INFLATION. Inflation is a long-term, sustained rise in the general level of prices, as measured by a consumer price index. For early modern European history, the best known of these are the "basket of consumables" indexes devised by Earl Hamilton for Spain (for the period 1501–1650), by Henry Phelps Brown and Sheila Hopkins for southern England (1264–1954), and by Herman van der Wee for the Antwerp-Lier-Brussels region of Brabant (1401–1700). In European economic history, undoubtedly one of the longest and certainly the best-known era of inflation was the so-called price revolution of circa 1515–1650 (See Table 1). If we take the decade 1501–1510 as the base, for which the average price index in all three regions equals 100, and then calculate five-year means of these price indexes, we would find, by the final quinquennium 1646–1650, that the Spanish index had risen to 457.09; the English index to 697.54; and the Brabantine index to 845.07 (i.e., an 8.45-fold increase). Thus, one may observe that, during this 135-year period, inflation was a Europewide phenomenon, but that its intensity and impact varied by region, according to local circumstances. Thereafter, prices fell in most of western Europe, as, by 1656–1660, to an index of 614.45 in Brabant and to 569.56 in England.
REAL (DEMOGRAPHIC) AND MONETARY FACTORS IN INFLATION: THE EQUATION OF EXCHANGE
In the literature of early modern economic history, the predominant though quite misleading explanation for this inflation has been population growth. To be sure, population growth, acting upon relatively fixed (inelastic) land and other natural resources, resulting in diminishing returns and rising marginal costs, may well explain the rise in the relative prices of some specific commodities, such as grain and timber (whose English prices did rise the most over this 130-year period). But demographic factors alone cannot explain a rise in the price level; for inflation is fundamentally though not uniquely monetary in origin and character. Indeed, since England's population in the early 1520s was only
|Composite Price Indexes for Brabant, Southern England, and Spain (Castile)|
|IN QUINQUENNIAL MEANS: 1501–05 TO 1646–50|
|INDEX: MEAN OF 1501–10 = 100|
|Years||Brabant 1501–10=100||England 1501–10=100||Spain 1501–10=100 Silver-Based||Spain 1501–10=100 Vellon from 1597*|
|* Vellon was a largely copper-based coinage, with little but diminishing amounts of silver. The high-denomination and basically pure silver and gold coins were not debased. From 1597 this index is based on actual Spanish prices, while the silver-based index is based on Hamilton's estimates of prices based on the silver contents of the entire coinage (i.e., as if the vellon coinage had been excluded).|
about 2.25 million, evidently less than half the late-medieval peak of about 5.0 million in 1300, it is inconceivable that any renewed population growth in the following three decades could have produced the ensuing inflation, by which the mean price index more than doubled, to a mean of 218.12, in the quinquennium 1546–1550.
The relationship between monetary and socalled "real factors" (population, investment, technology, trade) can be best expressed by the Equation of Exchange, M.V = P.y, which is a modified version of the famous Fisher Identity. On the righthand side, P stands for the price level, as measured by one of the aforementioned "basket of consumables" indexes; and y represents the real (deflated) value of net national income (NNI) = net national product (NNP = Gross National Product minus depreciation), replacing the unmeasurable T (total transactions) in the original Fisher Identity. On the left-hand side, M is the total stock of available money, which, in this era meant gold and silver coins, supplemented by some credit instruments; and V represents the income velocity of money: the rate at which a unit of money (e.g., the silver penny) circulates in producing aggregate national income y.
A much earlier generation of economists had quite fallaciously believed that both V and T (or y) were fixed, at least in the short run, so that changes in the quantity of money M necessarily produced a proportional change in the price level P. But since all four of these variables are in fact always variable, an increase in M need not produce any inflation, because it could be offset by a fall in V and a corresponding rise in y, that is, by stimulating real economic growth. Indeed, Keynesian economists believe that, since a high level of V reflects society's efforts to economize on scarce stocks of money, an increase in M should be offset by some fall in V, a theorem that can be historically demonstrated for much of western Europe from the thirteenth to nineteenth centuries, with one significant exception: the price revolution era, when V may have doubled.
For this era, we may conclude that the product of M.V ultimately expanded to a greater extent than did the real growth of national income y (or NNP), so that inflation (rising P) ensued. Population growth (more than doubling, in England, to 5.60 million by 1651) may have played a dual role in this inflation: by inducing diminishing returns and rising marginal costs in the agricultural and extractive industries, thus restricting the rate of economic growth; and by inducing a rise in V (income velocity), through changes in demographic structures (higher dependency ratios) and market structures, with increased urbanization and commercialization.
THE CAUSES OF THE EUROPEAN PRICE REVOLUTION, 1515–1650
But if the crude quantity theory of money is historically fallacious, nevertheless changes in money stocks and money instruments do remain paramount in explaining the price revolution. Monetary expansion in fact had begun far earlier, with Portuguese imports of West African gold from the 1460s, but most especially with the central European silver-copper mining boom, also from the 1460s. It may have increased European silver stocks fivefold by the 1540s (to possibly 90,000 kg per year); and a considerable stock of underutilized resources may explain why inflation did not ensue until after 1510. Only from the 1540s did an influx of Spanish American silver become truly important, with imports rising from an annual mean of 16,816 kg in 1541–1545 to a peak of 273,705 kg in 1591–1595 (223,027 kg in 1621–1625). But of equal monetary importance was a veritable financial revolution in negotiable credit, established in the Habsburg Netherlands and England from the 1520s: with effective institutions for legally enforceable transactions in negotiable bills of exchange, bills obligatory (promissory notes), and government annuities (rentes). Indeed in Habsburg Spain the issue of negotiable annuities (juros) (many of which were traded on the Antwerp Bourse) rose from 3.6 million ducats in 1516 to 80.4 million ducats in 1598 (death of Philip II). The impact of such changes in both private and public credit increased both the effective money supply and certainly its velocity of circulation.
One may therefore wonder why the degree of inflation was so much less in Spain than in the Netherlands (Brabant) and England. The principal reason lies in another monetary factor. For coinage debasements were absent in Spain before 1597 but had become quite drastic in sixteenth-century England ("Great Debasement" of 1542–1552) and in the southern Netherlands (less drastic, though more prolonged). Furthermore, credit undoubtedly played a smaller role in the relatively undeveloped Spanish economy.
THE CONSEQUENCES OF THE EUROPEAN PRICE REVOLUTION
Only a summary of the consequences of inflation may be suggested here. In general, inflation redistributes income from wage earners and those living on fixed incomes, especially landowners with many hereditary tenures, or leaseholds on long-term contracts, to merchants and industrialists, in particular. Many in the latter group certainly benefited from a general lag of wages behind prices, even if industrial prices rose much less than did grain prices; and, given the vital importance of capital in the economy, most merchants and industrialists benefited from a fall in real interest costs, all the more so since nominal as well as real interest rates fell over this entire period throughout western Europe. Many peasants or small landholders also gained, insofar as their rents remained fixed, while the prices of the products that they sold in the market continued to rise. On the other hand, some undoubtedly did suffer the consequences of population growth, at least in areas of partible inheritance, which thus meant a significant subdivision of holdings. A balance sheet of winners and losers from inflation would be most difficult to construct for the price revolution era.
