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Inflation is the rise in the general level of prices.

This is equivalent
to a fall in the value or purchasing power of money. It is the opposite
of deflation.

Measuring inflation

Inflation is measured by observing the changes in prices of goods in


the economy using econometric techniques. The rises in prices of the
various goods are combined to give a price index that reflects the
change in prices of these many goods, where the inflation rate is the
rate of increase in this index. There is no single true measure of
inflation, because the value of inflation will depend on the weight
given to each good in the index. Examples of common measures of
inflation include:

• consumer price indexes which measure the price of a


selection of goods purchased by a "typical consumer". In many
industrial nations, annualised percentage changes in these
indexes are the most commonly reported inflation figure.

• producer price indexes which measure the price of a


selection of inputs purchased by a "typical firm".

• wholesale price indexes which measure the change in price


of a selection of goods at wholesale (i.e., typically prior to sales
taxes).

• GDP deflator which is used to adjust measures of gross


domestic product for inflation.

The role of inflation in the economy

A great deal of economic literature concerns the question of what


causes inflation and what effects it has. A small amount of inflation is
often viewed as having a positive effect on the economy. One reason
for this is that it is difficult to renegotiate some prices, and
particularly wages, downwards, so that with generally increasing
prices it is easier for relative prices to adjust. Inflation may also have
negative effects on the economy:

• Increasing uncertainty may discourage investment and saving.


• Redistribution
o It will redistribute income from those on fixed incomes,
such as pensioners, and shifts it to those who draw a
Economic Analysis

variable income, for example from wages and profits


which may keep pace with inflation.
o Similarly it will redistribute wealth from those who lend a
fixed amount of money to those who borrow. For
example, where the government is a net debtor, as is
usually the case, it will reduce this debt redistributing
money towards the government. Thus inflation is
sometimes viewed as similar to a hidden tax.
• International trade: If the rate of inflation is higher than that
abroad, a fixed exchange rate will be undermined through a
weakening balance of trade.
• Shoe leather costs: Because the value of cash is eroded by
inflation, people will tend to hold less cash during times of
inflation. This imposes real costs, for example in more frequent
trips to the bank. (The term is a humorous reference to the
cost of replacing shoe leather worn out when walking to the
bank.)
• Menu costs: Firms must change their prices more frequently,
which imposes costs, for example with restaurants having to
reprint menus.

On balance many economists see moderate inflation as a benefit,


and so there are a variety of fiscal policy arguments which favor
moderate inflation. Central banks can affect inflation to a significant
extent through setting the prime rate of lending and through other
operations. This is due to the fact that most money in industrialised
economies is based on debt (see money and credit money), and so
controlling debt is thought to control the amount of money existing
and so influence inflation. A government may find some level of
inflation to be desirable, particularly in order to raise funds.

Causes of inflation

Inflation may be caused by an increase in the quantity of money in


circulation. This has been seen most graphically when governments
have financed spending in a crisis by printing money, leading to
hyperinflation where prices rise at extremely high rates. Another
cause of inflation occurs when there are many people and
organisations with enough market power to increase their prices.

The money supply is also thought to play a role in determining levels


of more moderate levels of inflation, although there are differences
of opinion on how important it is. For example, Monetarist
economists believe that the link is very strong; Keynesian economics
by contrast typically emphasise the role of aggregate demand in the
economy rather than the money supply in determining inflation.

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Economic Analysis

A fundamental concept in such Keynesian analysis is the relationship


between inflation and unemployment, called the Phillips curve. This
model suggested that price stability was a trade off against
employment. Therefore some level of inflation could be considered
desirable in order to minimize unemployment. The Philips curve
model described the US experience well in the 1960s, but failed to
describe the combination of rising inflation and economic stagnation
(sometimes referred to as stagflation) experienced in the 1970s.

Stopping inflation

There are a number of methods which have been suggested to stop


inflation. One method is simply instituting wage and price controls,
which were tried in the United States in the early 1970s. However,
most economists regard price controls as counterproductive in that
they tend to distort the functioning of the economy. Monetarists
emphasize increasing interest rates in the hope of reducing the
money supply. Keynesians emphasize reducing demand, often
through fiscal policy, using increased taxation or reduced
government spending to reduce demand. In some cases of
hyperinflation, confidence in the currency can be restored by
pegging the value of the currency to a commodity such as gold or a
stronger currency such as the U.S. dollar.

Types of inflation:

• Demand pull inflation


• Cost push inflation
• Inflation induced by adaptive expectations, often termed the
"wage-price spiral"

Historically, inflation meant an increase in the money supply, which


was the cause of price increases. Some economists still prefer this
meaning of the term, rather than to mean the price increases
themselves.

