Inflation
From Encyclopædia
Inflation is a process in which the
average level of prices increases at a substantial rate over a considerable period of time. In short, more
money is required each year to buy a given amount of goods and services. One can measure the rate of inflation as either the annual percentage rate of increase in the
average price level or decrease in the value of
money.Inflation properly refers only to episodes in which the rate of inflation is substantially positive over a considerable time period. What is meant by substantially positive may depend on recent experiences. In the
United States during the mid-1960s an inflation rate of 3% per year aroused great alarm, but some countries' governments have proclaimed victory over inflation by bringing the rate
Down from 50% or even 200% per year to only 10%. A deflation is the opposite of an inflation: a period of substantially falling prices and rising value of
money.EXPLANATIONS OF INFLATIONExplanations of inflation run along two lines: the general, or monetary, explanation and various special-factor explanations. The monetary explanation views inflation as always and everywhere the result of an excessive
growth rate of
money. Special-factor explanations relate each specific inflation to particular economic conditions that occur before or during the inflation.The monetary explanation starts with the observation that rising prices are the same thing as a falling value of
money. The more
money there is, relative to the goods and services to be bought, the less valuable is each dollar. A period of increasing prices occurs when the quantity of
money grows faster than real demand for it, measured in terms of the goods and services the
money buys. Thus, an inflation requires either a rapid
growth in the
money supply or a persistently falling real demand for
money.Rapid
money-supply
growth may occur for a
number of reasons, depending on the type of
money used in a country. When
money consisted of gold coins or paper exchangeable for gold, inflations followed major gold discoveries. In the
United States and most other countries
money is no longer convertible to a precious
metal but is either bank notes printed by the government or checking deposits exchangeable only for paper
money. Rapid monetary
growth can occur when the government sells securities to help finance a war or pay for other government programs, thus expanding the
money supply through deficit spending; in concert with the
Central bank the government may encourage
growth of the
money supply through an expansionary
monetary policy that increases bank reserves, and thus loanable funds. Countries may also increase their
money supply to maintain a stable domestic price for an inflating foreign currency, such as the U.S. dollar.Monetarist economists believe that unusual events may decrease the
growth rate of real-
money demand in any particular year but that over any considerable period of time these events
average out. As a result the
average growth rate of real-
money demand measured in terms of the goods or services to be bought is quite stable, and sustained inflations arise only from rapid
money-supply
growth. It is here that the special-factor explanations differ.Special-factor explanations focus on particular events or sequences of events--not necessarily directly related to the
money supply--to explain an episode of inflation. An example of this approach observes that a large increase in the price of imported oil would tend to make the consuming
nation poorer and so reduce its purchasing power and raise prices. A whole sequence of such events--and the absence of offsetting conditions (such as increased output) tending to increase real-
money demand--may be used to explain a given inflation. Responding, the monetarist posits that over periods of four or five years there is very little variation in the
growth of real
money measured in terms of purchasing power.A hybrid explanation of inflation begins with some special factor as the start of the proce?s. If the initial cause relates to the costs of producing goods and services, some economists have termed the process cost-push inflation. If, for example, the price of oil increases, the resulting increase in prices results in higher wage demands by workers who want to maintain their current standards of living. Producers may try to pass wage increases along to the consumer through higher prices; producers could meet increased wage demands by increased borrowing, which the
Central bank can accommodate through larger bank reserves, which increase the
money supply. The government
fears the temporary increase in unemployment that would result if the demands are frustrated. Thus, the argument goes, the government increases
money-supply
growth, which
leads to further price increases and starts the whole process over again. This sort of price-cost-
money vicious circle--or the so-called wage-price spiral--converts what might otherwise be a temporary increase in the rate of inflation into a substantial and sustained one.CONTEMPORARY INFLATIONThe
average level of U.S. prices grew very little from the end of the Korean War until the mid-1960s, when contemporary inflation began. Although more rapid
money growth began as early as 1962 or 1963, inflation did not immediately result. This delay occurred because the first effect of more rapid
money growth is temporarily to reduce unemployment and stimulate the output of goods and services. Subsequently, however, increased
growth in production costs--wages, rents, and equipment prices--results in higher final prices of goods and services purchased by consumers.The reasons for the increase in
money growth in the 1960s are not clear, but at least two factors seem to have been important. First, the economic disciples of John Maynard KEYNES gained new influence in the Kennedy and Johnson administrations. Many Keynesians supported the Phillips-curve model, which postulated a permanent trade-off between full employment and price increases; thus unemployment could be permanently reduced by increasing the rate of inflation by a few percentage points. Keynesian policy-makers therefore urged a stimulative
monetary policy that initially seemed to work better than anticipated. Only later did rapidly rising prices and simultaneous unemployment--together with analyses of Milton FRIEDMAN and others--demonstrate the fallacy of the Phillips-curve analysis. Second, increasing U.S. involvement in the
Vietnam War was financed by government deficit spending rather than taxation. Some economists argue that the inflation was especially difficult to curb because it was accompanied by a widespread economic slowdown, a phenomenon sometimes termed
stagflation. The traditional methods of encouraging economic
growth through monetary and fiscal policy, however, are designed to stimulate aggregate demand, and thus can result in further inflation.The government began programs to reduce excessive monetary
growth on several occasions--including 1969, 1973-75, and 1979-80--but each time the initial temporary increase in unemployment persuaded political leaders to abandon the program before inflation was much reduced. A wage-and-price-
Control program was tried (1971-74), but it also was abandoned as costly, inequitable, and with no real effect on inflation (see
INCOMES POLICY). Major price increases for imported oil occurred in 1973-74 and again in 1979-80, but these only slightly reduced real-
money-demand
growth so that their ultimate effect on inflation was small.Ronald Reagan's election as
president in 1980 was interpreted as a mandate to reverse the accelerating trend of inflation. The
executive branch supported and encouraged Federal Reserve efforts to reduce
growth in
money even at the cost of the major 1981-82 recession. Inflation in 1981 slowed somewhat from the above-10% rate of 1980 and averaged only about 4.5% per year over the ten years 1981-91. This performance was not achieved easily. The 1981-82 recession, a side-effect of the anti-inflationary policies, was the most severe since?
world War II. Once the economy adjusted to the lower inflation, however, real output and employment grew rapidly during 1983 and 1984 as they approached normal levels.Credit for the sharp reduction in inflation after 1980 generally starts with Paul VOLCKER, Federal Reserve chairman from 1979 to 1987. Volcker, with the active support of the Reagan administration from 1981, led the Federal Reserve to adopt a policy of slower
growth in the
money supply.When Alan GREENSPAN replaced Volcker in the summer of 1987, he inherited a
Federal Reserve System with a consensus that the
Central bank's goal should be to achieve stable prices. The Phillips-curve motivated attempt to use
monetary policy to lower unemployment was generally agreed a proven failure. It appears that the Federal Reserve was ready to take the next step of moving from 4-5% inflation to stable prices and to begin to reduce
money growth substantially. Tight
monetary policy contributed to the stock market crash of October 1987, forcing the Federal Reserve to retreat temporarily. In 1988 the Federal Reserve adopted a more gradualist approach aimed at gradually reducing inflation without causing a recession. The plan was for a period of slow
growth until the economy adjusted to stable prices, but the dramatic oil price increases following the August 1990 Iraqi invasion of Kuwait were sufficient to push the economy from slow
growth into the mild 1990-91 recession. Nonetheless, by 1991 the Federal Reserve strategy had lowered inflation to less than 3%.
