What is inflation?
Ceyda Oner
It may be one of the most familiar words in economics. Inflation has
plunged countries into long periods of instability. Central bankers
often aspire to be known as 'inflation hawks'. Politicians have won
elections with promises to combat inflation, only to lose power after
failing to do so.
Inflation was even declared Public Enemy No. 1 in the United States -
by President Gerald Ford in 1974. What, then, is inflation, and why is
it so important?
In an inflationary environment, unevenly rising prices
inevitably reduce the purchasing power of some consumers |
Inflation is the rate of increase in prices over a given period of
time. Inflation is typically a broad measure, such as the overall
increase in prices or the increase in the cost of living in a country.
But it can also be more narrowly calculated - for certain goods, such as
food, or for services, such as a haircut, for example.
Whatever the context, inflation represents how much more expensive
the relevant set of goods and/or services has become over a certain
period, most commonly a year.
Measuring inflation
Consumers' cost of living depends on the prices of many goods and
services and the share of each in the household budget.
To measure the average consumer's cost of living, government agencies
conduct household surveys to identify a basket of commonly purchased
items and track over time the cost of purchasing this basket. (Housing
expenses, including rent and mortgages, constitute the largest component
of the consumer basket in the United States.)
The cost of this basket at a given time expressed relative to a base
year is the consumer price index (CPI), and the percentage change in the
CPI over a certain period is consumer price inflation, the most widely
used measure of inflation.
(For example, if the base year CPI is 100 and the current CPI is 110,
inflation is 10 percent over the period.)
Core consumer inflation focuses on the underlying and persistent
trends in inflation by excluding prices set by the government and the
more volatile prices of products, such as food and energy, most affected
by seasonal factors or temporary supply conditions. Core inflation is
also watched closely by policymakers.
Calculation of an overall inflation rate - for a country, say, and
not just for consumers - requires an index with broader coverage, such
as the gross domestic product (GDP) deflator.
The CPI basket is mostly kept constant over time for consistency, but
is tweaked occasionally to reflect changing consumption patterns - for
example, to include new hi-tech goods and to replace items no longer
widely purchased.
Because it shows how, on average, prices change over time for
everything produced in an economy, the contents of the GDP deflator vary
each year and are more current than the mostly fixed CPI basket. On the
other hand, the deflator includes non-consumer items (such as military
spending) and is therefore not a good measure of the cost of living.
The good and the bad
To the extent that households' nominal income, which they receive in
current money, does not increase as much as prices, they are worse off,
because they can afford to purchase less. In other words, their
purchasing power or real - inflation-adjusted - income falls. Real
income is a proxy for the standard of living.
When real incomes are rising, so is the standard of living, and vice
versa.
In reality, prices change at different paces. Some, such as the
prices of traded commodities, change every day; others, such as wages
established by contracts, take longer to adjust (or are 'sticky', in
economic parlance).
In an inflationary environment, unevenly rising prices inevitably
reduce the purchasing power of some consumers, and this erosion of real
income is the single biggest cost of inflation. Inflation can also
distort purchasing power over time for recipients and payers of fixed
interest rates.
Take pensioners who receive a fixed five percent yearly increase to
their pension. If inflation is higher than five percent, a pensioner's
purchasing power falls. On the other hand, a borrower who pays a
fixed-rate mortgage of five percent would benefit from five percent
inflation, because the real interest rate (the nominal rate minus the
inflation rate) would be zero; servicing this debt would be even easier
if inflation were higher, as long as the borrower's income keeps up with
inflation.
The lender's real income, of course, suffers.
To the extent that inflation is not factored into nominal interest
rates, some gain and some lose purchasing power. What Indeed, many
countries have grappled with high inflation - and in some cases
hyperinflation, 1,000 percent or more a year.
In 2008, Zimbabwe experienced one of the worst cases of
hyperinflation ever, with estimated annual inflation at one point of 500
billion percent. Such high levels of inflation have been disastrous, and
countries have had to take difficult and painful policy measures to
bring inflation back to reasonable levels, sometimes by giving up their
national currency, as Zimbabwe has. Although high inflation hurts an
economy, deflation, or falling prices, is not desirable either.
