Like every Friday, from Raj Nallari and Breda Griffith's lecture notes.
Simply put, inflation is defined as the increase, over a given period, in the price of a representative basket of goods and services.
Inflation is measured by observing the change in the price of a representative basket of goods and services in an economy. The prices of goods and services are weighted in order of importance and combined to give a price index measuring the average price level; the inflation rate is the percentage rate of increase in this index.
Some common inflation measures include:
- Consumer price indexes (CPI) - these measure the price of a selection of goods and services purchased by the average consumer. These measures are often used in wage and salary negotiations since employees wish to have pay raises that equal or exceed the cost of living, best proxied by rate of increase of the CPI.
- Wholesale or Producer price indexes (WPI) – measure the price paid by a representative producer. This differs from the CPI since price subsidies, profits and taxes cause the amount received by the producer to differ from that paid by the consumer.
- Commodity price indexes measure the change in price of a selection of commodities.
- The GDP deflator is a measure of the changes in prices of all goods and services produced in an economy. Although this measure has the advantage of being comprehensive, it typically is only available quarterly, with a long lag, and is subject to revision.
Inflation is a sustained rise in the general price levels, combined with a fall in the purchasing power of money. If inflation is zero or very low, this is referred to as price stability. Under conditions of price stability, inflation is seen as having no material impact on individual economic decision making. Moreover, a low, but positive inflation rate (say 2 percent a year or less) can have positive effects on the economy since it allows relative prices or wages to adjust more easily. This can keep unemployment lower than it otherwise would be. However, once inflation rises above certain levels, it can distort decision making and can have negative effects on the economy and growth.
Types of Inflation
Economists distinguish between two types of inflation:
- Demand-pull inflation – occurs when there is too much money chasing too few goods, because the demand for current output by consumers, investors and government exceeds available supply. Because, under such conditions, resources are fully employed, the business sector cannot respond to this excess demand by expanding output, so they typically react by pushing up prices instead. If these conditions are sustained, the result is demand-pull inflation.
- Supply-side inflation or cost-push inflationt - occurs when a firm passes on an increase in production costs to the consumer in the form of higher prices. The inflationary effect of increased costs can be the result of: i) increased wages leading to: a) wage – price spiral, which occurs when price increases spark off a series of wage demands which lead to further price increases and so on. b) a wage-wage spiral, which occurs when one group of workers receive a wage increase which sparks off a series of wage demands from other workers ii). increased import prices which can be the result of: a) a rise in world prices for imported raw materials b) a depreciation in the local currency.
Central banks can impact inflation to a significant extent through setting interest rates and the use of monetary policy. High interest rates are the method of fighting inflation that Central Banks often resort to in order to fight inflation, using the resulting decline in production and unemployment to prevent price increases. However different central bankers have varying approaches to fighting inflation.
Some emphasize increasing interest rates by reducing the money supply through monetary policy to fight inflation. Another school of thought advocates fighting inflation by pegging the exchange rate between the currency and a stable reference such as the dollar. These different methods have met with differing measures of success: in spite of efforts to curb inflation, some nations have experienced double-digit, triple-digit or even astronomical annual rates of inflation in recent years.
The Cause of Inflation
As we have seen, inflation is often explained by excess demand conditions or through producers passing on higher costs in the form of higher prices. But for either condition to hold, the central bank plays a critical role. If the central bank pursues a tight monetary policy – by using instruments to increase interest rates or restrict the money supply – excess demand will be wrung out of the system and producers will not be in a position to pass on all their costs in the form of higher prices. On the other hand, an accommodative monetary policy stance – low interest rates of rapid expansion of the money supply - will allow prices increase to continue or even accelerate.
Fiscal policy can either support or hinder monetary policy operations. Prudent fiscal policies allow the government to get by with zero or minimal central bank borrowing (leading to zero or minimal excess money creation). By contrast, profligate fiscal policy and high central bank borrowing can force a central bank into a looser monetary stance.
Next week: Inflation and Economic Growth / Inflation and the Poor