Inflation is a general rise in prices — not all prices, some prices may even fall, but most prices. In the United States, inflation is measured by the Consumer Price Index (CPI) and the GDP deflator. The CPI measures the rate of inflation by the ratio of the consumer price index of one year over the base year or some other reference year. This result is then multiplied by 100 to yield an integer representation of the index. The inflation rate can, thus, be calculated by comparing the CPI of one year with that of the base year, or any other year:
|Inflation Rate||=||Current Year CPI - Base Year CPI |
Base Year CPI
The CPI is calculated much like the GDP deflator. However, the CPI only covers consumer goods and services. The GDP deflator covers many more goods and services, including goods and services bought by businesses and governments, and goods and services traded internationally, all of which are items included in the gross domestic product (GDP), but which are not consumer goods and services, and, therefore, not included in the CPI. Since GDP is based on prices, the nominal GDP is the price of all goods and services in the current, or target, year; the real GDP is the value of all goods and services expressed in the prices of the base year. The real GDP is the nominal GDP adjusted for inflation, using a base year as a reference.
GDP Deflator = Nominal GDP / Real GDP × 100
Types of Inflation: Demand-Pull Inflation and Cost-Push Inflation
There are 2 types of inflation distinguished by cause: demand-pull inflation and cost-push inflation.
Demand-pull inflation occurs when an increase in spending outstrips the increase in economic output, when aggregate demand exceeds aggregate supply. Demand-pull inflation occurs when the money supply increases faster than the economy. This shifts the demand curve rightward, causing prices to rise for every level of output.
As the economy grows, the money supply must increase proportionately. If the money supply grows too fast, then inflation results; if it grows too slowly, then deflation results. Inflation not only depends on the supply of the money stock, which is the quantity of money, but also depends on how fast people spend it, referred to as the velocity of money. For an economy, the velocity of money is simply equal to the value of all transactions divided by the value of the money stock. Both quantity and velocity determine inflation, but without velocity, the quantity of money is immaterial. For instance, if grandma wins a one million-dollar lottery, takes it as a lump-sum payment, then goes home and stuffs it in her big mattress, then it will have no effect on the economy. It will be as if the money never existed. In this case, the money supply actually decreases, since $1 million has been taken out of circulation. This would have a contractionary effect on the economy, albeit a minor one for a $20 trillion economy.
Although central banks control the availability of credit and the money stock, they cannot control the rate at which people spend the money. Sometimes, the money supply is increased by the easy availability of credit. One of the best illustrations of demand-pull inflation occurred during 2003-2007, when real estate prices exploded, because banks started giving loans to anyone who could breathe. The mortgages were packaged into mortgage-backed securities, which the banks then sold to investors, passing along the credit default risk of the mortgages to the investors. This took the mortgages off the banks' balance sheet, allowing them to make even more loans, which they did because they profited from the origination and servicing fees for the loans. This continual process increased demand much faster than the supply could increase, so demand-pull inflation resulted.
As long as the increase in economic output exceeds the increase in the money supply, there will be no demand-pull inflation. As long as firms have idle capacity, increases in spending will cause the firms to use up their capacity before raising prices. However, as the economy nears full employment, and idle capacity becomes used up, it becomes increasingly difficult to increase output without significant additional investments, so prices rise. The marginal cost of producing extra product increases substantially as the limits of fixed capital and limited labor are reached, so businesses must raise prices to remain profitable.
Generally, some demand-pull inflation is good because it indicates that the economy is closer to full output and that the unemployment rate is at its natural rate. This increases both economic growth and prosperity, which central banks try to maintain by allowing the money supply to grow only as fast as the economy. This keeps demand-pull inflation in check.
Monetary Policy and Demand-Pull Inflation
Demand-pull inflation is a monetary phenomenon, so it is natural to examine demand-pull inflation in terms of monetary variables. The quantity of money multiplied by the velocity of money equals aggregate demand, and when aggregate demand increases faster than economic output, then price levels must rise, which is inflation.