When prices are falling, consumers delay making purchases if they
can, anticipating lower prices in the future. For the economy this means
less economic activity, less income generated by producers, and lower
economic growth.
Japan is one country with a long period of nearly no economic growth,
largely because of deflation.
Preventing deflation during the global financial crisis that began in
2007 is one of the reasons the U.S. Federal Reserve and other central
banks around the world have kept interest rates low for a prolonged
period and have instituted other monetary policies to ensure financial
systems have plenty of liquidity.
Today global inflation is at one of its lowest levels since the early
1960s, partly because of the financial crisis. Most economists now
believe that low, stable, and - most important - predictable inflation
is good for an economy.
If inflation is low and predictable, it is easier to capture it in
price-adjustment contracts and interest rates, reducing its
distortionary impact.
Moreover, knowing that prices will be slightly higher in the future
gives consumers an incentive to make purchases sooner, which boosts
economic activity.
Many central bankers have made their primary policy objective
maintaining low and stable inflation, a policy called inflation
targeting (see 'Inflation Targeting Turns 20,' in this issue).
What creates inflation?
Long-lasting episodes of high inflation are often the result of lax
monetary policy. If the money supply grows too big relative to the size
of an economy, the unit value of the currency diminishes; in other
words, its purchasing power falls and prices rise.
This relationship between the money supply and the size of the
economy is called the quantity theory of money, and is one of the oldest
hypotheses in economics. Pressures on the supply or demand side of the
economy can also be inflationary. Supply shocks that disrupt production,
such as natural disasters, or raise production costs, such as high oil
prices, can reduce overall supply and lead to 'costpush' inflation, in
which the impetus for price increases comes from a disruption to supply.
The food and fuel inflation of 2008 was such a case for the global
economy - sharply rising food and fuel prices were transmitted from
country to country by trade. Conversely, demand shocks, such as a stock
market rally, or expansionary policies, such as when a central bank
lowers interest rates or a government raises spending, can temporarily
boost overall demand and economic growth.
If, however, this increase in demand exceeds an economy's production
capacity, the resulting strain on resources is reflected in
'demand-pull' inflation.
Policymakers must find the right balance between boosting demand and
growth when needed without overstimulating the economy and causing
inflation. Expectations also play a key role in determining inflation.
If people or firms anticipate higher prices, they build these
expectations into wage negotiations and contractual price adjustments
(such as automatic rent increases).
This behaviour partly determines the next period's inflation; once
the contracts are exercised and wages or prices rise as agreed,
expectations have become self-fulfilling.
And to the extent that people base their expectations on the recent
past, inflation will follow similar patterns over time, resulting in
inflation inertia.
How policymakers deal with inflation
The right set of anti-inflation policies, those aimed at reducing
inflation, depends on the causes of inflation. If the economy has
overheated, central banks - if they are committed to ensuring price
stability - can implement contractionary policies that rein in aggregate
demand, usually by raising interest rates.
Some central bankers have chosen, with varying degrees of success, to
impose monetary discipline by fixing the exchange rate - tying its
currency to another currency and, therefore, its monetary policy to that
of the country to which it is linked.
However, when inflation is driven by global rather than domestic
developments, such policies may not help. In 2008, when inflation rose
across the globe on the back of high food and fuel prices, many
countries allowed the high global prices to pass through to the domestic
economy. In some cases the government may directly set prices (as some
did in 2008 to prevent high food and fuel prices from passing through).
Such administrative price-setting measures usually result in the
government's accrual of large subsidy bills to compensate producers for
lost income.
Central bankers are increasingly relying on their ability to
influence inflation expectations as an inflation-reduction tool.
Policymakers announce their intention to keep economic activity low
temporarily to bring down inflation, hoping to influence expectations
and contracts' built-in inflation component.
The more credibility central banks have, the greater the influence of
their pronouncements on inflation expectations. (Courtesy: Finance
and Development, March 2010) Ceyda Oner is an Economist in the IMF's
Asia and Pacific Department. |