Inflation: Encyclopedia II - Causes of inflation

Inflation - Causes of inflation

There are different schools of thought as to what causes inflation. The two most prevalent theories are the neo-classical theory that inflation is driven by increases in the money supply, often used to finance government spending and the neo-Keynesian view that inflation is the result of diminishing returns of productivity.

Inflation - Monetary Theory

One of the most widespread theories of inflation is also the most straightforward: inflation is an increase in the supply of money at a rate greater than the expansion in the size of the economy. This is practically measured by comparing the GDP deflator to the rate of increase of the money supply, and setting the interest rate through the central bank to maintain a constant quantity of money. This view differs from the Austrian school below in that it focuses on a "quantity of money" theory, rather than the "quality of money" theory. In the monetarist framework, it is the aggregate money supply which is important.

The Quantity Theory of Money, simply stated, is that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:

P is the general price level of consumers' goods, D_C is the aggregate demand for consumers' goods and S_C is the aggregate supply of consumers' goods. The idea behind this formula is that the general price level of consumers' goods will rise only if the aggregate supply of consumers' goods goes down relative to the aggregate demand for consumers' goods, or if the aggregate demand increases relative to the aggregate supply of consumers' goods. Based on the idea that total spending is based primarily on the total amount of money in existence, the economists calculate aggregate demand for consumers' goods based on the total quantity of money. Therefore, they posit that as the quantity of money increases, total spending increases and the aggregate demand for consumers' goods increases as well. For this reason the economists who believe in the Quantity Theory of Money also believe that the only cause for rising prices in a growing economy (ie an economy in which aggregate supply is increasing), is an increase of the total quantity of money in existence, which is caused by monetary policies of central banks.

From this perspective, the root cause of inflation is an increase in money supply over demand for money, and therefore "inflation is always and everywhere a monetary phenomenon", as Friedman puts it. This means that controlling inflation rests on monetary and fiscal restraint: the government must neither make it too easy to borrow, nor must it borrow excessively itself. This view focuses on the importance of controlling central government budget deficits and interest rates, as well as the productivity of the economy, which is, in effect, "cost pull" inflation.

More broadly neo-classical theory asserts that government contribution to aggregate demand by borrowing is the main culprit in the central bank taking an accommodative stance, because governments have the ability to borrow even when ordinary borrowers would retrench from rising interest rates. In this model, the fiscal authority spends, and the monetary authority, which may or may not be nominally independent, accommodates this spending by increasing the money supply to allow it. In its most direct form, the government simply writes checks backed without assets and uses them to pay for government spending. Hence reducing budget deficits and constraining budget spending is a key part of neo-classical theory and fighting inflation.

Inflation - Neo-Keynesian Theory

According to Neo-Keynesian economic theory there are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":

• Demand pull inflation - inflation due to high demand for GDP and low unemployment, also known as Phillips Curve inflation.

• Cost push inflation - nowadays termed "supply shock inflation", due to an event such as a sudden increase in the price of oil.

• Built-in inflation - induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up 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. It is also known as "inertial" inflation, "inflationary momentum", and even "structural inflation".

These three types of inflation can be added up at any time to get an explanation of the current inflation rate. However, over time, the first two (and the actual inflation rate) affect the amount of built-in inflation: persistently high (or low) actual inflation leads to higher (lower) built-in inflation.

Within the context of the triangle model, there are two main elements: movements along the Phillips Curve, for example as unemployment rates fall, encouraging greater inflation, and shifts of that curve, as when inflation rises or falls at a given unemployment rate.

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 has been seen most graphically when governments have financed spending in a crisis by increasing the amount of currency in circulation to avoid the results of economic collapse, sometimes during wartime conditions. This has lead to hyperinflation where prices rise at extremely high rates in short periods of time in extreme cases.

A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. In classical Keynesian economics this model suggested that price stability was a trade off against employment. Therefore some level of inflation could be considered desirable in order to minimize unemployment. The Philips curve model described the US 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. The modern use of the Phillips curve relates payroll growth to the general inflation rate, rather than relating the unemployment rate to the inflation rate, and suggests that trade offs between inflation and employment are based on the change in the rate of inflation, rather than the inflation rate itself.

In this model, increases in aggregate demand drive prices upwards, as suppliers are aware that they have pricing power, which leads to more people working, which leads to increased aggregate demand.

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) due to 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 Keynesian concept 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 NAIRU or the "natural" rate of unemployment or the full-employment unemployment rate. In this framework, the built-in inflation rate is determined endogenously (by the normal workings of the economy):

• if GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that, all else equal, inflation will accelerate as suppliers increase their prices and built-in inflation worsens. This causes the Phillips curve to shift in the stagflationary direction, toward greater inflation and greater unemployment. This kind of "inflationary acceleration" may have been seen in the late 1960s in the U.S., when Vietnam war spending (counteracted only by small tax hikes) kept unemployment below 4 percent for several years.

• if GDP falls below its potential level (and unemployment is above the NAIRU), all else equal inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation: there is disinflation. This causes the Phillips curve to shift in the desired direction, toward less inflation and less unemployment. This disinflation may have been seen in the early 1980s, when Fed chief Paul Volcker's anti-inflation campaign kept unemployment high for several years and at almost 10 percent for two years.

• If GDP is equal to potential (and the unemployment rate equals the NAIRU), the inflation rate will not change, as long as there are no supply shocks. In the "long run," most neo-Keynesian macroeconomists see the Phillips Curve as vertical. That is, the unemployment rate is given and equal to the NAIRU, while there are a large number of possible inflation rates that can prevail at that unemployment rate.