See also Capitalism ; Economic Crises ; Landholding ; Money and Coinage ; Peasantry .
Fisher, Douglas. "The Price Revolution: A Monetary Interpretation." Journal of Economic History 49 (December 1989): 883–902.
Goldstone, Jack A. "Urbanization and Inflation: Lessons from the English Price Revolution of the Sixteenth and Seventeenth Centuries." American Journal of Sociology 89 (1984): 1122–1160.
Lindert, Peter. "English Population, Wages, and Prices: 1541–1913." Journal of Interdisciplinary History 15, no. 4 (spring 1985): 609–634.
Mayhew, Nicholas. "Population, Money Supply, and the Velocity of Circulation in England, 1300–1700." Economic History Review, 2nd ser., 482 (May 1995): 238–257.
Munro, John. "The Monetary Origins of the 'Price Revolution': South German Silver Mining, Merchant-Banking, and Venetian Commerce, 1470–1540." In Global Connections and Monetary History, 1470–1800. Edited by Dennis O. Flynn, Arturo Giráldez, and Richard von Glahn. Aldershot, U.K., 2002.
Ramsey, Peter H., ed. The Price Revolution in Sixteenth Century England. London, 1971.
John H. Munro
The standard hot Big Bang cosmology has developed into a remarkably precise, well-tested theory of the evolution of the universe from its primordial state into the complex cosmos of today. Measurements of high precision have been performed over the last decade, confirming the basic predictions of the theory including Hubble's expansion law, the thermal spectrum of the cosmic background radiation, and the primordial abundances of the elements. A concordance model has emerged that with only a few parameters succeeds in fitting a great array of astronomical data ranging from the abundance and distribution of galaxies to the temperature pattern of the radiation left over from the Big Bang.
Despite its extraordinary success, the standard cosmology is clearly incomplete. It fails to answer many basic questions: Why is the universe so large, so smooth, and so geometrically flat on large scales? What was the original driving force behind the expansion of the universe? What was the origin of the density inhomogeneities that eventually grew to form galaxies, stars, and planets?
In the standard theory, it is assumed that the universe began in a hot, dense state that was almost uniform over macroscopic scales and undergoing very rapid expansion. Such a state is very special. Gravity tends to amplify density variations because denser regions undergo gravitational collapse and less dense regions fly apart. The beginning of the Big Bang had to be carefully adjusted to be very uniform and flat on large scales, with small variations at a level of about one part in a hundred thousand, just sufficient to lead to the formation of the observed structures.
The near uniformity of the temperature of the cosmic microwave sky provides a dramatic illustration of how special the initial conditions for the hot Big Bang had to be. Radiation received from opposite points on the sky is found to be at very nearly the same temperature. However, at least naively, the two emitting regions could not have been in causal contact because light from both is only now reaching the Earth. The puzzle therefore is the apparently strong correlation in the state of the universe on scales so large that no communication has been possible over the entire age of the universe.
Cosmic inflation was proposed by Alan Guth in 1979, although it was prefigured in the prior work of Alexei Starobinsky and others. It provides a beguilingly simple resolution of these basic puzzles. The basic idea is that an exotic form of matter (the simplest being scalar field matter) can have repulsive gravitational fields. If such matter was the dominant component of the early universe, it would have caused the universe to expand exponentially, making it very large, homogeneous, and flat. The most remarkable side-effect is that microscopic short-wave-length quantum mechanical variations in the scalar field matter are exponentially stretched and amplified during inflation, leading to very large-scale density variations. This provides a beautifully economical mechanism for the formation of structure in the universe, within a smooth background. So compelling, in fact, that for two decades inflation has dominated theoretical cosmology and to a large extent even set the agenda for observations.
The basic idea for inflation dates back to the 1930s when cosmological solutions to the equations of Einstein's theory of general relativity were still being developed. It was realized by Willem de Sitter, among others, that these equations allowed one to introduce an arbitrary constant, which became known as the cosmological constant. If this constant is positive, it causes the scale factor of the universe to grow exponentially and without bound. The cosmological constant was later interpreted as describing the energy density of the vacuum, that is, empty space. This vacuum has to be invariant under the Lorentz transformations of special relativity, and it follows that it possesses a negative pressure P equal in magnitude to its density ρ times the speed of light c squared. In equations, the stress energy tensor where gμν is the space-time metric.
In general relativity, one equates 8πGTμν to the Einstein tensor Gμν, measuring the curvature of space-time. A homogeneous, isotropic universe only evolves via an overall scale factor R , which is a function of time. Einstein's equations read: written in "Newtonian" form: G is Newton's gravitational constant, and M (R ) is the mass in a sphere of radius R . Units have been chosen so that the speed of light c is unity. If the pressure is small, P ≪ρ, then one sees that for ordinary matter with positive energy, gravity is attractive. A universe that starts out static will tend to collapse. However, for matter in the form of a cosmological constant, equation (1), P = -ρ, and instead one finds gravity to be repulsive. The two solutions to (2) are easily obtained: as long as ρ is constant. The physical consequence is that a universe dominated by positive vacuum energy density will generally expand exponentially, since the exponentially growing solution quickly dominates over the contracting one. Homogeneity is assumed here, but a nearly homogeneous region will also start to grow exponentially. And once exponential expansion begins, it will dilute the density of matter (which scales as R-3) or radiation (which scales as R-4), whereas the cosmological constant, or vacuum energy, remains constant. One finds in consequence that a positive cosmological constant causes expansion, which dilutes any matter or radiation initially present. It may also be shown that any curvature of space is likewise expanded away. Literally, the expansion of the universe blows the universe up, and if one assumes that the universe prior to inflation was smooth and flat on small scales, inflation caused it to become smooth and flat on large scales.
All of this is interesting but not useful. After all, the universe has large amounts of matter and radiation today, and these must have dominated in the early universe if the theory of the abundances of the elements is to work. What Guth realized is that a certain form of matter postulated in unified theories of high-energy physics could provide a temporary cosmological constant in the early universe. The density ρ can be nearly constant for some time but then decay into other forms of matter. When it does so, the exponential expansion ceases, and the standard hot Big Bang evolution can begin.
The form of matter in question is known as scalar field matter. This was developed in the early days of quantum field theory as a description of elementary particles (pions) before it was realized that pions are actually made out of quarks. Later, Peter Higgs realized that scalar fields could be used to give other fields a mass in particle physics, and Steven Weinberg and Abdus Salam built a detailed model of the weak interactions incorporating this mechanism. Particle physics experiments continue to decisively probe for the existence of the Higgs particle. If it is found, it will be the first proof that scalar field matter of the type needed for inflation actually exists. (The Higgs scalar field does not drive inflation because its potential V (ф) [see below] is not sufficiently flat).