The relationship between the quantity of money (M), the velocity of money (V), aggregate price levels (P), and economic output (Y) are summarized by the following equation:
MV = PY
Or, solving for aggregate price levels:
P = MV – Y
Central banks conduct monetary policy with the primary objective of keeping inflation low. Low inflation allows consumers and businesses to manage their money more effectively, by keeping the value of money relatively stable and inflation predictable. However, central banks can only control the supply of money, they cannot directly control the velocity of money or economic output.
The velocity of money is variable in the short run. Velocity tends to slow down when interest rates fall and increase when they rise. However, this probably does not reflect causation, meaning that interest rate changes occur because of changes in velocity. Rather, velocity declines when the economy declines, which is when the Fed, or central banks in other economies, decreases interest rates. When the economy is booming, velocity is high, and the Fed is increasing interest rates to cool the economy. For instance, money velocity declined after the Great Recession that began in 2007, because people had no money to spend, so the Fed lowered interest rates to stimulate the economy. Thus, the lower velocity of money and decreased interest rates were caused by the slowdown in the economy. Without this common cause, it would be more natural to assume that money velocity would increase with lower interest rates, since lower interest rates generally increase consumption and investments in capital by businesses.
This decrease in velocity also explains why there was little inflation during the Great Recession, even though the Fed increased the money supply. People were deeply in debt, so they could not spend any more money, with the consequence that businesses could not sell their products and services, so they had to lay people off. Thus, increasing the money supply itself does not necessarily increase inflation, especially in a depressed economy.
However, over the long run, the velocity of money is considered constant, so an increased money supply relative to the growth of the economy leads to higher inflation.
Sometimes inflation is caused by increases in the cost of inputs, or the factors of production, which gives rise to cost-push inflation. However, cost-push inflation does not occur as frequently as demand-pull inflation, especially in less developed countries, where politicians are inclined to solve monetary problems by printing more money, a major cause of demand-pull inflation in those nations. Cost-push inflation arises as the per-unit production costs increase.
Per-unit production cost equals the total input cost divided by the units of output.
Per-Unit Production Cost = Total Input Cost ÷ Output Units
Because businesses want to make a profit, as per-unit production costs increase, businesses raise their prices, even while output and employment are decreasing. Such was the case in the 1970s when the price of imported oil nearly quadrupled in 1973 – 1974 and rose sharply again in 1979 – 1980. Such major sources of cost-push inflation have sometimes been referred to as supply shocks.
Sometimes it is difficult to distinguish between demand-pull and cost-push inflation – it is even possible that both causes of inflation are operative. However, demand-pull inflation will continue as long as the money supply increases, whereas cost-push inflation is self-limiting, because higher prices reduce demand when the money supply is not increasing.
Cost-push inflation decreases output. When the Organization of Petroleum Exporting Countries (OPEC), quadrupled the price of oil in 1973 to 1975, economic output declined dramatically, and the unemployment rate rose from 5% in 1973 to 8.5% in 1975.
Redistribution Effects of Inflation
Different groups of people are affected differently by inflation, but to determine who those groups will be, it is helpful to distinguish between nominal income and real income. Nominal income is the actual number of dollars of income received by individuals, households, and businesses. Real income is equal to the purchasing power of those dollars.
Real Income = Nominal Income / Price Index (in hundreds)
Obviously, if people's nominal income rises at the inflation rate, then their real purchasing power remains the same. However, when nominal income does not increase as fast as the inflation rate, then people suffer.
A change in real income equals the percentage change in nominal income minus the percentage change in the average price level.
Percentage Change in Real Income = Percentage Change in Nominal Income – Percentage Change in Average Price Level
So if nominal income rises by 5%, but the inflation rate is 6%, then real income will decline by 1%.
Some people are less affected by inflation. People who receive incomes adjusted for inflation, such as social security, or union workers with automatic cost-of-living adjustments (COLAs), which raises pay according to some percentage of the CPI, will largely be unaffected by inflation.
