INFLATION Basics

[K.Karthik Raja]

INFLATION
In mainstream economics, inflation means a rise in the general level
of prices of goods and services over time.
This definition differs from that of monetary inflation, in which
inflation refers to the increase of the money supply, which is based
on the earliest definition of inflation, which concerned debasement of
the currency.
Economists agree that high rates of inflation are caused by high rates
of growth of the money supply.[2] 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 supply or demand for money. In the mid-
twentieth century, two camps disagreed strongly on the main causes of
inflation at moderate rates: the "monetarists" argued that money
supply dominated all other factors in determining inflation, while
"Keynesians" argued that real demand was often more important than
changes in the money supply.
In contrast to these two camps, the Austrian School maintains that
inflation is a distinct action taken by the state, meaning simply that
the central government or central bank permits or allows an increase
in the supply of monetary units either by its own actions or by its
inaction in controlling the growth of bank credit (i.e. the central
bank allows the debasement of the means of exchange by inflating the
money supply


Measures of inflation

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.
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.
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."

· 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.
· The 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.
· 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 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.

· True Money Supply (TMS)
Following their definition, Austrian economists measure the inflation
by calculating the growth of the money supply, i.e. how many new units
of money that are available for immediate use in exchange, that have
been created over time.


Causes of inflation
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In the long run inflation is generally believed to be a monetary
phenomenon while in the short and medium term it is influenced by the
relative elasticity of wages, prices and interest rates. 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 trendline. 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. According to the Austrian School,
inflation is a distinctive action taken by central bank, meaning the
creation of new units of money. This newly created credit is then
expanded due to the multiplying effect of the fractional-reserve
banking system.
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 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":
· 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.