For simplicity, consider a spatially uniform scalar field ф. In an expanding universe, it evolves in time according to the equation where V (ф) is an arbitrary function of ф, known as its potential. This equation is just for a ball moving in a one-dimensional potential, along with a damping term that depends on the rate of expansion of the universe. To describe cosmology with scalar field matter, the density and pressure must be determined: From the last equation here and equation (2), it follows that if the kinetic energy of the field is small, the scalar field causes R to accelerate, leading to exponential expansion.
A potential of the form shown in Figure 1 (e.g., a simple quadratic, V αф2) allows one to start the universe with a temporary cosmological constant as follows. The slope of V (ф) is chosen to be shallow, so that it is possible for ф to roll slowly downhill. Then, one chooses the initial conditions for the universe so that ф starts out uphill, moving slowly. Finally, the initial conditions for the scale factor of the universe R are chosen so that it is expanding. If these conditions are fulfilled, then ф will gradually roll downhill, with its motion damped by the second term in (4). As it rolls slowly downhill, the scale factor R will drive an epoch of exponential expansion, making the universe very large, very smooth, and very flat. When the scalar field nears the minimum of the potential V (ф), then its kinetic energy ф2 begins to overwhelm V (ф), and it is seen from (5) that
ρ + 3P becomes positive so the acceleration of the scale factor ceases.
When the field ф is incorporated into a unified theory of particle physics and forces, it automatically couples to all the particles of the Standard Model. This coupling provides a natural mechanism through which the energy stored in ф during inflation is eventually released into the radiation and matter needed to start the hot Big Bang. When ф reaches its potential minimum, it starts to oscillate, and these oscillations cause the creation of particles to which ф couples, particles that comprise the radiation and matter required for the hot Big Bang. The energy initially stored in ф is thus redistributed amongst all the particle species present. Generally, it is easy to arrange that sufficient energy is transferred to heat the universe to temperatures well above those needed for the production of the primordial elements in the Big Bang.
Precisely what was gained from this early epoch of exponential expansion? The puzzle is to explain why the universe is so smooth today, where the natural expectation from "random" initial conditions for the universe would be a lumpy universe becoming ever more lumpy under the influence of gravitational collapse. Exponential expansion improves this situation. A characteristic length scale in gravitational physics is the Planck scale By random initial conditions, one might mean a universe composed of many Planck-sized domains of differing energy densities and expansion rates. Compare this picture with the picture obtained if the current observed universe is traced all the way back to the Planck time, LPlanck/c or 10-43 seconds. The observed universe is now some 13 to 15 billion light-years across. Following this scale back in time using the known densities of matter and radiation, the size of the region it occupied at the Planck time can be calculated. It turns out to be just a millimeter, which, even though small, is a huge scale in Planck units. The problem of the initial conditions needed for the hot Big Bang cosmology is that the universe had to have started in a state almost perfectly uniform on a scale of 1032 times the natural length scale.
Inflation greatly improves this situation. Take instead one Planck-sized region, 10-33 centimeters across, within which the conditions required for inflation happen to be satisfied, with the scalar field ф large enough to ensure that inflation lasted for 100 expansion times within it. The size of such a region would have grown by e100 ≈ 1043 during inflation, so that by the end of inflation it would be approximately a kilometer across. Following inflation, this region would then undergo standard hot Big Bang expansion, during which a millimeter-sized subregion would grow to the size of the visible cosmos today. Thus, given just one Planck-sized region with the right inflationary initial conditions, one can account for the present vast cosmos of great uniformity and flatness (see Figure 2).
This argument is plausible but not necessarily compelling. After all, the field needed to drive inflation has been added by hand, and the discussion of the likelihood of obtaining inflation is hardly rigorous. What happened to all those regions that did not inflate? Is inflation still occurring somewhere else in the universe? Scientists have struggled with these questions, but no convincing answer has yet emerged.
What made inflationary theory much more convincing was the fact that it was able to explain the density inhomogeneities needed for cosmic structure formation in a quite magical way. This became apparent soon after inflation was invented and was a surprising, and for some a compelling, success.
Relativity and quantum mechanics lie at the heart of the inflationary mechanism for generating inhomogeneities. If ф is a field, then according to relativity, if it can vary in time, it must also be allowed to vary in space. But according to quantum mechanics (the Heisenberg uncertainty principle), there must be a minimal level of fluctuations in such a field so that even in empty space, it is constantly fluctuating about its minimal value.
In the context of inflation, the quantum "jitter" in the inflation field ф becomes stretched and amplified into large-scale density homogeneities. First, as the universe is blown up by inflation, the scale of any fluctuation in ф grows exponentially in time. When the scale of the fluctuation is short, it oscillates like a sound or light wave.
But when the scale of the fluctuation is stretched beyond a certain point, different regions of the fluctuation no longer communicate, and the fluctuation becomes "frozen," thereafter simply undergoing a continuous stretching until the end of inflation. The remarkable consequence of this mechanism is that the final spectrum of fluctuations is "scale-free." That is to say, over an exponentially large range of scales, at the end of inflation one finds that the density of the universe fluctuates with the same amplitude on all length scales.
It was realized long before inflation that scale-free primordial fluctuations could plausibly explain the observed distribution of galaxies in the universe. This spectrum became known as the Harrison-Z'eldovich spectrum, named after the physicists who first postulated it. Therefore, the realization that inflation, invented for very different purposes, automatically produced the Harrison-Z'eldovich spectrum was quite spectacular and convinced many physicists that inflation must have actually occurred.
The Harrison-Z'eldovich hypothesis can be understood as follows. The early universe is filled with many different particles: nucleons such as protons and neutrons, electrons, photons, and neutrinos, and some form of dark matter needed to explain the structure of galaxies as observed today. The simplest possibility is that the overall density of the universe varied from place to place, but the relative abundances of the different particle species were the same everywhere. This possibility is realized in the simplest inflation models. Again, the simplest possibility is that the density variations take the form of a Gaussian random field. That is to say, the amplitudes of plane waves of each wavelength are chosen at random from a Gaussian probability distribution, and there is no correlation between modes of different wavelengths. More prosaically, the density variations are like small ripples on the surface of the sea, with random locations and no special features.
Recent observations of the cosmic background radiation have provided spectacular confirmation of the Harrison-Z'eldovich spectrum, combined with the simplest form of primordial density variations. The Boomerang and Maxima experiments used balloon-borne telescopes to map the cosmic background radiation over hundreds of square degrees on the sky, to a level of tens of microKelvin. They measured the amplitude of the temperature fluctuations as a function of angular scale. What was found was that as one goes from large to smaller scales, the amplitude grows and then oscillates. So far there is evidence for three peaks, on scales of a degree, half a degree, and one-third of a degree. This is in astonishingly close accord with the expectations from theory, under the assumption of the simplest form of perturbations. These measurements have also allowed a measurement of the spatial geometry of the universe on the largest visible scales. Again, the measurements are in accord with the simplest models of inflation, according to which there was a lot of inflation and the universe became spatially flat with exponential accuracy.
