newly created money and credit enter the economy.
Ludwig von Mises
Ludwig Heinrich Edler von Mises (; 29 September 1881 – 10 October 1973) was an Austrian School economist, historian, logician, and Sociology, sociologist. Mises wrote and lectured extensively on the societal contributions of classical liberali ...
said that inflation should refer to an increase in the quantity of money, that is not offset by a corresponding increase in the need for money, and that price inflation will necessarily follow, always leaving a poorer nation.
[The Theory of Money and Credit, Mises (1912, ]981
Year 981 ( CMLXXXI) was a common year starting on Saturday (link will display the full calendar) of the Julian calendar.
Events
Births
* Abu'l-Qasim al-Husayn ibn Ali al-Maghribi, Arab statesman (d. 1027)
* Giovanni Orseolo, Venetian ...
p. 272)
Real bills doctrine
The real bills doctrine (RBD) asserts that banks should issue their money in exchange for short-term real bills of adequate value. As long as banks only issue a dollar in exchange for assets worth at least a dollar, the issuing bank's assets will naturally move in step with its issuance of money, and the money will hold its value. Should the bank fail to get or maintain assets of adequate value, then the bank's money will lose value, just as any financial security will lose value if its asset backing diminishes. The real bills doctrine (also known as the backing theory) thus asserts that inflation results when money outruns its issuer's assets. The quantity theory of money, in contrast, claims that inflation results when money outruns the economy's production of goods.
Currency and banking schools of economics argue the RBD, 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
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
. 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 board
In public finance, a currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exch ...
s. It is generally held in ill repute today, with
Frederic Mishkin
Frederic Stanley "Rick" Mishkin (born January 11, 1951) is an American economist and Alfred Lerner professor of Banking and Financial Institutions at the Graduate School of Business, Columbia University. He was a member of the Federal Reserve Boa ...
, a governor of the
Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
going so far as to say it had been "completely discredited."
The debate between currency, or quantity theory, and the
banking schools during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century, the banking schools had greater influence in policy in the United States and Great Britain, while the
currency schools had more influence "on the continent", that is in non-British countries, particularly in the
Latin Monetary Union
The Latin Monetary Union (LMU) was a 19th-century system that unified several European currencies into a single currency that could be used in all member states when most national currencies were still made out of gold and silver. It was establ ...
and the
Scandinavian Monetary Union __NOTOC__
The Scandinavian Monetary Union was a monetary union formed by Denmark and Sweden on 5 May 1873, with Norway joining in 1875. It established a common currency unit, the krone/krona, based on the gold standard. It was one of the few tan ...
.
In 2019 monetary historians
Thomas M. Humphrey
Thomas MacGillivray Humphrey (born 1935) is an American economist. Until 2005 he was a research advisor and senior economist in the research department of the Federal Reserve Bank of Richmond and editor of the Bank's flagship publication, the ''E ...
and
Richard H. Timberlake published "Gold, the Real Bills Doctrine, and the Fed: Sources of Monetary Disorder 1922-1938".
Effects of inflation
General effect
![Restaurant increasing prices by $1](https://upload.wikimedia.org/wikipedia/commons/3/36/Restaurant_increasing_prices_by_%241.00_due_to_inflation.jpg)
Inflation is the decrease in the purchasing power of a currency. That is, when the general level of prices rise, each monetary unit can buy fewer goods and services in aggregate. The effect of inflation differs on different sectors of the economy, with some sectors being adversely affected while others benefitting. For example, with inflation, those segments in society which own physical assets, such as property, stock etc., benefit from the price/value of their holdings going up, when those who seek to acquire them will need to pay more for them. Their ability to do so will depend on the degree to which their income is fixed. For example, increases in payments to workers and pensioners often lag behind inflation, and for some people income is fixed. Also, individuals or institutions with cash assets will experience a decline in the purchasing power of the cash. Increases in the price level (inflation) erode the real value of money (the functional currency) and other items with an underlying monetary nature.
Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the inflation rate. The formula ''R = N-I'' approximates the correct answer as long as both the nominal interest rate and the inflation rate are small. The correct equation is ''r = n/i'' where ''r'', ''n'' and ''i'' are expressed as
ratio
In mathematics, a ratio shows how many times one number contains another. For example, if there are eight oranges and six lemons in a bowl of fruit, then the ratio of oranges to lemons is eight to six (that is, 8:6, which is equivalent to the ...
s (e.g. 1.2 for +20%, 0.8 for −20%). As an example, when the inflation rate is 3%, a loan with a nominal interest rate of 5% would have a real interest rate of approximately 2% (in fact, it's 1.94%). Any unexpected increase in the inflation rate would decrease the real interest rate. Banks and other lenders adjust for this inflation risk either by including an inflation risk premium to fixed interest rate loans, or lending at an adjustable rate.
Negative
High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services to focus on profit and losses from currency inflation.
Uncertainty about the future purchasing power of money discourages investment and saving. Inflation can also impose hidden tax increases. For instance, inflated earnings push taxpayers into higher income tax rates unless the tax brackets are indexed to inflation.
With high inflation, purchasing power is redistributed from those on fixed nominal incomes, such as some pensioners whose pensions are not indexed to the price level, towards those with variable incomes whose earnings may better keep pace with the inflation.
This redistribution of purchasing power will also occur between international trading partners. Where fixed
exchange rates are imposed, higher inflation in one economy than another will cause the first economy's exports to become more expensive and affect the
balance of trade
The balance of trade, commercial balance, or net exports (sometimes symbolized as NX), is the difference between the monetary value of a nation's exports and imports over a certain time period. Sometimes a distinction is made between a balance ...
. There can also be negative effects to trade from an increased instability in currency exchange prices caused by unpredictable inflation.
;
Hoarding
Hoarding is a behavior where people or animals accumulate food or other items.
Animal behavior
''Hoarding'' and ''caching'' are common in many bird species as well as in rodents. Most animal caches are of food. However, some birds will a ...
: People buy durable and/or non-perishable commodities and other goods as stores of wealth, to avoid the losses expected from the declining purchasing power of money, creating shortages of the hoarded goods.
;Social unrest and revolts: Inflation can lead to massive demonstrations and revolutions. For example, inflation and in particular food inflation is considered one of the main reasons that caused the 2010–11
Tunisian revolution
The Tunisian Revolution, also called the Jasmine Revolution, was an intensive 28-day campaign of civil resistance. It included a series of street demonstrations which took place in Tunisia, and led to the ousting of longtime president Zine El ...
and the
2011 Egyptian revolution
The 2011 Egyptian revolution, also known as the 25 January revolution ( ar, ثورة ٢٥ يناير; ), began on 25 January 2011 and spread across Egypt. The date was set by various youth groups to coincide with the annual Egyptian "Police ho ...
,
according to many observers including
Robert Zoellick
Robert Bruce Zoellick (; ; born July 25, 1953) is an American public official and lawyer who was the eleventh president of the World Bank, a position he held from July 1, 2007 to June 30, 2012. He was previously a managing director of Goldman Sach ...
, president of the
World Bank
The World Bank is an international financial institution that provides loans and grants to the governments of low- and middle-income countries for the purpose of pursuing capital projects. The World Bank is the collective name for the Inte ...
. Tunisian president
Zine El Abidine Ben Ali
Zine El Abidine Ben Ali ( ar, زين العابدين بن علي, translit=Zayn al-'Ābidīn bin 'Alī; 3 September 1936 – 19 September 2019), commonly known as Ben Ali ( ar, بن علي) or Ezzine ( ar, الزين), was a Tunisian politician ...
was ousted, Egyptian President
Hosni Mubarak
Muhammad Hosni El Sayed Mubarak, (; 4 May 1928 – 25 February 2020) was an Egyptian politician and military officer who served as the fourth president of Egypt from 1981 to 2011.
Before he entered politics, Mubarak was a career officer in ...
was also ousted after only 18 days of demonstrations, and protests soon spread in many countries of North Africa and Middle East.
;
Hyperinflation
In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as t ...
: If inflation becomes too high, it can cause people to severely curtail their use of the currency, leading to an acceleration in the inflation rate. High and accelerating inflation grossly interferes with the normal workings of the economy, hurting its ability to supply goods. Hyperinflation can lead people to abandon the use of the country's currency in favour of external currencies (
dollarization
Currency substitution is the use of a foreign currency in parallel to or instead of a domestic currency. The process is also known as dollarization or euroization when the foreign currency is the dollar or the euro, respectively.
Currency subs ...
