Inflation (economics)

Economics
Economies by region  Africa · North America South America · Asia Europe · Oceania
Outline of topics
General classifications
History of economic thought Microeconomics · Macroeconomics
Methodologies
Behavioral · Computational Econometrics · Evolutionary Experimental · Game theory Mathematical · Heterodox
Fields and subfields
Development · Growth · History International trade · Labour Welfare economics · Financial Monetary theory · Public sector Industrial organization · Law Ecological · Economic systems Natural resource · Agricultural Environmental · Regional science Urban · Culture · Health
Lists
Journals · Publications Categories · Topics · Economists
Economic ideologies  Anarchist · Capitalist Communist · Corporatist Fascist · Georgist Islamic · Laissez-faire Market socialist · Mercantilist Protectionist · Socialist Syndicalist · Third Way
Other economies  Anglo-Saxon · Feudal Global · Hunter-gatherer Newly industrialized country Palace · Plantation Post-capitalist · Post-industrial Social market · Socialist market Token · Traditional Information · Transition
Business and Economics Portal
This box: view • talk • edit

In economics, inflation or price inflation is a rise in the general level of prices of goods and services over a period of time.^[1] The term "inflation" originally referred to increases in the money supply (monetary inflation); however, debates regarding cause and effect have led to its primary use today in describing price inflation.^[2] Inflation can also be described as a decline in the real value of money—a loss of purchasing power.^[3] When the general level of prices rises, each unit of currency buys fewer goods and services. Price inflation is usually measured by calculating the inflation rate, which is the percentage change in a price index, such as the consumer price index.^[4]

Inflation causes certain adverse effects in the economy. For example, uncertainty about future inflation may discourage investment and saving. Inflation also shifts income from those on fixed incomes to those with variable incomes. Fixed nominal payments (e.g. rents and wages) are eroded if they are not inflation-adjusted. High inflation may cause hoarding by households as they buy consumer durables as stores of wealth.

Economists generally agree that high rates of inflation and hyperinflation are caused by high growth rates of the money supply.^[5] Views on the factors that determine moderate rates of inflation are more varied: changes in inflation are sometimes attributed to fluctuations in real demand for goods and services or in available supplies (i.e. changes in scarcity) and sometimes to changes in the money supply (i.e. the amount of units of currency). However, there is general consensus that in the long run, inflation is caused by money supply increasing faster than the growth rate of the economy.^[6][7]

Most central banks (who control money supply) are tasked with keeping inflation at a low level. There are a number of methods that have been suggested to control it. Inflation can be affected to a significant extent through setting interest rates and through other central bank actions (that is, through monetary policy). Others advocate fighting inflation by fixing the exchange rate between the currency and some other reference currency, such as the Euro, U.S. dollar or gold (see fixed exchange rate). Another method attempted in the past has been wage and price controls (incomes policies).

Contents 1 Origins 2 Related definitions 3 Measures 3.1 Issues in measuring 4 Effects 4.1 Cost-of-living allowance 5 Causes 5.1 Keynesian view 5.2 Monetarist view 5.3 Rational expectations theory 5.4 Austrian theory 5.5 Real bills doctrine 5.6 Anti-classical or backing theory 6 Controlling inflation 6.1 Monetary policy 6.2 Fixed exchange rates 6.3 Gold standard 6.4 Wage and price controls 7 See also 8 Notes 9 References 10 Further reading 11 External links

Origins

Inflation originally referred to the debasement of the currency, where gold coins were collected by the government (e.g. the king or the ruler of the region), melted down, mixed with other metals (e.g. silver, copper or lead) and reissued at the same nominal value. By mixing gold with other metals, the government could increase the total number of coins issued using the same amount of gold, and thus gained a profit known as seigniorage.^[8] However, this action increased the money supply, and lowered the relative value of money. As the real value of each coin had decreased, the consumer had to pay more coins in exchange for goods and services of the same value (i.e. prices had increased).^[9] In the 19th century, the word inflation started to appear as a direct reference to the action of increasing the amount of currency units by the central bank.^[2] Classical political economists from Hume to Ricardo did distinguish between and debate the cause and effect: the Bullionists, for example, argued that the Bank of England had over-issued banknotes (over-increased the money supply) and caused 'the depreciation of banknotes' (price inflation).^[10]