These measurements are a considerable success for inflation. However, one should not infer that inflation has been proven. The observations really confirm something much simpler: scale invariance and the "simplest" type of fluctuations. There is no direct evidence for the existence of the inflation field ф. Also, apart from the qualitative successes of inflation— the observed flatness of the universe and the scale invariance of the inhomogeneities—one does not have a quantitative prediction which provides specific evidence that inflation occurred. On the contrary, inflationary theory can only be reconciled with the observed amplitude of the primordial fluctuations if certain parameters in the theory are adjusted to very small values, to fit the data. It is possible that another physical mechanism could make the universe large, flat, and smooth and produce density variations of the observed form.
What would convince skeptics that inflation did, in fact, occur? One of the most distinctive inflationary predictions is that during the period of exponential expansion, gravitational waves would have been amplified and stretched to large scales just as the fluctuations in ф were. This leads again to a scale-invariant spectrum of gravitational waves, which would in principle be detectable in today's universe. The most powerful way to search for these waves employs the polarization of the cosmic microwave sky. If gravitational waves are present, they lead to a pattern of polarization that is impossible to obtain from ordinary density inhomogeneities. Observation of this pattern would be a much more direct confirmation of the inflationary mechanism. The Planck satellite, scheduled to be flown by the European Space Agency in 2007, should be able to see this signal, at least for the simplest inflation models.
Even if inflation did provide the mechanism for the Big Bang and the density variations in the universe, many theoretical questions are unresolved. The biggest problem in physics is that of quantizing the gravitational field. However, inflationary fluctuations involve both quantum mechanics and the effects of gravity. How can they be treated consistently, when there is no consistent theory? Current calculations of inflationary fluctuations are performed in an approximation (linear theory) in which the theoretical inconsistencies do not yet appear. Calculations to the next level of accuracy produce meaningless infinities and ambiguities that are still not resolved. Thus within its current framework, inflation can only be viewed as a provisional theory, recognized to be inconsistent at a deep level. More consistent theories of quantum gravity, including string theory and supergravity, so far do not seem to produce inflationary models of the form needed to match observation.
It is also important to emphasize that inflation does not solve many of the most fundamental puzzles in cosmology: Did the universe begin? And if so, how? Recent observations indicate the presence of a positive vacuum energy (or cosmological constant). This discovery was entirely unexpected within inflationary cosmology.
Why is there a cosmological constant today? The current cosmological constant is smaller than that needed for inflation by at least 100 orders of magnitude. So, inflationary cosmology requires two cosmological constants, differing by 10100 in magnitude. Since the goal of inflation was to avoid "fine tuning," the actual need for it is quite disturbing. If the expansion of the universe is accelerating today, as observations indicate, where will that expansion lead? What is the future of the universe?
These questions illustrate that inflation is only a theory of the early universe, one that neither addresses how the universe began nor its current state nor its future direction. The successes of inflation are considerable, but they may yet be reproduced by other theories that are more complete.
Guth, A. H. The Inflationary Universe (Addison-Wesley, Reading, MA, 1998).
Guth, A. H., and Steinhardt, P. J. Scientific American250 (5), 90–128 (1984).
Linde, A. D. Particle Physics and Inflationary Cosmology (Harwood, New York, 1990).
Neil G. Turok
Like many topics in economics, the concept of inflation—defined as an overall increase in the general price level of goods and services measured against a standard level of purchasing power—is subject to considerable disagreements among economists, highlighting the important differences between orthodox and heterodox economics. There are three important areas of disagreements. First, there is no consensus on the possible causes and consequences of inflation, even in a small, open economy. Second, economists disagree on the advantages of fighting inflation; in other words, should inflation-reduction be the primary goal of macroeconomic policy? Finally, economists disagree on the policies to be used to combat inflation. Indeed, in recent years there has been widespread agreement over interest rate–tightening as a way of fighting inflation, but such policies are misplaced, because they produce lower economic activity and higher unemployment.
Inflation is measured by keeping track of the changes in the prices of a number of items within a specific basket of goods and services over a given period of time, ignoring any improvement in quality. There are a number of ways of calculating inflation. For instance, the consumer price index (CPI) measures the changes in the prices of goods and services generally purchased by consumers. It is by far the most commonly used measurement. Other measurements include the gross domestic product (GDP) deflator, which measures inflation over the entire domestic economy.
For orthodox economists, inflation carries important costs because there are advantages to lower inflation. Among the costs, orthodox economists claim that inflation erodes the value of money, and economic agents are frustrated in making their consumption and saving decisions; it encourages speculative investment to the detriment of productive investment; and it represents hardship for those on limited incomes or on incomes that are not indexed.
Among the benefits of low inflation, orthodox economists point to the ability of economic agents to make better, more informed, long-term decisions given the relative stability of purchasing power. For instance, because inflation is considered to lower the value of money, low inflation restores confidence in money: By reducing future variations in the price level, households can better plan their consumption and saving plans and regain confidence in the future value of money. Economists also claim that low inflation lowers nominal and real interest rates, and therefore produces overall stability of the economic system, as low inflation is self-reinforcing.
In orthodox economics, the principal cause of inflation is excess demand in the goods and/or labor markets, a direct result of scarcity in both markets. Whenever aggregate demand is greater than aggregate supply at any given price, the overall level of prices of goods and services will tend to increase in order to eliminate the excess demand: Inflation is demand-led. This is the necessary consequence of interpreting macroeconomics through the use of aggregate demand (AD; the total demand for goods and services in a national economy) and aggregate supply (AS; the total supply of goods and services in a national economy) analysis, interacting in price-output space. If there is a positive relationship between prices and output, it is because the AS curve is nonhorizontal. In this sense, both output and the price level are the result of AD-AS interaction. This analysis leads to an understanding of the role of prices in orthodox theory as a mechanism that guarantees market clearing.
In fact, irrespective of the specific neoclassical or orthodox approach, excess demand is always a central focus of inflation. Indeed, for monetarists, the growth of the money supply over and above the growth of output is seen as the principal cause of inflation. In their words, inflation is “always and everywhere a monetary phenomenon” (Friedman 1963). For monetarists, increases in the money supply always precede increases in prices. This results from the belief that the money supply is an exogenously determined quantity, independent of the needs of the economic system. The money supply is simply imposed on the system by the central bank, which can choose at will the growth rate of the money supply. Hence, whenever the central bank is pursuing expansionary policies, it allow the growth rate of the money supply to exceed that of output, resulting in “too much money chasing too few goods,” the inevitable result of which is higher price levels. This view is based on the well-known quantity theory of money.
Keynesians, however, although they do not deny the role played by the exogenous money supply, place the emphasis primarily on output, given the relationship between output (unemployment) and inflation as embedded in the Phillips curve, according to which there is a trade-off between unemployment and inflation: Lower unemployment implies higher inflation. In other words, fighting unemployment comes at the cost of higher inflation. As unemployment decreases, wages tend to increase, raising prices in the process.