), as has been reported to have occurred in
North Korea
North Korea, officially the Democratic People's Republic of Korea (DPRK), is a country in East Asia. It constitutes the northern half of the Korean Peninsula and shares borders with China and Russia to the north, at the Yalu (Amnok) and T ...
).
;
Allocative efficiency
Allocative efficiency is a state of the economy in which production is aligned with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the mar ...
: A change in the supply or demand for a good will normally cause its
relative price
A relative price is the price of a commodity such as a good or service in terms of another; i.e., the ratio of two prices. A relative price may be expressed in terms of a ratio between the prices of any two goods or the ratio between the price o ...
to change, signaling the buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, price changes due to genuine relative
price signal
A price signal is information conveyed to consumers and producers, via the prices offered or requested for, and the amount requested or offered of a product or service, which provides a signal to increase or decrease quantity supplied or quantit ...
s are difficult to distinguish from price changes due to general inflation, so agents are slow to respond to them. The result is a loss of
allocative efficiency
Allocative efficiency is a state of the economy in which production is aligned with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the mar ...
.
;
Shoe leather cost Metaphorically, shoe leather cost is the cost of time and effort (or opportunity costs of time and effort) that people expend by holding less cash in order to reduce the inflation tax that they pay on cash holdings when there is high inflation. The ...
: High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed to carry out transactions this means that more "trips to the bank" are necessary to make withdrawals, proverbially wearing out the "shoe leather" with each trip.
;
Menu cost In economics, the menu cost is a cost that a firm incurs due to changing its prices. It is one microeconomic explanation of the price-stickiness of the macroeconomy put by New Keynesian economists. The term originated from the cost when restaura ...
s
;
![Subway pizza inflation 2022 jeh](https://upload.wikimedia.org/wikipedia/commons/f/fd/Subway_pizza_inflation_2022_jeh.jpg)
: With high inflation, firms must change their prices often to keep up with economy-wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly, as with the extra time and effort needed to change prices constantly.
;
Tax
A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or n ...
: Inflation serves as a hidden tax on currency holdings.
Positive
;Labour-market adjustments: Nominal wages are
slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation allows real wages to fall even if nominal wages are kept constant, moderate inflation enables labor markets to reach equilibrium faster.
;Room to maneuver: The primary tools for controlling the money supply are the ability to set the
discount rate, the rate at which banks can borrow from the central bank, and
open market operations
In macroeconomics, an open market operation (OMO) is an activity by a central bank to give (or take) liquidity in its currency to (or from) a bank or a group of banks. The central bank can either buy or sell government bonds (or other financial a ...
, which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) to stimulate the economy this situation is known as a
liquidity trap.
;Mundell–Tobin effect: According to the Mundell-Tobin effect, an increase in inflation leads to an increase in capital investment, which leads to an increase in growth.:: The
Nobel laureate
Robert Mundell
Robert Alexander Mundell (October 24, 1932 – April 4, 2021) was a Canadian economist. He was a professor of economics at Columbia University and the Chinese University of Hong Kong.
He received the Nobel Memorial Prize in Economic Sciences i ...
noted that moderate inflation would induce savers to substitute lending for some money holding as a means to finance future spending. That substitution would cause market clearing real interest rates to fall. The lower real rate of interest would induce more borrowing to finance investment. In a similar vein, Nobel laureate
James Tobin
James Tobin (March 5, 1918 – March 11, 2002) was an American economist who served on the Council of Economic Advisers and consulted with the Board of Governors of the Federal Reserve System, and taught at Harvard and Yale Universities. He d ...
noted that such inflation would cause businesses to substitute investment in
physical capital
Physical capital represents in economics one of the three primary factors of production. Physical capital is the apparatus used to produce a good and services. Physical capital represents the tangible man-made goods that help and support the produ ...
(plant, equipment, and inventories) for money balances in their asset portfolios. That substitution would mean choosing the making of investments with lower rates of real return. (The rates of return are lower because the investments with higher rates of return were already being made before.) The two related effects are known as the
Mundell–Tobin effect The Mundell–Tobin effect suggests that nominal interest rates would rise less than one-for-one with inflation because in response to inflation the public would hold less in money balances and more in other assets, which would drive interest rates ...
. Unless the economy is already overinvesting according to models of
economic growth theory, that extra investment resulting from the effect would be seen as positive.