Related definitions

While "inflation" usually refers to a rise in some broad price index like the consumer price index that indicates the overall level of prices, it is also used to refer to a rise in the prices of some specific set of goods or services, as in "commodities inflation",^[11][12] "food inflation",^[13] or "house price inflation"^[14] or core inflation (a measure of inflation of some sub-set of the broader index, usually excluding goods with higher volatility or strong seasonality). Related economic concepts include: deflation, a fall in the general price level; disinflation, a decrease in the rate of inflation; hyperinflation, an out-of-control inflationary spiral; stagflation, a combination of inflation and slow economic growth and rising unemployment; and reflation, which is an attempt to raise the general level of prices to counteract deflationary pressures.

While economic theory before the "marginal revolution" is no longer the basis for current economic theory, many of the institutions, concepts, and terms used in economics come from the "classical" period of political economy, including monetary policy, quantity and quality theories of economics, central banking, velocity of money, price levels and division of the economy into production and consumption. For this reason, debates about present economics often reference problems of classical political economy, and the currency versus banking debates of that period.

Measures

Inflation is measured by calculating the inflation rate, which means the percentage rate of change of a price index, such as the Consumer Price Index.^[15][16][17]

For example, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. Therefore, using these numbers, we can calculate that the annual percentage rate of CPI inflation over the course of 2007 was

That is, the general level of prices for typical U.S. consumers rose by approximately four per cent in 2007.^[18]

Price indices include the following.

• Consumer price index (CPI) which measure the price of a selection of goods and services purchased by a "typical consumer."^[19]
• Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes.
• 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.
• Commodity price indices, 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.
• GDP deflator 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.
• Core inflation because food and oil prices 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 looking at those prices. Therefore most national statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a wider price index like the CPI. Since core inflation is less affected by short run supply and demand conditions in specific markets, it helps central banks better measure the inflationary impact of current monetary policy.
• Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US.
• True Inflation Index (TII), which measure a basic cost of survival on austere rations and is usually higher than RPI and CPI. It avoids errors of weighting for individuals and provides a baseline cost which will not reflect individual spending patterns above basic costs. This indicator is regularly published by The Daily Telegraph, and is the subject of a Downing Street Petition against misleading indices.
• 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 is an undue increase in the prices of real or financial assets, such as stock (equity) and real estate, can be called 'asset price inflation'. While there is no widely-accepted index of this type, some central bankers have suggested that it would be better to aim at stabilizing a wider general price level inflation measure that includes some asset prices, instead of stabilizing CPI or core inflation only. The reason is that by raising interest rates when stock prices or real estate prices rise, and lowering them when these asset prices fall, central banks might be more successful in avoiding bubbles and crashes in asset prices.

Issues in measuring

Measuring inflation requires finding objective ways of separating out changes in nominal prices from other influences related to real activity. In the simplest possible case, if the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price change represents inflation. This single price change does not, however, demonstrate how overall cost of living changes, and instead of looking at the change in price of one good, the price of a large "basket" of goods and services is measured. This is the purpose of looking at a price index, which is a weighted average of many prices. The weights in the Consumer Price Index, for example, represent the fraction of spending that typical consumers spend on each type of goods (using data collected by surveying households).

Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods from the present are compared with goods from the past. This includes hedonic adjustments and "reweighting" as well as using chained measures of inflation. These adjustments are necessary because the type of goods purchased by 'typical consumers' changes over time, and the quality of some types of goods may change, and new types of goods may be invented.

As with many economic numbers, inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost increases, versus changes in the economy. Inflation numbers are averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices. Finally, when looking at inflation, economic institutions sometimes only look at subsets or special indices. One common set is inflation excluding food and energy, which is often called "core inflation".