An obvious question is what then may cause excess demand? The answer lies in expansionary monetary and fiscal policies—in other words, the central bank and the state. In addition to an expansionary monetary policy, inflation arises because governments pursue an expansionary fiscal policy. Inflation arises either because the deficit is financed by printing money, or because an increase in fiscal policy will increase output, spending, and therefore demand for goods and labor.
Given the above discussion, the policy solution to contain inflation is to reduce the pressure on prices by reducing overall demand in the economy. This means limiting the growth of the money supply and reducing fiscal expenditures: Policymakers need to adopt responsible, sound policies. For Keynesians, this implies higher unemployment and lower wages.
For heterodox economists and post-Keynesians in particular, excess demand is not the principal cause of inflation, largely because the economy almost always produces at less than full capacity: There is almost never an excess demand for goods, and similarly, there is but rarely scarcity in the labor market. Post-Keynesians and heterodox economists nonetheless acknowledge that demand may have some influence on prices, but it is considered to be small and indirect. This statement has direct implications for and stands in stark contrast with neoclassical theory. For instance, one of the main consequences is that fiscal spending or excess growth of the money supply cannot be a causal or direct influence on prices and inflation. Indeed, for heterodox economists, money is never a cause of inflation. This is because the money supply is endogenously determined: Excess money cannot exist (Lavoie 1992; Rochon 1999). In other words, the money supply is not determined by the central bank, but rather by the needs of production.
In contrast to orthodox theory, therefore, the principal cause of changes in the price level is increases in the costs of production. In this sense, heterodox economists adopt a cost-push approach to inflation. That said, orthodox economists do not deny the importance of costs in determining changes in the price level, but there are important differences between the orthodox and heterodox approaches. For the former, changes in cost are usually the result of “supply shocks,” which occur only occasionally, such as a sudden increase in the price of oil or some unexpected and unforeseen event abroad. For heterodox economists, however, changes in the costs of production are the primary and dominant cause of inflation, and are part of the normal operations of contemporary economic systems.
For heterodox economists, however, inflation is not merely cost-driven, but it is also the result of conflicting claims over the appropriate division of income. Markets are characterized by dynamic interactions between macro-groups, such as workers, firms, and rentiers, each vying to get a larger share of income: Workers want higher wages, firms want higher profits, and rentiers want higher rents. In this sense, inflation is the result of a struggle over the distribution of income. It can arise largely from either a wage-wage spiral or a wage-price spiral, or from the attempt by firms to impose a given rate of return. In this sense, two important features of the heterodox explanation of inflation are collective bargaining and administered prices.
For instance, in formalized conflicting claim models, such as that described by Louis-Philippe Rochon and Mark Setterfield (2007), workers have a target wage share that they consider fair, equitable, or just. And although workers in general want to increase their overall nominal (or real) wages, they also want to maintain their social standing and their wages relative to other workers. If a specific group of workers negotiates higher wages, other groups may also demand higher wages in order to maintain their relative standing in the social order, fuelling the inflationary spiral. In turn, this wage-wage spiral implies higher costs of production for firms, which may try to pass on these costs to consumers through higher prices, which in turn will reduce real wages and lead to possible demand for higher wages in the future.
Moreover, firms may want to increase their standard rate of return to historical levels (Lavoie 1992). Firms may experience lower than normal returns and may want to increase their mark-up in order to bring their rate of return in line with more traditional levels, raising prices in the process. This in turn will lead to lower real wages, and workers may demand higher nominal wages to compensate.
Firms may be able to raise prices because, unlike in neoclassical theory, prices are administered: Firms set prices according to a mark-up over costs of production, not by competitive forces in the economy. In other words, firms will impose a rate of return over and above the normal costs of production, primarily wages and interest costs on debt, because they target a certain margin of profit.
In the end, whether firms or workers succeed in imposing their wills depends on the relative power of workers vis-à-vis firms in the wage bargain, and the relative power of firms in commodity markets. In turn, these powers vary according to the economic cycle or with the market structure. For instance, during periods of growth when unemployment is low, workers have greater power and may be able to demand higher wages. As for firms, brand loyalty, advertising, and the complexity of products give them greater power over prices (Lavoie 1992).
Finally, conflict also arises between firms and rentiers, who also want to increase their share of income. When the central bank increases interest rates, satisfying rentiers, firms may increase their mark-up and prices, and thus lower real wages. This also highlights an indirect conflict between workers and rentiers. For John Smithin (1994), rentiers are at the heart of the conflict. It is in this sense that heterodox economists see the rate of interest as a distributive variable.
The same analysis can be used to analyze deflation, that is a generalized decrease in the overall price level. In a conflicting claims model, one can assume that during periods of high unemployment, when workers are more desperate for work, they would be willing to work at wages lower (lower target wage) than what firms would be willing to offer in an effort to squeeze themselves into the labor market. With these downward pressures on wages, it remains possible for firms to lower prices, although deflation remains a rare phenomenon in contemporary developed economies since World War II, where the general trend on prices has been upward.
Similarly, the cost-plus approach and conflicting-claims model can be used to explain periods of hyperinflation (Camara and Vernengo 2001). For instance, in the case of inter-war Germany, the most probable cause of hyperinflation was the extreme costs of war reparations imposed by the Treaty of Versailles, a collapse of German exports, a depreciation of the currency, and higher prices. One may further assume that workers may resist the resulting important decline in real wages, along the same lines as described earlier. In the end, conflicting claims and distribution are key components of the explanation of both inflation and hyperinflation.
Heterodox economists also stand in contrast with orthodox economists in proposing policy remedies for fighting inflation. Three questions arise. First, should inflation always be the primary target of economic policy? Second, should the central bank be solely responsible for pursuing anti-inflationary policies, as has become the case in recent years? Finally, how can inflation be tamed?
Heterodox economists believe that too much emphasis is placed on fighting inflation, to the detriment of fighting unemployment and growth, which are the central focus of heterodox policy. As excess demand is not a direct contributor to inflation, there is no reason to believe that economic growth necessarily accompanies inflation. Moreover, because money is not seen as the principal cause of inflation, and also because there is only an indirect link between interest rates and inflation, heterodox economists do not see the central bank as the primary institution to fight inflation. In fact, central bank policy exacerbates the inflationary process.
Nevertheless, to fight inflation, heterodox economists propose a two-prong policy. First, we need de-emphasize the role of the central bank by setting the real interest rate at a “fair” level (equal to the growth rate of labor productivity), thereby limiting the influence of the rentier class. Second, we should adopt a permanent price and income policy in order to limit the increase in wages and prices.