;Instability with deflation: Economist
S.C. Tsiang noted that once substantial deflation is expected, two important effects will appear; both a result of money holding substituting for lending as a vehicle for saving. The first was that continually falling prices and the resulting incentive to hoard money will cause instability resulting from the likely increasing fear, while money hoards grow in value, that the value of those hoards are at risk, as people realize that a movement to trade those money hoards for real goods and assets will quickly drive those prices up. Any movement to spend those hoards "once started would become a tremendous avalanche, which could rampage for a long time before it would spend itself." Thus, a regime of long-term deflation is likely to be interrupted by periodic spikes of rapid inflation and consequent real economic disruptions. The second effect noted by Tsiang is that when savers have substituted money holding for lending on financial markets, the role of those markets in channeling savings into investment is undermined. With nominal interest rates driven to zero, or near zero, from the competition with a high return money asset, there would be no price mechanism in whatever is left of those markets. With financial markets effectively euthanized, the remaining goods and physical asset prices would move in perverse directions. For example, an increased desire to save could not push interest rates further down (and thereby stimulate investment) but would instead cause additional money hoarding, driving consumer prices further down and making investment in consumer goods production thereby less attractive. Moderate inflation, once its expectation is incorporated into nominal interest rates, would give those interest rates room to go both up and down in response to shifting investment opportunities, or savers' preferences, and thus allow financial markets to function in a more normal fashion.
Cost-of-living allowance
The real purchasing power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as
social security
Welfare, or commonly social welfare, is a type of government support intended to ensure that members of a society can meet basic human needs such as food and shelter. Social security may either be synonymous with welfare, or refer specifical ...
) are tied to a cost-of-living index, typically to the
consumer price index.
A ''cost-of-living adjustment'' (COLA) adjusts salaries based on changes in a cost-of-living index. It does not control inflation, but rather seeks to mitigate the consequences of inflation for those on fixed incomes. Salaries are typically adjusted annually in low inflation economies. During hyperinflation they are adjusted more often.
They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.
Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments ("COLAs") or cost-of-living increases because of their similarity to increases tied to externally determined indexes.
Controlling inflation
Monetary policy
Monetary policy is the policy enacted by the
monetary authorities (most frequently the
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central b ...
of a nation) to control the
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...
or equivalently the
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circul ...
so as to control inflation and ensure price stability. Higher interest rates reduce the economy's money supply because fewer people seek loans. When banks make loans, the loan proceeds are generally deposited in bank accounts that are part of the money supply, thereby expanding it. When banks make fewer loans, the amount of bank deposits and hence the money supply decrease. For example, in the early 1980s, when the US
federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances a ...
exceeded 15%, the quantity of
Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
dollars fell 8.1%, from US$8.6 trillion down to $7.9 trillion.
In the latter half of the 20th century, there was debate between
Keynesian
Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output an ...
s and
monetarists about the appropriate instrument to use to control inflation. Monetarists emphasize a low and steady growth rate of the money supply, while Keynesians emphasize controlling
aggregate demand, by reducing demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved by using either monetary policy or
fiscal policy
In economics and political science, fiscal policy is the use of government revenue collection (taxes or tax cuts) and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variab ...
(increasing taxation or reducing government spending to reduce demand). Ever since the 1980s, most countries have primarily relied on monetary policy to control inflation. When inflation beyond an acceptable level takes place, the country's central bank increases the interest rate, which will tend to slow down economic growth and inflation. Some central banks have a
symmetrical inflation target, while others only react when inflation rises above a certain threshold.
In the 21st century, most economists favor a low and steady rate of inflation. In most countries, central banks or other monetary authorities are tasked with keeping interest rates and prices stable, and inflation near a target rate. These
inflation targets may be publicly disclosed or not. In most
OECD countries, the inflation target is usually about 2% to 3% (in developing countries like Armenia, the inflation target is higher, at around 4%). Central banks target a low inflation rate because they believe that high inflation is economically costly because it would create uncertainty about differences in
relative price
A relative price is the price of a commodity such as a good or service in terms of another; i.e., the ratio of two prices. A relative price may be expressed in terms of a ratio between the prices of any two goods or the ratio between the price o ...
s and about the inflation rate itself. A low positive inflation rate is targeted rather than a zero or negative one because the latter could cause or worsen
recession
In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
s;
low (as opposed to zero or
Deflation, negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a
liquidity trap prevents monetary policy from stabilizing the economy.
