Inflation is a continual increase in prices throughout a nation’s economy. The rate of inflation is determined by changes in the price level, an average of all prices. If some prices rise and others fall, the price level may not change. Therefore, inflation occurs only if most major prices go up.
Inflation reduces the value—also called the purchasing power—of money. During an inflationary period, a certain amount of money buys less than before. For example, a worker may get a salary increase of 10 percent. If prices remain stable, the worker can buy 10 percent more goods and services. But if prices also increase 10 percent, the worker’s purchasing power has not changed. If prices rise more than 10 percent, the worker cannot buy as much as he or she previously could.
Inflation has many causes. It may result if consumers demand more goods and services than businesses can produce. Inflation may also occur if employers grant wage increases that exceed gains in productivity. The employers pass most or all of the cost of the wage increase along to consumers by charging higher prices.
A government can try to control inflation by reducing its budget deficit or reducing the money supply. A budget deficit is the amount by which a government’s spending exceeds its revenue. The money supply is the total amount of money in a country, including cash and bank deposits. Most governments use their money supply to try to control inflation. This tool against inflation is called monetary policy.
The opposite of inflation is deflation, a decrease in prices throughout a nation’s economy. Deflation tends to occur during periods of economic depression.
Measuring inflation
Economists use measurements called indexes to determine changes in the price level. The indexes compare current prices with prices of an earlier period called the base period.
The most widely used price index in the United States is the Consumer Price Index (CPI). The CPI measures monthly changes in the price of a group of goods and services that people buy regularly. Such items include food, clothing, housing, and medical care. The total price of these items is compared with their total price during a base period. In 1995, for example, people in the United States paid about $152 for an assortment of goods and services that cost $100 during the 1982-1984 base period.
Other price indexes include the Producer Price Index and the Gross Domestic Product Deflator. The Producer Price Index calculates changes in the prices of regularly used products at various stages of production. The Gross Domestic Product Deflator, also called the Implicit Price Index or Implicit Price Deflator, measures price changes for everything produced within the country in a certain period.
Kinds of inflation
Mild inflation
occurs when the price level increases from 2 to 4 percent a year. If businesses can pass the increases along to consumers, the economy thrives. Jobs are plentiful, and unemployment falls. If wages rise faster than prices, workers have greater purchasing power. But mild inflation usually lasts only a short time. Employers seek larger profits during periods of economic growth, and unions seek higher wages. As a result, prices rise even further—and inflation increases.
Moderate inflation
results when the annual rate of inflation ranges from 5 to 9 percent. During a period of moderate inflation, prices increase more quickly than wages, and so purchasing power declines. Most people purchase more at such times because they would rather have goods and services than money that is declining in value. This increased demand for goods and services causes prices to rise even further.
Severe inflation
occurs when the annual rate of inflation is 10 percent or higher. This type of inflation is also called double-digit inflation. During a period of severe inflation, prices rise much faster than wages, and so purchasing power decreases rapidly.
When inflation is severe and unexpected—that is, not factored into wage and lending contracts—debtors benefit at the expense of lenders. If prices increase during the period of a loan, the debtor repays the debt with dollars less valuable than those that were borrowed. In terms of purchasing power, the lender does not get back as much money as was lent.
Severe inflation can also decrease a country’s output (goods and services produced) by reducing demand from both foreign and domestic buyers. An exchange rate is the price of one country’s currency in terms of another country’s currency. If exchange rates adjust slowly to changes in a country’s inflation rate relative to the inflation rate of countries it trades with, a country experiencing severe inflation might find its exports become more expensive relative to the goods and services of other countries. As a result, the demand for exported goods from the country with severe inflation would be reduced. At the same time, buyers who live in that country might find foreign goods and services cheaper, reducing demand for that country’s domestic output.
Hyperinflation
is rapid, uncontrolled inflation that destroys a nation’s economy. Money loses its value, and many people exchange goods and services instead of using currency. Hyperinflation occurs when a government spends much more money than it receives in taxes. The government then borrows or prints additional money to pay for the goods and services it needs. The increased demand for these items causes an overall increase in prices. The government then may have to print even more money to pay its expenses. The vast amount of money in circulation causes its value to drop sharply.
Hyperinflation has ruined the economies of some nations during or after wars. It caused the collapse of the German economy after World War I ended in 1918. The German government printed large amounts of currency to finance itself after the war. As a result, prices in Germany increased dramatically. In 1919, $1 in U.S. currency was worth a little more than 8 marks. But by 1923, $1 in U.S. currency was worth more than 4 trillion marks.
Effects of inflation
Mild inflation, according to some economists, encourages the growth of a nation’s economy. Moderate inflation causes some changes in consumer buying habits, and its economic effects increase if the inflation becomes severe. Hyperinflation, although rare, can significantly hurt a nation’s economic activity. This section focuses mainly on the effects of moderate and severe inflation.
Effects on consumer behavior.
During a period of inflation, many people feel l discouraged because their income cannot keep up with rising prices. They cannot plan for future expenses because they do not know how much their money will buy at any later time.