Demand pull inflation arises where there is an increase in


aggregate demand in an economy relative to aggregate supply. This
is commonly described as "too much money chasing too few goods".
This would not be expected to persist over time due to increases in
supply, unless the economy is already at a full employment level.

Cost push is a type of inflation caused by arbitrary increases in the


cost of goods or services where no suitable alternative is available. A
situation that has been often cited as of this was the oil crisis of the

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Economic Analysis

1970s, which some economists attribute as the cause of the inflation


experienced in the Western world in that decade. It is argued that
this inflation resulted from increases in the cost of oil imposed by the
member states of OPEC.

Monetarist economists such as Milton Friedman argue against the


concept of cost push inflation because they believe that increases in
the cost of goods and services do not lead to inflation without the
government cooperating in increasing the money supply. The
argument is that if the money supply is constant, increases in the
cost of a good or service will decrease the money available for other
goods and services, and therefore the price of some those goods will
fall and offset the rise in price of those goods whose prices have
increased.

One consequence of this is that monetarist economists do not


believe that the rise in the cost of oil was a direct cause of the
inflation of the 1970's.

Hyperinflation is a form of economic inflation in which the general


price level is increasing rapidly. No single definition is universally
accepted; one simplistic definition is a monthly inflation rate of 50%.
Hyperinflation is just out-of-control inflation at an extremely high
rate.

Hyperinflation was rare before the 20th century, because past a


certain level of inflation the economy would revert to either specie
metals or barter. The widespread use of fiat money created the
possibility for hyperinflation as governments often tended to print
larger amounts of money to finance their expenses. Where such an
increase in money supply is done without regard for the actual
market demand for money then inflation results.

Rates of inflation of several hundred percent per month are often


seen. Extreme examples include Germany in the early 1920s when
the rate of inflation hit 3.25 million percent per month, Greece in the
mid-1940s with 8.55 billion percent per month, and Hungary during
the same approximate time period at 4.19 quintillion percent per
month. Other more moderate examples include Eastern European
countries in the period of economic transition in the early 1990s and
in Bolivia and Peru in 1985 and 1988, respectively.

Nations such as Ghana in North Western Africa continue to this day


to have inflation in the order of 30% per annum.

Hyperinflation produces some interesting banknotes.

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Economic Analysis

One type has a big long row of zeros on the number. (like this:
"10,000,000,000").

Another type uses words for part or all of the number (like this: "10
Billion" or this: "Ten Billion")

Still others avoid the use of large numbers simply by declaring a new
unit of currency (so, instead of 10,000,000,000 Dollars, you might set
1 New Dollar = 1,000,000,000 old Dollars, so your new banknote
would read "10 New Dollars".)

In countries experiencing hyperinflation it is common to see men and


women bringing enormous grocery bags full of banknotes to the
store, even for simple purchases like bread or milk.

Stagflation is a portmanteau word used to describe a period with a


high rate of inflation combined with an economic recession.

The Phillips curve, which is associated with Keynesian economics


suggests that stagflation is impossible because high unemployment
lowers demand for goods and services which lowers prices. This
results in low or no inflation. By contrast, monetarism which argues
that inflation is due to the money supply rather than to demand
predicts that inflation can occur with high unemployment if the
government increases the money supply.

Stagflation occurred in the economies of the United Kingdom in the


1960s and 1970s and the United States in the late 1970s, and the
difficulty in fitting its existence within a Keynesian framework led to a
greater acceptance of monetarist theories in the 1970s and 1980s.
But some still believe in Keynesian economics, saying that there was
no recession at that time. The coinage of the term has been claimed
for the UK Finance Minister Iain Macleod who died in 1970.

Adaptive expectations

In economics, adaptive expectations means that people base their


expectations of what will happen in the future based on what has
happened in the past. For example, if inflation has been high in the
past, people would expect it to be high in the future.

In the theory of inflation, demand pull inflation and cost push


inflation are usually one off shocks. However, a series of such shocks
may lead people to assume that inflation is a permanent feature of
the economy, in which case they will modify their economic
behaviour accordingly, based on their expectation of future inflation

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Economic Analysis

rates. For instance, they may begin demanding larger pay raises -
this in itself acts as a cost push, leading firms to push their prices
higher, and thus to another round of pay-raises. This "wage-price
spiral" builds some inflation directly into the economy! The theory of
adaptive expectations was popular in the 1980s, as an explanation of
some aspects of the economic crisis that the West went through after
the 1970s oil shock. The fact that some countries, particularly the
UK, took until the 1990s to achieve stable low inflation rates again
suggests there may well be something in the idea.

An alternative theory of how expectations are formed is rational expectations.