Other methods
Fixed exchange rates
Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy to achieve macroeconomic stability.
Under the
Bretton Woods Bretton Woods can refer to:
*Bretton Woods, New Hampshire, a village in the United States
**Bretton Woods Mountain Resort, a ski resort located in Bretton Woods, New Hampshire
*The 1944 Bretton Woods Conference, also known as the "United Nations Mo ...
agreement, most countries around the world had currencies that were fixed to the U.S. dollar. This limited inflation in those countries, but also exposed them to the danger of
speculative attack In economics, a speculative attack is a precipitous selling of untrustworthy assets by previously inactive speculators and the corresponding acquisition of some valuable assets ( currencies, gold). The first model of a speculative attack was contai ...
s. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to
floating exchange rates
In macroeconomics and economic policy, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of exchange rate regime in which a currency's value is allowed to fluctuate in response to foreign exchange marke ...
. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e.g.
Argentina (1991–2002), Bolivia, Brazil, Chile, Pakistan, etc.).
Gold standard
![Two 20kr gold coins](https://upload.wikimedia.org/wikipedia/commons/a/a2/Two_20kr_gold_coins.png)
The gold standard is a monetary system in which a region's common medium of exchange is paper notes (or other monetary token) that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of
specie
Specie may refer to:
* Coins or other metal money in mass circulation
* Bullion coins
* Hard money (policy)
* Commodity money
Commodity money is money whose value comes from a commodity of which it is made. Commodity money consists of objects ...
per currency unit. The currency itself has no ''innate value'', but is accepted by traders because it can be redeemed for the equivalent specie. A
U.S. silver certificate, for example, could be redeemed for an actual piece of silver.
The gold standard was partially abandoned via the international adoption of the
Bretton Woods system. Under this system all other major currencies were tied at fixed rates to the US dollar, which itself was tied by the US government to gold at the rate of US$35 per ounce. The Bretton Woods system broke down in 1971, causing most countries to switch to
fiat money
Fiat money (from la, fiat, "let it be done") is a type of currency that is not backed by any commodity such as gold or silver. It is typically designated by the issuing government to be legal tender. Throughout history, fiat money was sometim ...
money backed only by the laws of the country.
Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output.
Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining.
Wage and price controls
Another method attempted in the past have been wage and
price controls ("incomes policies"). Temporary price controls may be used as a complement to other policies to fight inflation; price controls may make disinflation faster, while reducing the need for unemployment to reduce inflation. If price controls are used during a recession, the kinds of distortions that price controls cause may be lessened. However, economists generally advise against the imposition of price controls.
Wage and price controls, in combination with rationing, have been used successfully in wartime environments. 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
Richard Milhous Nixon (January 9, 1913April 22, 1994) was the 37th president of the United States, serving from 1969 to 1974. A member of the Republican Party, he previously served as a representative and senator from California and was ...
. More successful examples include the
Prices and Incomes Accord
The Prices and Incomes Accord was an agreement between the Australian Council of Trade Unions and the Australian Labor Party government of Prime Minister Bob Hawke and Treasurer (later Prime Minister) Paul Keating in 1983. Employers were not par ...
in Australia and the
Wassenaar Agreement
The Wassenaar Agreement was an agreement reached in 1982 between employers' organisations and labour unions in the Netherlands to restrain wage growth in return for the adoption of policies to combat unemployment and inflation, such as reductions ...
in the
Netherlands
)
, anthem = ( en, "William of Nassau")
, image_map =
, map_caption =
, subdivision_type = Sovereign state
, subdivision_name = Kingdom of the Netherlands
, established_title = Before independence
, established_date = Spanish Netherl ...
.
In general, wage and price controls are regarded as a temporary and exceptional measures, 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 bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.
See also
*
Core inflation
Core inflation represents the long run trend in the price level. In measuring long run inflation, transitory price changes should be excluded. One way of accomplishing this is by excluding items frequently subject to volatile prices, like foo ...
*
Food prices
Food prices refer to the average price level for food across countries, regions and on a global scale. Food prices have an impact on producers and consumers of food.
Price levels depend on the food production process, including food marketing ...
*
Hyperinflation
In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as t ...