Effects

This article or section may require cleanup because it is in a list format that may be better presented using prose. You can help by converting this section to prose, if appropriate. Editing help is available. (September 2008)

An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services.^[20]

In general, high or unpredictable inflation rates are regarded as bad for the following reasons:

• Uncertainty about future inflation may discourage investment and saving.^[21]

• Redistribution - Inflation redistributes income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and current profits which may keep pace with inflation. However, debtors may be helped by inflation due to reduction of the real value of debt burden.

• Implicit taxation - A particular form of inflation as a tax is Bracket Creep (also called fiscal drag). By allowing inflation to move upwards, certain sticky aspects of the tax code are met by more and more people. For example, income tax brackets, where the next dollar of income is taxed at a higher rate than previous dollars, tend to become distorted. Governments that allow inflation to "bump" people over these thresholds are, in effect, allowing a tax increase because the same real purchasing power is being taxed at a higher rate.

• International trade: Where fixed exchange rates are imposed, higher inflation than in trading partners' economies will make exports more expensive and tend toward a weakening balance of trade. A sustained higher level of inflation than in the trading partners' economies will also, over the long run, put upward pressure on the implicit exchange rate (what the exchange rate would be if left to be decided in the market) making the fix unsustainable and potentially inviting a an exchange rate crisis.

• Cost-push inflation: Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral.^[22] In a sense, inflation begets further inflationary expectations.

• Hoarding: people buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.

• Hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.

• Shoe leather cost: 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 in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.

• Menu costs: With high inflation, firms must change their prices often in order 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.

• Austrian School explanation of business cycles: According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.^[23]

• Inflation erodes the real value of nominally fixed payments - The real value of fixed nominal payments (like rents, pensions, wages, interest, and taxes) are eroded by inflation.^[24][25] In many countries, such payments are adjusted for inflation on an annual basis.^[26]

• Inflation erodes the real value of historical cost accounting items - In accounting, the real values of non-monetary assets and liabilities stated at historical cost, (e.g. retained earnings,^[27] issued share capital,^[28] capital reserves, provisions, taxes, dividends, trade payables and receivables,^[29] etc.) - are eroded when they are not inflation-adjusted.^[30][31] The real values of historical cost non-monetary items are completely eroded over time.^[32] Two percent inflation - the European Central Bank´s definition of price stability^[33] - will destroy 51 percent of the real value of historical cost non-monetary items over 35 years.^[34]

Some possibly positive effects of (moderate) inflation include:

• Labor Market Adjustments: Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesian argue that some inflation is good for the economy, as it would allow 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 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) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.

• Tobin effect: The Nobel prize winning economist James Tobin at one point had argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects. See Tobin monetary model^[35]

• Inflation erodes the real value of government debt.^[36][37]

Cost-of-living allowance

For more details on this topic, see Cost of living.

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) are tied to a cost-of-living index, typically to the consumer price index.^[38] A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually.^[38] 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 or cost-of-living increases because of their similarity to increases tied to externally-determined indexes. Most economists and compensation analysts would consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized world, average wages have increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity and worker bargaining power rather than simply living costs, and (2) most cost-of-living indexes are not forward-looking, but instead compare current or historical data.

Causes

There is broad agreement among economists that in the long run, inflation is essentially a monetary phenomenon. 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.^[39] The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian schools. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian view, 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.

A great deal of economic literature concerns the question of what causes inflation and what effect it has. There are different schools of thought as to what causes inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. Many theories of inflation combine the two. 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 that are desirable as a buyer. The quantity theory of inflation rests on the equation of the money supply, its velocity, and exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.

Keynesian view

Keynesian economic theory proposes that money is transparent to real forces in the economy, and that visible inflation is the result of pressures in the economy expressing themselves in prices.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":^[40]

• Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
• Cost-push inflation: also called "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
• Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively, often leading to hyperinflation, a condition where prices can double in a month or less. Another cause can be a rapid decline in the demand for money, as happened in Europe during the Black Death.