SEE ALSO Aggregate Demand; Class, Rentier; Economics, Keynesian; Economics, Post Keynesian; Excess Demand; Expectations; Macroeconomics; Misery Index; Monetarism; Money; Money, Endogenous; Money, Exogenous; Phillips Curve; Policy, Fiscal; Policy, Monetary; Prices; Quantity Theory of Money; Real Income; Stagflation; Wage and Price Controls; Wages
Camara, Alcino, and Matias Vernengo. 2001. The German Balance of Payment School and the Latin American Neo-Structuralists. In Credit, Interest Rates and the Open Economy: Essays on Horizontalism, ed. Louis-Philippe Rochon and Matias Vernengo, 143–159. Cheltenham, U.K.: Edward Elgar.
Friedman, Milton. 1963. Inflation: Causes and Consequences, New York: Asia Publishing House.
Lavoie, Marc. 1992. Foundations of Post-Keynesian Economic Analysis. Aldershot, U.K.: Edward Elgar.
Rochon, Louis-Philippe. 1999. Credit, Money and Production: An Alternative Post-Keynesian Approach. Cheltenham, U.K.: Edward Elgar.
Rochon, Louis-Philippe, and Mark Setterfield. 2007. Interest Rates, Income Distribution, and Monetary Policy Dominance: Post-Keynesians and the “Fair” Rate of Interest. http://www.trincoll.edu/~setterfi/Rochon%20Setterfield%20I%20-%20complete%20paper.pdf.
Smithin, John. 1994. Controversies in Monetary Economics: Ideas, Issues, and Policy. Aldershot, U.K.: Edward Elgar.
INFLATION.OVERVIEW OF TWENTIETH CENTURY
SOME MORE EXTREME EPISODES
WORLDWIDE INFLATION AFTER WORLD WAR II
MORE GENERAL EXPLANATION
POLICIES TO COMBAT INFLATION
Inflation is best described as a sustained rise in the general price level. That is sometimes expressed as nominal income rising in excess of real income. It is a relatively recent phenomenon in world history, belonging mainly—but with exceptions in a few rare episodes—to the twentieth century. There can be many pressures that produce price changes in the short term, but there is no inflation without a corresponding growth in the stock of money. That growth was not easily achieved before technology allowed the production of a reliable paper currency, and that technology belongs to the twentieth century. This in itself is highly suggestive of the basic cause.
For most of the world's history, the time plot of the general price level was almost flat. Occasionally, the discovery of silver and gold or improved mining or production techniques would produce a period of rising prices, though these were generally modest—seldom much above 5 percent per annum. There were one or two episodes before the twentieth century, such as in Britain during the Napoleonic Wars, when metallic backing for the currency was abandoned. But even in that period, inflation rates were quite low, 2 or 3 percent at most over a twenty-five-year period. Some other more extreme cases, such as the French Revolution or the U.S. civil war, are good examples of the use of paper money and consequent rapid inflation. What changed after 1914 was that inflation became a common feature of economies. Certainly after the mid-1930s there was a relentless rise in the general price level for the rest of the century, and that continued into the twenty-first century.
A discussion of "world prices" can be useful for individual commodities, but for the general price level it can be tolerated only up to a point. It is difficult enough constructing an index of prices for one country without attempting it for the world. However, since many countries have similar price experience, one modern industrial country tends to look like another in that respect. There are also some interesting differences that help in an understanding of inflation.
The general pattern of inflation in the twentieth century was as follows. Prices rose sharply after 1914 until about 1920. There was then a decade or so of hesitancy when major countries were pursuing deflationary policies in order to restore and then adhere to the new gold standard. But after that attempt collapsed in the 1930s, the monetary discipline of a metallic base had largely disappeared and prices rose almost without interruption. World War II gave a boost to inflation, despite all manner of attempts at containing it. After 1945, inflation appeared to become endemic and increasingly a problem. After 1971, when the world was for the first time ever exclusively reliant on paper money, inflation accelerated almost everywhere. That 1970s experience concentrated attention on the problem, and there developed a widespread desire to contain and even kill inflation. In the last twenty years of the twentieth century, inflation seemed to be completely under control in most developed countries. There was even some concern that the opposite—deflation, a sustained fall in prices—might be emerging. But that was never a serious prospect, and in the early years of the twenty-first century concern about deflation had already all but disappeared. As of 2005 most Organisation for Economic Cooperation and Development (OECD) countries live with inflation, albeit at low levels by twentieth-century standards.
In the course of the twentieth century, there were some experiences of violent inflation and some others that were extremely serious. The most violent have been described as hyperinflations. That can be defined in different ways, but one of the most accepted definitions is that of economist Philip Cagan: prices rising at more than 50 percent per month and accelerating. And the period of hyperinflation was over by this definition when the rate fell below 50 percent per month. The other "extreme" cases can be thought of as rates in excess of 100 percent per annum. There were several episodes of hyperinflation in the 1920s, mostly between 1919 and 1924. In these years, Hungary, Poland, Russia, Austria, and Germany all experienced hyperinflation, in fact in the millions percent per annum. In Germany, the worst of these, prices were rising at a rate of 1,000 million percent per annum in 1923–1924.
There was another burst of violent inflation episodes in the 1940s, when Greece, Hungary again, and China all suffered hyperinflation as defined by Cagan. In the years after the 1950s, there have been scores of examples of countries where inflation has been in excess of 100 percent per annum but without taking off into hyperinflation. These were usually for brief—though sometimes recurring—periods. Many Latin American countries, for example, suffered persistent bouts of very rapid inflation right up until the 1990s. The same is true for many countries in Africa and others, such as Indonesia in the mid-1960s, Serbia and some other Balkan countries in the 1980s and 1990s.
The striking feature about all these episodes of very rapid inflation or of hyperinflation is that of an unbacked paper currency. The growth in the money supply was enormous. Such a growth was impossible in the absence of paper currency. The velocity of circulation can always change, but with a metallic currency it cannot change fast enough to produce such high inflation: it is just not possible to move it around quickly enough. The other feature that stands out is that money growth was accompanied by huge and growing fiscal deficits.
Deficits cannot be sustained for very long, eventually requiring monetization. What were the circumstances that produced such deficits? It has frequently been asserted that it is war that forces expenditure rapidly above the ability to tax. Up to a point, that is true. But the history of the world is in large part the history of war, and yet there is little or no inflation before the twentieth century. A closer look at these episodes reveals that it is civil war or revolution, or at minimum serious social unrest, that is present in almost all cases: in Russia after 1917; in Hungary in 1919; in Poland in the early 1920s. In Germany, too, there were attempted communist coups (and in Bavaria, a Bolshevik government, so the threat was real). In 1922 and 1923, there were armed uprisings and major breakdowns in public order in Germany. Then in the 1940s, there was civil war in China and in Greece. Hungary in 1946 was the worst case of hyperinflation up to that date, but it was slightly different in the way in which it was subjected to Soviet pressure.