The people hurt most by inflation are people who receive income at a fixed interest rate. This includes retirees, who may depend on a fixed pension or annuity income, savers who have bought bonds, or who have savings accounts or certificates of deposit, and creditors, who often lend money at a fixed rate of interest. Higher inflation will reduce the value of money over time. If the inflation rate is higher than the interest rate, then the actual purchasing power of the money received by those who are receiving this fixed interest income will decline.
Many of the effects of inflation depend on whether it is anticipated or unanticipated. Anticipated inflation causes people to counteract the consequences of the higher inflation rate. For instance, unions will ask for higher pay raises and workers will also demand higher pay raises. However, unanticipated inflation causes people to lose purchasing power – their real income declines, because it takes time to recognize the inflation.
The main effect of anticipated inflation is that people who lend money will demand a higher interest rate for their loans to compensate for the loss of the purchasing power of their future cash flow. Generally, lenders increase the rate of interest they charge by the inflation premium, which is the interest rate that covers the expected rate of inflation. So if a lender thinks that a 6% return is a fair return, and the inflation rate is 3%, then the lender will seek a 9% interest rate on its loan.
Some people benefit from inflation. Debtors are the main beneficiaries of inflation, for they borrow more valuable money than the money they will use to pay back the loan. The longer the term of the loan, the greater the difference between the purchasing power of what was received with what was paid back. Hence, although the federal government is deeply in debt because of the recent credit crisis, its borrowing costs are very low, maybe even lower than inflation, which makes the present debt of the United States not nearly as dire as some suggest.
Like income, interest rates can also be divided into nominal interest rates and real interest rates. A nominal interest rate is the increase in the nominal value of the principal, while the real interest rate is the increase in purchasing power of the principal. This leads to the Fisher equation:
Nominal Interest Rate = Real Interest Rate + Inflation Rate
Other Inflation Costs
Besides a redistribution effects of inflation, inflation incurs other costs. A major purpose of money is to serve as a store of value, but with inflation, that value declines continually. Hence, most people either buy something with the money or they invest it. Nonetheless, people do keep some cash, i.e. maintain liquidity, to make purchases or to wait for better investments. If they need more cash, then they will convert some of their investments into cash, which incurs a transaction cost, depending on the type of investment. Of course, even if there was no inflation, people would still invest money to earn additional money, but inflation gives a greater impetus to do something with the money, since holding significant amounts of cash can be detrimental to one's wealth.
Another type of inflation cost is so-called menu costs, which are the costs incurred to update prices. A typical example is a restaurant menu. When prices go up, restaurant owners must update their prices by printing new menus. Hence, the name.
Inflation also distorts prices, because it takes time for the increased demand caused by inflation to affect all products and services. Therefore, some products and services go up in price before others, thereby distorting their previous price relationship.
If inflation is unpredictable, then financial planning is difficult, for people, firms, governments, and other organizations. Business and investment tools, such as present value and future value, become virtually worthless, since present and future value have little meaning when the value of the currency fluctuates unpredictably.
A great example is Bitcoin. In 2017, the price of 1 Bitcoin varied from less than $1000 to more than $17000. If you deposited 100 Bitcoins in a bank account paying 5% interest, then at the end of 1 year, you will have 105 Bitcoins, but you will have no idea what that money will be worth then. So how can you plan what to do with it? If it drops substantially in value, then you may be able to buy a scooter. If it greatly increases in value, as it has, then you may be able to buy a Rolls-Royce. And this is just a personal expense. Imagine if you are running a business!
Factors Mitigating Inflation
Inflation is overestimated because it does not include the purchases of cheaper substitutions or the quality improvements of products and services, or even the introduction of new products and services. When prices increase, people often buy cheaper substitutes. This substitution effect mitigates or eliminates the loss of purchasing power from inflation. Although the CPI is based on a consumer market basket of goods and services in quantities considered an average purchase, the average purchase changes over time, and that is not reflected in the CPI basket of goods and services until later.
Price indexes also do not measure quality improvements, since it is difficult to quantify. The CPI does try to assess quality improvements, but these adjustments probably do not reflect all the quality differences.