Effects of Inflation:
Regardless of whether inflation is demand pull or cost-push, the failure to correctly
anticipate it results in unintended consequences. These unintended consequences
impose costs in both labor markets and capital markets. Let's examine these costs.

Unanticipated Inflation in Labor Market

Unanticipated inflation has two main consequences for the operation of the labor
market:
• Redistribution of income
• Departure from full employment
Redistribution of Income Unanticipated inflation redistributes income between
employers and workers. Sometimes employers gain at the expense of workers, and
sometimes they lose. If an unexpected increase in aggregate demand increases [he
inflation- rate, [hen wages will not have been set high enough. Profits will be higher
than expected, and wages will buy fewer goods than expected. In this case, employers
gain at the expense of workers. But if aggregate demand is expected to increase at a
rapid rate and it fails to do so, workers gain at the expense of employers. With a high
inflation rate anticipated, wages are set too high and profits are squeezed.
Redistribution between employers and workers creates an incentive for both firms and
workers to try to forecast inflation correctly.
Departures from Full Employment
Redistribution brings gains to some and losses to others. But departures from full
employment impose costs on everyone. To see why, let's return to the soda-bottling
plant in Kalamazoo.

If the bottling plant and its workers do not anticipate inflation, but inflation occurs, the
money wage rate does not rise to keep up with inflation. The real wage rate falls, and
the firm tries to hire more labor and increase production. But because the real wage rate
has fallen, the firm has a hard time attracting the labor it wants to employ. It pays
overtime rates to its existing work force, and because it runs its plant at a faster pace, it
incurs higher plant maintenance and parts replacement costs. But also, because the real
wage rate has fallen, workers begin to quit the bottling plant to find jobs that pay a real
wage rate that is closer to one that prevailed before the outbreak of inflation. This
Labor turnover imposes "additional costs on the firm. So even though its production
increases, the firm incurs additional costs, and its profits do not increase as much as

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Economic Analysis

they other- wise would. The workers incur additional costs of job search, and those
who remain at the bottling plant wind up feeling cheated. They've worked overtime
to produce the extra output, and when they come to spend their wages, they discover
that prices have increased, so their wages buy a smaller quantity of goods and services
than expected.
If the bottling plant and its workers anticipate a high inflation rate that does not occur,
they increase the money wage rate by too much, and the real wage rate rises. At the
higher real wage rate, the firm lays off some workers and the unemployment rate
increases. Those workers who keep their jobs gain, but those who become unemployed
lose. Also, the bottling plant loses because its output and profits fall.

Unanticipated Inflation in the Capital Market

Unanticipated inflation has two consequences for the operation of the capital market.
They are:
• Redistribution of income
• Too much or too little lending and borrowing

Redistribution of Income Unanticipated inflation redistributes income between


borrowers and lenders. Sometimes borrowers gain at the expense of lenders, and
sometimes they lose. When inflation is unexpected, interest rates are not set high
enough to compensate lenders for the falling value of money. In this case, borrowers
gain at the expense of lenders. But if inflation is expected and then fails to occur,
interest rates are set too high. In this case, lenders gain at the expense of borrowers.
Redistributions of income between borrowers and lenders create an incentive
for both groups to try to forecast inflation correctly.

Too Much or Too Little Lending and Borrowing If the inflation rate turns out to be
either higher or lower than expected, the interest rate does not incorporate a correct
allowance for the falling value of money and the real interest rate is either lower or
higher than it otherwise would be. When the real interest rate turns out to be too low,
which occurs when inflation is higher than expected, borrowers wish they had
borrowed more and lenders wish they had lent less-: Both groups would have made
different lending and borrowing decisions with greater fore- sight about the inflation
rate. When the real interest rate turns out to be too high, which occurs when inflation is
lower than expected, borrowers wish they had borrowed less and lenders wish they had
lent more. Again, both groups would have made different lending and borrowing
decisions with greater fore- sight about the inflation rate.

So unanticipated inflation imposes costs regard- less of whether the inflation turns out
to be higher or lower than anticipated. The presence of these costs gives everyone an
incentive to forecast inflation correctly. Let's see how people go about this task.

Forecasting Inflation:

Inflation is difficult to forecast. The reasons are, first, there are several sources of
inflation--the demand-pull and cost-push sources you've just studied. Second, the speed
with which a change in either aggregate demand or aggregate supply translates into a
change in the price level varies. This speed of response also depends, as you will see
below, on the extent to which the inflation is anticipated.