Governments have always been keen to get hold of resources, and on occasions they simply confiscate resources. The simplest way of doing that is through the inflation tax. The authorities can maximize their revenue from this when inflation is in excess of 100 percent per annum. Of course, such levels of inflation would have potentially dire political consequences. When would it be worth pursuing such a course? The answer must be when the state is seriously threatened from within. An external threat is not critical, since that usually stimulates patriotism so that borrowing can be carried out more easily and tax can be raised without too much complaint. But with a major threat from within, a government may calculate that the risk attached is worth running. Thus civil war is a prime cause of inflation. Expenditure rises sharply as the established authority fights to resist the rebellion, but tax revenues fall since tax payments from the rebellious section disappear. Borrowing becomes equally difficult. A resort to the printing press is immediate.
Not all wars have produced inflation, nor have all civil wars produced great inflation. One line of explanation is that monetary growth does not of itself lead to inflation. The prevailing and anticipated fiscal positions have to be considered in conjunction with monetary policy. The argument is that in a fiat money (that is, command money, usually by decree of government) regime, an appropriate fiscal policy can back the money stock: the value of government liabilities is determined in the same way as a firm's liabilities. An issue of additional shares in the absence of prospective improvement in the future stream of income leads to a fall in the price of the shares. In the case of government, an increase in its liabilities (bank-notes) without an increase in prospective tax receipts provides an expectation of a fall in the value of the liabilities; that is, in inflation. An illustration of this might be found in Britain during World War I. Not only did Britain borrow on a huge scale, but huge budget deficits also opened up as the enormous scale of spending went on. The deficits were in excess of 50 percent of gross domestic product (GDP). Yet comparatively low inflation was recorded. Why did it not burst into the extreme kind? The explanation outlined above seems to have some applicability. As soon as it came to be believed that victory was likely, so did the appreciation that there would be a return to Gladstonian principles of finance—balanced budgets. And that is what happened very soon after the war.
The general path of prices for the world in the second half of the twentieth century was of a relentless rise across the period. Translated into inflation rates, what shows up is how inflation accelerated in the 1970s and that the rate of inflation has moderated greatly since the beginning of the 1980s. The path for some countries varies a bit. While there was inflation in all countries, and that pattern was similar, in some cases it was significantly lower than in others. The principal reason for the similarity was that in the years up to the early 1970s, most countries were on a fixed (or more accurately, a pegged) exchange rate—essentially tied to the U.S. dollar through the 1944 Bretton Woods Agreement. Under such a system, the small countries import the monetary policy of the large country.
From the early 1970s, though, exchange rates have floated and countries then regained control of their money supply. Those who exercised appropriate control appear to have had greater success with inflation.
There have been two main competing views on the explanation for the accelerating inflation that began in the mid 1960s. One has been called "international monetarism," and the other wage-push or "sociological." The first regards inflation as a monetary phenomenon. The second denies this and sees it as non-economic, pointing to supposedly spontaneous wage explosions of the late 1960s and early 1970s. Thus for international monetarism, the explanation lies in the United States in the 1960s. The United States had embarked on a huge spending program: domestically on the Great Society and abroad on the Vietnam War. The latter was unpopular, so could not be financed from borrowing or from increased taxation without serious electoral damage. It therefore had to be done by printing money. The monetary expansion produced inflation, and that was transmitted to other countries through the exchange-rate system. Other countries therefore experienced similar inflation to the United States. There were occasions when some countries changed their parity with the dollar—some up, some down—and that reflected their relative individual success or failure in controlling inflation.
The great weight of the evidence suggests that inflation is a monetary phenomenon. But outcomes depend on the relative strengths of the parties involved—the government on the one hand and the people, or powerful interest groups, on the other. If there is strong government that can be trusted to behave with prudence, there is unlikely to be inflation. If the opposition to the government is sufficient to get its way, there will be inflation. It always requires an expansion of the money supply at a rate greater than the growth of real income, and over the long run that rate will be the rate of inflation.
The sociological explanation for inflation is that the cause was trade unions. The argument was that they exerted monopoly power, and monopolies can change the price—in this case wages—of their product when they wish. However, what this does is change relative prices—the wages of one union (or perhaps more) and not the general price level. What if the majority of the labor force belonged to monopoly unions? That is unlikely, but it takes us back to the relative strength of government in resisting the claims and not expanding the money supply. Further, monopolies are much less common than was once supposed, and are much less likely to appear in an open world economy.
Other explanations have focused on the price of a major commodity—in the 1970s, this commodity was oil. However, a price shock does not produce inflation. Where it is accommodated by the monetary authorities, it can shift the price level to a higher point. But that is not inflation; it is a once and for all change. Thereafter, the trend rate of inflation will carry on from where it was, unless the authorities persist in monetary ease after having accommodated the shock.
Throughout history there have been attempts at controlling prices directly. This practice was given a great boost in the twentieth century during wartime. Price controls were imposed in many countries, including the United States and the United Kingdom. And in some respects they did seem to work. However, they were supported by other factors. In wartime, patriotism possibly plays some part and people are more prepared to play by the rules for the sake of the greater good. More than that, rationing often accompanied the price controls and it was difficult or impossible to make purchases without coupons. That certainly supported the price controls. Subsidies were used, as well. And there were severe penalties for breach of the controls.
But while price controls seem to have worked for a period, the common experience was that when they were removed, prices jumped up to where they would have been had the controls never existed. They may have served their purpose in wartime, but not beyond that. Price controls were tried in peacetime, too, but in the absence of these other factors, they invariably failed.
Another approach to the control of inflation was to attempt to control wages or incomes more generally. This followed from the belief that trade unions caused inflation. So there were attempts in the 1960s and 1970s to contain inflation by resorting to controls on incomes. This was tried in many countries without success. Apart from being incompatible with a free society, there were simply too many ways of circumventing the controls.
There was for a while the belief that the economy could be managed primarily by operating on demand through fiscal policy. When the economy was growing "too fast" and inflationary pressures developing, tightening fiscal policy would dampen activity down. This course also proved a failure.
It was only after there was a better appreciation of the role of money in causing inflation that there developed a desire to control the growth of money as the means of controlling inflation. This appreciation and desire began to emerge in the 1970s. There was much debate about whether this monetary control was best exerted by trying to operate directly on monetary aggregates or by using interest rates. But whatever the conclusion of this debate, it became clear that it was only central banks that could control monetary growth; and increasingly it was seen that they should be given the independence to do this—to produce the particular kind of price stability that governments laid down.
There are several reasons for regarding inflation as a bad thing. The first is that it has damaging effects on the distribution of wealth. It works to the advantage of debtors and to the disadvantage of creditors. Huge debts disappear over a period of inflation. While this might be thought a useful way of rearranging the distribution of wealth, the fact is that it is governments who were the largest debtors in the twentieth century. They were thus able to cheat their populations out of their savings in a number of ways. (This may also be seen as a contribution to the distrust of government, and of the lack of trust more generally, which has led to ever-increasing and costly regulation, regulation being a substitute for the trust that formerly obtained.) Creditors suffer and that in turn dissuades saving and ultimately damages investment and so probably economic growth.