*
Indexed unit of account When a daily indexed unit of account or Daily Consumer Price Index (Daily CPI) or monetized daily indexed unit of account is used in contracts or in the Capital Maintenance in Units of Constant Purchasing Power accounting model, deferred payments an ...
*
Inflationism Inflationism is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy.
Mainstream ec ...
*
Inflation hedge An inflation hedge is an investment intended to protect the investor against (hedge) a decrease in the purchasing power of money (inflation). There is no investment known to be a successful hedge in all inflationary environments, just as there is n ...
*
Headline inflation Headline inflation is a measure of the total inflation within an economy, including commodities such as food and energy prices (e.g., oil and gas), which tend to be much more volatile and prone to inflationary spikes. On the other hand, "core in ...
*
List of countries by inflation rate
*
Measuring economic worth over time The measurement of economic worth over time is the problem of relating past prices, costs, values and proportions of social production to current ones. For a number of reasons, relating any past indicator to a current indicator of worth is theoreti ...
*
Overconsumption
Overconsumption describes a situation where a consumer overuses their available goods and services to where they can't, or don't want to, replenish or reuse them. In microeconomics, this may be described as the point where the marginal cost of ...
*
Shrinkflation
In economics, shrinkflation, also known as the grocery shrink ray, deflation, or package downsizing, is the process of items shrinking in size or quantity, or even sometimes reformulating or reducing quality, while their prices remain the same o ...
and
Skimpflation
*
Real versus nominal value (economics)
*
Steady-state economy
*
Welfare cost of inflation In macroeconomics, the welfare cost of inflation comprises the changes in social welfare caused by inflation.
The traditional approach, developed by Bailey (1956) and Friedman (1969), treats real money balances as a consumption good and inflat ...
*
Supply shock
A supply shock is an event that suddenly increases or decreases the supply of a commodity or service, or of commodities and services in general. This sudden change affects the equilibrium price of the good or service or the economy's general pr ...
*
Template:Inflation – for price conversions in Wikipedia articles
Notes
References
* Measurement of inflation is discussed in Ch. 2, pp. 45–50; Money growth & Inflation in Ch. 7, pp. 266–269; Keynesian business cycles and inflation in Ch. 9, pp. 308–348.
*
*
* Measurement of inflation is discussed in Ch. 2, pp. 22–32; Money growth & Inflation in Ch. 4, pp. 81–107; Keynesian business cycles and inflation in Ch. 9, pp. 238–255.
*
*
Further reading
* World Bank, 2018
''Inflation in Emerging and Developing Economies: Evolution, Drivers and Policies'' Edited by Jongrim Ha, M. Ayhan Kose, and Franziska Ohnsorge.
*
Auernheimer, Leonardo, "The Honest Government's Guide to the Revenue From the Creation of Money," Journal of Political Economy, Vol. 82, No. 3, May/June 1974, pp. 598–606.
*
Baumol, William J. and
Alan S. Blinder
Alan Stuart Blinder (, born October 14, 1945) is an American economics professor at Princeton University and is listed among the most influential economists in the world according to IDEAS/RePEc. He is a leading macroeconomist, politically liber ...
, ''Macroeconomics: Principles and Policy'', Tenth edition. Thomson South-Western, 2006.
*
Friedman, Milton, Nobel lecture
Inflation and unemployment1977
*
Mishkin, Frederic S., ''The Economics of Money, Banking, and Financial Markets'', New York, Harper Collins, 1995.
*
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
The Phillips curve is an economic model, named after William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did not state a linked relationship ...
article)
External links
OECD Consumer Price IndexUnited States Bureau of Labor Statistics – Consumer Price IndexGeneral purpose compounded inflation calculatorU.S. Cost of Living Calculator (1913–present)(
AIER)
U.S. Inflation Calculator (1913–present)(
US BLS)
U.S. Inflation (historical documents)(
FRASER Fraser may refer to:
Places Antarctica
* Fraser Point, South Orkney Islands
Australia
* Fraser, Australian Capital Territory, a suburb in the Canberra district of Belconnen
* Division of Fraser (Australian Capital Territory), a former federal e ...
)
World Inflation (1290–2006)(
Consumer Price Index) (
Swedish Riksbank)
World Bank annual inflation rates for all countries
{{Authority control
Financial economics
Macroeconomic aggregates
Macroeconomic problems