Likewise, for the introduction of new products and services. If people start buying a new product or service, then it must be providing a greater marginal utility than what they were buying before. Hence, total utility is increased, i.e. people are buying a more desirable product or service, but this is not reflected immediately in price indexes, since there is always a lag of time until the new item is added to the consumer market basket.
There are also several benefits with inflation, which is why central banks try to maintain low inflation rather than no inflation.
- Inflation can help finance governments. Since only the federal government is legally permitted to print money, when it does print money, it benefits from the additional cash before the economy can respond with higher prices.
- Inflation can stimulate the economy when it lags below optimal output, by setting negative real interest rates, which would be virtually impossible using any other method, except in restricted applications, such as when the central bank charges its member banks to hold their money. By increasing inflation above the nominal interest rate, the real interest rate becomes negative, motivating people to spend money rather than save it.
- Real Interest Rate = Nominal Interest Rate – Inflation Rate
- Inflation can also help to adjust prices that become distorted because of changes in supply and demand. Although most prices fall when demand decreases or supply increases, some prices are sticky because people are unwilling to accept lower prices. The most prominent example of sticky prices is the price of labor, since most people are not willing to accept a lower wage. Likewise, for home sales, since most homeowners are not willing to accept a lower price than what they paid. Hence, inflation can allow these types of prices to reach a natural equilibrium, based on supply and demand.
Deflation results when there is a general decline in the price level. Hence, the beneficiaries of deflation are the opposite of those who benefit from inflation. People receiving interest based on a fixed interest rate will see their purchasing power increase over time; likewise, for creditors. Even people who save cash will earn a return during deflation, because the inflation premium is now negative. However, people with physical assets, such as real estate, will suffer.
Hence, deflation causes a liquidity trap, where people hold onto the money itself because it becomes more valuable over time, which only increases the deflation. Even if the central bank increases the money supply, people may decide to hold onto the extra money rather than spend it.
The Japanese economy is a good illustration of what happens during deflation. Because money increases in value as prices drop, people hoard their money, which causes the economy to contract, thereby causing prices to drop even more into a deflationary spiral.
However, deflation hurts debtors, because they pay back money that is more valuable than the money they received, even if no interest rate was charged.
When inflation becomes extreme, hyperinflation is the result. This most often occurs when the government tries to solve fiscal problems by printing more money, otherwise known as seigniorage. Hyperinflation results when the government cannot collect enough tax revenue to pay its expenses or borrow the money, usually because the government is untrustworthy.
When the economy starts to recognize hyperinflation, people and businesses start buying hard assets to protect their income. However, most of these assets, such as gold, collectibles, and even real estate, do not produce output. Time and effort is spent in trying to profit from the inflation or to prevent its ruinous effects, but these efforts have no economic value, since they do not result in increased output.
Furthermore, people have increasing difficulty knowing what normal prices should be. Likewise, businesses cannot be certain at what price they should sell their products and services, since their cost for new materials and other input such as labor, may rise substantially in a short time.
Because money loses value quickly under hyperinflation, people spend the money as fast as they can, which increases inflation even further, because the velocity of money is accelerated.
The end result of most cases of hyperinflation is that the economy starts using hard assets, such as gold or silver, for money, or, as is more often the case, the economy starts using a foreign currency, which is known as dollarization, because most of these economies in the past have turned to the United States dollar. Then the government loses control over the economy, and the economy becomes dependent on the availability of foreign currency or hard assets.
Bitcoin Exemplifies the Problems of an Unstable Currency
Bitcoin exemplifies the problems when the value of currency is unstable. From July until November 2017, the value Bitcoin varied from less than $3000 to $7800. In the 1st week of November, Bitcoin fell to $5507 from a peak above $7800. In a single day during that week, the price of Bitcoin fell more than $1000. Frequently, the daily price of 1 Bitcoin drops or increases in value by more than $100. So, imagine if you are a restaurant owner with menu prices listed in Bitcoins. You would have to change your menu virtually every day. Or imagine you took out a car loan based on Bitcoin. If, as you pay the loan back over 6 years, Bitcoin reaches astronomical values, how will you would feel about that? Enormous transfers of wealth would go from you to your lender, assuming that your employer increases your pay fast enough to be able to make the payments on your loan. Not likely. Or imagine that you wanted to start a business. How could you even determine what initial costs would be, since the price of a single Bitcoin can change substantially in a single day.