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 economics, 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 economists consider this a 'hocus pocus' approach: They disagree with the notion that central banks control the money supply, arguing that central banks have little control because the money supply adapts to the demand for bank credit issued by commercial banks. This is the theory of endogenous money. Advocated strongly by post-Keynesians as far back as the 1960s, it has today become a central focus of Taylor rule advocates. This position is not universally accepted: banks create money by making loans, but the aggregate volume of these loans diminishes as real interest rates increase. Thus, central banks influence the money supply by making money cheaper or more expensive, and thus increasing or decreasing its production.

A fundamental concept in inflation analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment. The Phillips curve model described the U.S. 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.

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.

Another concept of note is the potential output (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, or the "natural" rate of unemployment 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. Worse, it can change because of policy: for example, high unemployment under British Prime Minister Margaret Thatcher might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed (also see unemployment), 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.

Monetarist view

For more details on this topic, see Monetarists.

Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. This theory begins with the identity:

where

P is the general price level;

V is the velocity of money in final expenditures;

Q is an index of the real value of final expenditures;

M is the quantity of money.

In this formula, the general price level is affected by the level of 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 expenditure () to the quantity of money (M).

Velocity of money is often assumed to be constant, 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 constant velocity, the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not constant, and can only be measured indirectly and so the formula does not necessarily imply a stable relationship between money supply and nominal output. However, in the long run, changes in money supply and level of economic activity usually dwarf changes in velocity. If velocity is relatively constant, the long run rate of increase in prices (inflation) is equal to the difference between the long run growth rate of money supply and the long run growth rate of real output.^[41]

Rational expectations theory

Main article: 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 have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession.

Austrian theory

For more details on this topic, see The Austrian view of inflation

The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation.^[42] Austrian economists measure the inflation by calculating the growth of what they call 'the true money supply', i.e. how many new units of money that are available for immediate use in exchange, that have been created over time.^[43][44][45] This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply.^[46] In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.^[47]

Austrians argue that the state uses inflation as one of the three means by which it can fund its activities (inflation tax), the other two being taxation and borrowing.^[48] Various forms of military spending is often cited as a reason for resorting to inflation and borrowing, as this can be a short term way of acquiring marketable resources and is often favored by desperate, indebted governments.^[49] In other cases, the central bank may try to avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions or depressions by artificially trying to "stimulate" the economy through "encouraging" money supply growth and further borrowing via artificially low interest rates.^[50] Accordingly, many Austrian economists support the abolition of the central banks and the fractional-reserve banking system, and advocate returning to a 100 percent gold standard, or less frequently, free banking.^[51][52] They argue this would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth (and inflation) would never spiral out of control.^[53][54]

Real bills doctrine

Main article: Real bills doctrine

Within the context of a fixed specie basis for money, one important controversy was between the quantity theory of money and the real bills doctrine (RBD). Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. 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. 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 boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of the Federal Reserve going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with libertarian principles of laissez-faire, even though almost all libertarian economists are opposed to the RBD.

The debate between currency, or quantity theory, and banking schools in Britain during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.

Anti-classical or backing theory

Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory". The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency.^[55] Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions.

Controlling inflation

A variety of methods have been used in attempts to control inflation.

Monetary policy

Main article: Monetary policy

Please help improve this article or section by expanding it. Further information might be found on the talk page or at requests for expansion. (September 2008)

Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping inflation at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum.

There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.

Monetarists emphasize increasing interest rates (slowing the rise in the money supply, monetary policy) to fight inflation. Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand as well as by using monetary policy. Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a return to the gold standard. All of these policies are achieved in practice through a process of open market operations.

Fixed exchange rates

Main article: Fixed exchange rate

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 used as a means to control inflation. However, as the reference value rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the 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 in order to achieve macroeconomic stability.

Under the Bretton Woods agreement, most countries around the world had currencies that were fixed to the US dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attacks. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. 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 has been used in many countries in South America. For instance, Argentina (1991-2002), Bolivia, Brazil, Chile.