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 due to policy: for example, high unemployment under Prime Minister Margaret Thatcher in the U.K. may have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed, unable to find jobs that fit their skills in the British economy. 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.

Most non-Keynesian theories of inflation can be understood within the neo-Keynesian perspective as assuming that the NAIRU and potential output are both unique and are attained relatively quickly. With the "supply side" at a fixed level, the amount of inflation is then determined by aggregate demand. The fixed supply side also implies that government and private-sector spending are always in conflict, so that government deficit spending leads to crowding out of the private sector and has no effect on the level of employment. Thus, it is only the money supply and monetary policy that determine the inflation rate.

For these reasons neo-Keynesian theory focuses on productivty, because it is falling productivity which signals diminishing returns of production, and therefore inflationary pressures from overheating and output above "potential". From the neo-Keynesian perspective budget balancing and restraints on spending do not control inflation, and persistent budget deficits do not cause inflation. What causes inflation is an increase in the velocity of money, and the reduction in efficiency caused by excessive present consumption versus investment. That is, a savings rate that is too low to fund the improvements in production required to keep pace with increases in aggregate demand. Consequently neo-Keynesians such as Franco Modigliani warned that it is an insufficient savings rate which is the better predictor of future inflation.

In the 1980s several industrialized nations experienced persistent inflation, and attempted to address it by cutting budgets and engaging in IMF backed austerity plans. These plans had the paradoxical effect of causing people to flee the main currency, and pushing up the inflation rate. The next round of programs were targeted at reducing budget deficits, but they focused on ending wage indexing and on cutting government subsidies for commodities, instead of simply reducing government spending in the aggregate. Neo-Keynesians argue that the experience of Israel, Argentina, Bolivia and Brazil in dealing with inflation and hyperinflation shows that government budget deficits are exogenous to money supply growth, and that therefore central banks which are accommodating them may not have the autonomy to constrict the money supply. Thus it is fiscal, not monetary policy, which is the main agent for driving inflation where governments use seigniorage as an active source of revenue where the market for money clears.

Inflation - Other theories of inflation

• Austrian economics focuses on a theory related to the "quality of money", or the expectation by holders of debt and currency that the purchasing power of their holdings will remain stable. This view is related to the ideas of "business confidence" which are still widely held, and to arguments in favor of a gold standard, as well as arguments that the credibility of a central bank is important for fighting inflation. In the Austrian view, however, this concept is far more rigorously defined, as holding the notes or other instruments of a government is regarded as less preferable to holding the original commodity which is the store of value. Since at its base Austrian economics asserts that there is no such thing as "money" but merely a set of inter-related commodities, some of which have greater stability of purchasing power than others, the Austrian view of inflation is that notes are a substitute, and only a substitute, for some commodity of value, or are backed only by the force of the government issuing them.

In this view, actions which undermine the linkage between the original commodity and the notes undermine the quality of the currency, and by Gresham's Law individuals will preferentially spend those notes whose future buying power is less certain, in preference to others where the value is more certain. That is, "bad money will drive out good." Actions taken by governments which undermine property rights are seen as contributing to inflation. Austrian economics also argues for very strong forms of hedonic adjustment, in that falls or rises in price level which are related to improvements in technology should not be considered to be "inflation". Hence the key policies for inflation fighting in an Austrian framework are incentives for investment and entrepreneurship - which improve productivity, and protection of property rights, which maintain confidence in the linkage between currency and the underlying commodities which store value.

While this view is unorthodox in neo-classical economics, it is not without its analogs in other forms of economic theory, which accept the idea that contagion can destabilize currencies, and a lack of transparency can diminish confidence in an economy or currency. It also relates to the neo-Keynesian view that it is productivity which is the key lens for predicting inflation. In an Austrian framework improved productivity does not produce deflation, even if prices are falling.

• Supply-side economics asserts that inflation is always caused by either an increase in the supply of base money or a decrease in the demand for base money (or both). The value of money is seen as being purely subject to these two factors. Thus the inflation experienced during the Black Plague in medieval Europe is seen as being caused by a decrease in the demand for money as the volume of production and trade fell, while the inflation of the 1970s is regarded as been initially caused by an increased supply of money that occurred following the US exit from the Bretton Woods gold standard. Supply-side economics asserts that the money supply can grow without causing inflation as long as the demand for money also grows at the same rate.

One of the factors that supply side economists say was instrumental in ending the US experience of high inflation was the economic expansion of the 1980s ushered in by lower taxes. The argument is that an expanding economy creates an increased demand for base money and in so doing it counteracts inflationary forces. An expanding economy can be seen as frequently leading to an increased demand for money, and, all else being equal, an increase in the value of money. In international currency markets this principle is mostly undisputed, however, supply side economists argue that economic expansion increases the domestic valuation of money and not just the international valuation.

• Welfare economics takes the concept that the real purchasing power of an individual is measured in the basket of commodities that they can command. Therefore, it measures standard of living differently from GDP and price level, and instead uses the concept of "welfare" or happiness grounded in other measures. Neoclassical economics defines utility as being related to price, and therefore does not need to look at separate components of general welfare individually, only their aggregate price. This view is used by Marxian economists to argue that production and not consumption should be central to the definition of inflation.

This view stands outside that of mainstream economic thought, but is influential in political economy. Measures of well being are used by NGOs in arguing for greater aid, and Nepal has adopted a happiness, rather than product based measure of standard of living.

Adapted from the Wikipedia article "Causes of inflation", http://en.wikipedia.org/wiki/Inflation, under the G.N U Free Docmentation License. Please also see http://en.wikipedia.org/wiki