As you can see with the very few examples I have just illustrated, it would be virtually impossible to run a modern economy based on a currency that fluctuates unpredictably, which is why I believe that Bitcoin will never serve as a major currency for a major economy. It may serve as a currency for people living in those countries where they cannot trust the government, but enormous costs would be incurred in using it as money for a whole economy. This is true for any type of money that cannot easily be created or destroyed, such as gold, since supply and demand could change the value of the currency frequently and unpredictably. Because central banks can adjust the supply of money in response to demand and the economy, inflation can be kept low and predictable, allowing the economy to function optimally. And this works because people usually trust the central bank in democracies, especially when it is insulated from the whims of politicians.
- Inflation is the rise of nominal prices of goods and services.
- Both the GDP deflator and the Consumer Price Index (CPI) measure inflation relative to some base year, by comparing prices in the target year over the base year.
- The CPI measures inflation of consumer goods and services, while the GDP deflator measures inflation of all goods and services, including purchases by businesses and governments.
- GDP Deflator = Nominal GDP / Real GDP × 100
- Inflation occurs when the product of the quantity and velocity of money grows faster than the economy.
- Over the long-term, the velocity of money is considered relatively constant, so inflation is caused primarily by increases in the money supply.
- There are 2 types of inflation distinguished by cause: demand-pull inflation and cost-push inflation.
- Demand-pull inflation is caused when aggregate demand grows faster than aggregate supply.
- As long as the growth of economic output exceeds the growth of the money supply, there will be no demand-pull inflation.
- When the economy reaches full employment, then there is no idle capacity, and additional investments yield diminishing margins of return, so prices increase.
- Cost-push inflation is caused by increases in the prices of factors of production, such as energy or labor. Rising per-unit production costs increases prices.
- Per-Unit Production Cost = Total Input Cost ÷ Output Units
- Cost-push inflation reduces economic output, since higher prices reduce aggregate demand.
- Nominal income is the dollar value of income, whereas real income is the purchasing power of that income.
- Real Income = Nominal Income / Price Index (in hundreds)
- Percentage Change in Real Income = Percentage Change in Nominal Income – Percentage Change in Average Price Level
- Inflation redistributes the wealth. People with fixed incomes will become poorer, but people with income with cost-of-living adjustments will suffer less. Debtors will profit over creditors, since the money used to pay back loans becomes less valuable over time.
- People can adjust to anticipated inflation, by asking for raises, for instance, but usually suffer from unanticipated inflation.
- Lenders adjust to anticipated inflation by adding inflation premium to the real interest rate.
- The nominal interest rate is the growth rate of the principal in dollars, while the real interest rate is the growth rate of the purchasing power of the principal.
- Nominal Interest Rate = Real Interest Rate + Inflation Rate
- The costs of inflation include lowering the value of held money, menu costs, which are costs associated with updating prices, such as with menus or signs, and economic distortions caused by inflation affecting some products and services before others.
- Uncertain inflation increases planning risks, especially for businesses.
- Inflation is overestimated because it's measurement does not include quality improvements, substitution effects, or the introduction of new products and services.
- Inflation also has benefits:
- helps to finance the government, since the government prints the money;
- can be used monetary policy to optimize the economy;
- can adjust sticky prices, since many people do not want to accept a lower price in some cases, such as lower prices for homes or lower wages.
- Deflation is a general decline in prices, caused when aggregate demand is less than aggregate supply. Deflation causes people to hold onto their money, causing a further contraction in the economy and a further decline in prices.
- Hyperinflation is extreme inflation caused by a government trying to solve fiscal problems or to enrich themselves by printing money.