Gold standard

Main article: Gold standard

The gold standard is a monetary system in which a region's common media of exchange are paper notes 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 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.

Gold was a common form of representative money due to its rarity, durability, divisibility, fungibility, and ease of identification.^[56] Representative money and the gold standard were used to protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression. However, they were not without their problems and critics, and so were partially abandoned via the international adoption of the Bretton Woods System. That system eventually collapsed in 1971, at which time all nations had switched to full fiat money. Austrian economists strongly favor a return to a 100 percent gold standard.

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.^[57] Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining,^[58][59] which some believe contributed to the Great Depression.^[60][61][59]

Wage and price controls

Main article: Incomes policies

Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have been successful in wartime environments in combination with rationing. 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. More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands.

In general wage and price controls are regarded as a temporary and exceptional measure, 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.

Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed (see creative destruction).

See also

Notes

References

• Abel, Andrew & Bernanke, Ben (2005), Macroeconomics (5th ed.), Pearson 

• Mankiw, N. Gregory (2002), Macroeconomics (5th ed.), Worth 

Further reading

• Baumol, William J. and Alan S. Blinder, Macroeconomics: Principles and Policy, Tenth edition. Thomson South-Western, 2006. ISBN 0-324-22114-2
• Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, New York, Harper Collins, 1995.
• Henry Hazlitt, What You Should Know About Inflation
• Juan de Mariana, On the debasement of money (De Mutatione Monetae)
• 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 article)

External links

• Inflation News
• Maps of inflation

Statistical sources

• Inflation Data - up-to-date US inflation data
• United States Bureau of Labor Statistics Consumer Price Index homepage
• Shadow Government Statistics - Current U.S. figures calculated using older official methodologies to allow more accurate comparison of current vs. historic figures
• US Consumer Price Index Over Time - A time-series chart of U.S. Consumer Price Index.
• Current Value of Old Money - discusses changes in the value of money over time.
• Various inflation calculators - US Dollars (1790-2006), UK pounds (1830-2006), price of gold (1257-2006)
• Inflation 1290-2006 - Based on the historical Consumer Price Index of the Swedish Riksbank
• Inflation Calculator - Based on CPI (1913-2008)
• US Inflation calculator - Based on consumer price indices (1800-2006)
• Cost-of-Living Calculator from American Institute for Economic Research (AIER)
• Up-to-date monthly inflation rates for the UK
• FRENCH INFLATION - Current and Historical since 1901 with Calculator to compare evolution between two dates.

---

No comments have been added.

Your name:
City:
Country:	USA UK India Pakistan UAE Saudi Arabia Germany Afghanistan Albania Algeria Andorra Angola Antigua Barbuda Argentina Armenia Australia Austria Azerbaijan Bahamas Bahrain Bangladesh Barbados Belarus Belgium Belize Benin Bhutan Bolivia Bosnia Herzegovina Botswana Brazil Brunei Bulgaria Burkina Faso Burma Burund Cambodia Cameroon Canada Central African Rep Chad Chile China Columbia Comoros Congo Costa Rica Croatia Cuba Cyprus Czech Republic DR Congo Denmark Djiboutil Dominica Dominican Rep Ecuador Egypt El Salvador Eq Guinea Eritrea Estonia Ethiopia Fiji Finland France Gabon Gambia Georgia Germany Ghana Greece Grenada Grenadines Guatemala Guinea Bissau Guinea Guyana Haiti Honduras Hong Kong Hungary Iceland India Indonesia Iran Iraq Ireland Israel Italy Ivory Coast Jamaica Japan Jordan Kazakhstan Kenya Kiribati Kuwait Kyrgyzstan Laos Latvia Lebanon Liberia Libya Liechtenstein Lithuania Luxembourg Macedonia Macau Madagascar Malawi Malaysia Maldives Mali Malta Mauritania Mauritius Mexico Micronesia Moldova Monaco