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Economic Analysis

Because inflation is costly and difficult to forecast, people devote considerable


resources to improving inflation forecasts. Some people specialize in forecasting, and
others buy forecasts from specialists. The specialist forecasters are economists who
work for public and private macroeconomic forecasting agencies and for banks,
insurance companies, labor unions, and large corporations. The returns these specialists
make depend on the quality of their forecasts, so they have a strong incentive to
forecast as accurately as possible. The most accurate forecast possible is the one that is
based on all the relevant information and is called a rational expectation.

A rational expectation is not a correct forecast. 1t is simply the best forecast available.
It will often turn out to be wrong, but no ocher forecast that could have been made
with the information available could be predicted to be better.

You've seen the effects of inflation when people fail to anticipate it. And you've seen
why it pays to try to anticipate inflation. Let's now see what happens if inflation is
correctly anticipated.

Anticipated Inflation:
In the demand-pull and cost-push inflations that we studied earlier in this chapter,
money wages are sticky. When aggregate demand increases, either to set off a demand-
pull inflation or to accommodate cost-push inflation, the money wage does not change
immediately. But if people correctly anticipate increases in aggregate demand, they
will adjust money wage rates so as to keep up with anticipated inflation.

In this case, inflation proceeds with real GDP equal to potential GDP and
unemployment equal to the natural rate. Figure 32.7 explains why. Suppose that last
year the price level was 110 and real GDP was $7 trillion, which is also potential GDP.
The. aggregate demand curve. was ADo; the aggregate supply curve was SASo, and the
long-run aggregate supply curve was LAS.
Suppose that potential GDP does not change, so the LAS curve does not shift. Also
suppose that aggregate demand is expected to increase and that the expected aggregate
demand curve for this year is ADl' In anticipation of this increase in aggregate demand,
money wage rates rise and the short-run aggregate supply curve shifts leftward. If the
money wage rate rises by the same percentage as the price level rises, the short-run
aggregate supply curve for next year is SASl.
If aggregate demand turns out to be the same as expected, the aggregate demand curve
is ADl and with the short-run aggregate supply curve SASl the actual price level is 121.
Between last year and this year, the price level increased from 110 to 121 and the
economy experienced an inflation rate of 10 percent, the same as the inflation rate that
was anticipated. If this anticipated inflation is ongoing, in the following year aggregate
demand increases (as anticipated) and the aggregate demand curve shifts to AD2. The
money wage rate rises to reflect the anticipated inflation, and the short-run aggregate
supply curve shifts to SAS2. The price level rises by a further 10 percent to 133.

What has caused this inflation? The immediate answer is that because people expected
inflation, wages were increased and prices increased. But the expectation was correct.
Aggregate demand was expected to increase, and it did increase. Because aggregate
demand was expected to increase from ADo to ADl, the short-run aggregate supply
curve shifted from SASo to SASl. Because aggregate demand actually did increase by
the amount that was expected, the actual aggregate demand curve shifted from ADo to
ADl. The combination of the anticipated and actual increases in aggregate demand
produced an increase in the price level that was anticipated.

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Economic Analysis

Only if aggregate demand growth is correctly forecasted does the economy follow the
course described in Fig. 32.7. If the expected growth rate of aggregate demand is
different from its actual growth rate, the expected aggregate demand curve shifts by an
amount that is different from the actual aggregate demand curve. The inflation rate
departs from its expected level, and to some extent, there is unanticipated inflation.

Page 348 figure 15.7

Unanticipated Inflation:
When aggregate demand increases by more than expected, there is some unanticipated-
inflation that looks just like the demand-pull inflation that you studied earlier. Some
inflation is expected, and the money wage rate is set to reflect that expectation. The
SAS curve intersects the LAS curve at the expected price level. Aggregate demand then
increases, but by more than expected. So the AD curve intersects the SAS curve at a
level of real GDP that exceeds potential GDP. With real GDP above potential GDP and
unemployment below the natural rate, the money wage rate rises. So the price level
rises further., If aggregate demand increases again, a: demand-pull inflation spiral
unwinds.

When aggregate demand increases by less than expected, there is some unanticipated
inflation that looks like the cost-push inflation that you studied earlier. Again, some
inflation is expected, and the money wage rate is set to reflect that expectation. The
SAS curve intersects the LAS curve at the expected price level. Aggregate demand then-
increases, but by less than expected. So the AD curve intersects the SAS curve at a level
of real GDP-below potential GDP. Aggregate demand increases to restore full
employment. But if aggregate demand is expected to increase by more than it actually
does, wages again rise, short-run aggregate supply again decreases, and a cost push
spiral unwinds

We've seen that only when inflation is unanticipated does real GDP depart from
potential GDP. When inflation is anticipated, real GDP remains at potential GDP. Does
this mean that an anticipated inflation has no costs?

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