Some people buy more than usual during an inflationary period. Many borrow money or use credit for large expenses, rather than buying later when prices will probably have risen even further.
Some consumers fight the effects of inflation by bartering their services, doing their own home repairs, and making their own clothes. Shoppers may save money by avoiding luxuries and growing their own vegetables.
Effects on income.
Inflation affects people whose incomes do not increase at the same rate as inflation. Most pensions and other retirement benefits are fixed—that is, they neither increase nor decrease. Some benefits, such as U.S. Social Security benefits, are adjusted according to changes in price indexes. As the price level rises, money paid to people receiving these benefits also increases. This adjustment is known as indexing or indexation.
Indexation is also used to adjust interest rates, taxes, and wages and certain other earnings to correspond with the rate of inflation. Many union contracts provide automatic wage increases based on the inflation rate.
Effects on investment.
Some people try to protect themselves against inflation by investing in items that quickly increase in value. Such items include art objects, diamonds, gold bars, rare stamps, and gold and silver coins. Many people buy real estate during inflationary periods because the value of buildings and land increases rapidly at such times.
Effects on business.
Some businesses prosper during periods of inflation. They include credit-card agencies, discount stores, and agencies that collect overdue debts. Businesses that lease such items as cars and large appliances, which many people cannot afford to buy, also thrive at these times.
Theories about the causes of inflation
Economists have various theories that attempt to explain why inflation occurs. Many factors contribute to inflation. One element that is almost always present is an increase in a nation’s money supply, which either causes or eases the increase in prices.
Inflation occurs during many wars and periods of reconstruction that follow wars. At such times, a nation’s economy operates at full capacity, and the demand for goods and services exceeds the supply. This situation causes prices to increase.
The quantity theory
says inflation results when the demand for goods and services exceeds the supply. This situation occurs because the money supply rises faster than the rate at which goods and services are produced. Increased demand causes prices to increase, resulting in what is known as demand-pull inflation.
The Keynesian theory,
developed by the British economist John Maynard Keynes, also focuses on excess demand as the cause of inflation. Keynes believed that increased demand for goods and services should be met by expanded production. However, after a nation’s economy reaches full capacity, production cannot expand. If the demand for goods and services increases, prices continue to rise and inflation occurs. In such cases, Keynes recommended a tax increase, which would reduce the demand for goods and services and relieve the pressure on prices.
The cost-push theory.
When businesses raise their prices in response to cost increases, cost-push inflation results. Workers then may want higher wages to keep up with rising prices, and an upward wage-price spiral occurs.
Cost-push inflation also occurs if a limited number of businesses control the supply of certain products. A monopoly exists if one business controls an entire industry. In an oligopoly, so few companies provide a product or service that each of the firms can influence the price—with or without an agreement among them. In such controlled industries, consumers must buy from a limited number of sellers at prices set by the controlling firms. But if competition is intense, each firm tries to offer a better or cheaper product than the others.
In addition, cost-push inflation results if several firms form a cartel, a group of businesses that functions as a monopoly. A cartel may limit the supply of a product, such as oil or copper, to drive prices up and thus earn higher profits. If the product sold by the cartel is used to make other goods, the cost of those items will also rise.
Weapons against inflation
Fiscal policy
of a nation is reflected by the government’s spending and taxing programs. The government can use these programs to reduce the demand for goods and services. It can accomplish this goal by reducing its own spending. If the government buys less from businesses, sales go down and people have less money to spend. The government can also reduce the spendable income of consumers by raising taxes. If consumers spend less money, the demand for goods and services decreases—and prices level off.
Many people object to fiscal policy as a means of controlling inflation. They oppose a reduction in government spending because the funds involved help provide education, health care, and other services. No one wants to pay higher taxes, and a sharp reduction in demand often increases unemployment.
Monetary policy
is the program a nation follows to influence such economic factors as interest rates, the availability of loans, and the money supply. The monetary policy of the United States is controlled by the Federal Reserve System, an independent agency of the government. Most large U.S. commercial banks belong to the system. The Federal Reserve determines the amount of money that most deposit-taking institutions must have in their vaults or as deposits at Federal Reserve Banks. This amount is called a reserve requirement.
The Federal Reserve can try to reduce the rate of inflation by increasing interest rates. People take out fewer loans at higher interest rates and thus have less money to spend. As a result, the demand for goods and services decreases, and prices rise more slowly. When the Federal Reserve implements policies that cause interest rates to increase, it is said to be following a tight monetary policy.
Wage and price controls
are established by a government to limit wage and price increases during an inflationary period. When a wage-price spiral occurs, wages and prices increase continually to keep up with each other. Some economists believe that if a government limits these increases, wages and prices will eventually level off. Many other economists consider wage and price controls ineffective because such limits are difficult to establish and hard to enforce. Others believe wage and price controls interfere with the natural rise and fall of wages and prices. For the most part, wage and price controls have proven to be ineffective in advanced economies. Some developing countries still use them, but such controls seldom work.