Inflation acts adversely on production in another way. When producers detect an increase in demand for their product, they have difficulty in distinguishing between the demand for their product alone and what might be a general increase in demand from the extra money (excess balances) that consumers are spending. The producer might therefore expand plant to cope with the new demand and then later be left with unwanted plant when the temporary burst of general spending is over.
Inflation distorts prices and interest rates. As inflation rises it becomes more volatile, and this contributes to the difficulty in using prices as good signals—their key function. Different prices will be affected in different ways. Long-term contracts will suffer at the expense of short-term and of flexible arrangements. To that extent it will discourage long-term contracts, and therefore some activity will not be undertaken that otherwise would have been in conditions of less uncertainty.
All in all, inflation is bad for morale and the sum of the distortions it creates makes it bad not only for income and growth, but bad for democracy and for a free society.
Cagan, Philip. "The Monetary Dynamics of Hyperinflation." In Studies in the Quantity Theory of Money, edited by Milton Friedman, 25–117. Chicago, 1956.
Capie, Forrest. "Conditions in Which Very Rapid Inflation Has Appeared." Carnegie-Rochester Conference Series on Public Policy 24 (1986): 115–168.
Capie, Forrest, ed. Major Inflations in History. Aldershot, U.K., 1991.
Gordon, Robert. "Can the Inflation of the 1970s Be Explained?" Brookings Papers on Economic Activity 1 (1977): 253–277.
Hall, Robert, ed. Inflation: Causes and Effects. Chicago, 1982.
Sargent, Thomas J. "The End of Four Big Inflations." In Inflation: Causes and Effects, edited by Robert Hall, 41–97. Chicago, 1982.
Velde, Francois. "Poor Hand or Poor Play? The Rise and Fall of Inflation in the U.S." Economic Perspectives (spring 2004): 35–51.
INFLATION. The definition of "inflation" cannot be separated from that of the "price level." Economists measure the price level by computing a weighted average of consumer prices or so-called "producer" prices. The value of the average is arbitrarily set equal to one (or one hundred) in a base year, and the index in any other year is expressed relative to the base year. The value of the consumer price index in 1999 was 167, relative to a value of 100 in 1982 (the base year). That is, prices in 1999 were 67 percent higher on average than in 1982.
Inflation occurs when the price level rises from one period to the next. The rate of inflation expresses the increase in percentage terms. Thus, a 3 percent annual inflation rate means that, on average, prices rose 3 percent over the previous year. Theoretically, the rate of inflation could be by the hour or the minute. For an economy suffering from "hyperinflation"—Germany in the 1920s is an example—this might be an appropriate thing to do (assuming the data could be collected and processed quickly enough). For the contemporary United States, which has never experienced hyperinflation, the rate of inflation is reported on a monthly basis.
Deflation is the opposite of inflation: a fall in the price level. Prior to World War II deflation was quite common in the United States, but since World War II, inflation has been the norm. Prewar deflation took two forms. First, the price level might decline very sharply during an economic downturn. This happened, for example, in the early 1840s, when the country was hit by a severe depression, as well as during the Great Depression of the 1930s. Second, deflation might occur over long periods of time, including periods of economic expansion. For example, the price level in the United States in 1860 was lower than in 1820, yet during these four decades the economy grew rapidly and experienced much structural change.
The measurement of the price level is a difficult task and, therefore, so is the measurement of the inflation rate. For example, many economists believe that the consumer price index has overstated the rate of inflation in recent decades because improvements in the quality of goods and services are not adequately reflected in the index. An index that held quality constant, according to this view, would show a smaller rate of price increase from year to year, and thus a smaller average rate of inflation.
It is important to recognize that a positive rate of inflation, as measured by a price index, does not mean that all prices have increased by the same proportion. Some prices may rise relative to others. Some might even fall in absolute terms, and yet, on average, inflation is still positive.
The distinction between absolute and relative price change is important in understanding the theory behind the effects of inflation on economic activity. In the simplest "static" (one-period) economic model of consumer behavior, a fully "anticipated" (understood and expected by consumers and producers) doubling of all prices—the prices of the various consumer goods and the prices of the various productive "inputs" (factors of production, like labor)—does not change the structure of relative prices and therefore should have no effect on the quantities of goods demanded. Similarly, the conventional model of producer behavior predicts that a doubling of all prices would not affect output price relative to the cost of production and therefore would not affect the quantity of goods supplied. The nominal value of GNP (gross national product) would double, but the real value would remain constant. In such a model, money is said to be "neutral," and consumers and producers are free of "money illusion." In more complex, dynamic models, it is possible that a sustained, higher rate of inflation would alter consumers' desired holds of money versus other assets (for example, real estate) and this might change real economic activity.
When inflation is unexpected, however, it is entirely possible—indeed, almost inevitable—that real economic activity will be affected. Throughout American history there is evidence that money wages are "sticky" relative to prices; that is, changes in money wages lag behind (unexpected) changes in the price level. During the early years of the Great Depression of the 1930s, nominal hourly wages fell but not nearly as much as prices. With the real price of labor "too high," unemployment was the inevitable result. When inflation is unexpected, consumers or producers may react as if relative prices are changing, rather than the absolute price level. This can occur especially if the economy experiences a price "shock" in a key sector—for example, an unexpected rise in the price of oil—that sets off a chain of price increases of related products, and a downturn in economic activity.
Causes of Inflation
All of which begs the underlying question: What ultimately causes inflation (or deflation)? Although this is still a matter of dispute among economists in the details, most believe that inflation typically occurs when the supply of money increases more rapidly than the demand for money; or equivalent, when the supply of money per unit of output is increasing. This might occur within a single country; in a global economy, it can also spill over from one country to another. The supply of money per unit of output can increase either because the "velocity" at which it circulates in the economy has increased or, holding velocity constant, because the stock of money per unit of output has increased.
This leads to another question: What factors determine the rate of growth of the money supply relative to money demand? The demand for money depends on the overall scale of economic activity, along with interest rates, which measure the opportunity cost of holding money balances. The supply of money depends on the so-called "monetary regime"—the institutional framework by which money is created.
During the nineteenth century and part of the twentieth, the United States adhered to the gold standard and, at times, a bimetallic (silver) standard. Under the gold standard, the money supply was "backed" (guaranteed) by holdings of gold, so the supply of money could grow only as rapidly as the government's holdings of specie. If these holdings increased more slowly than the demand for money, the price level would fall. Conversely, if holdings of specie increased more rapidly than the demand for money, the price level could rise. Generally, the latter would occur with the discovery of new deposits of gold (or silver) in the United States—or elsewhere, because gold flowed across international borders—as occurred in California in the late 1840s, or in South Africa in the late 1890s.
During periods of war the money supply was augmented with paper money. For example, during the Civil War, both the Union and Confederate governments issued greenbacks as legal tender. The price level rose sharply during the war years. Real wages fell, producing an inflation "tax" that both sides used to help pay for the war effort.
In the contemporary United States, the main institutional determinant of the money supply is the Federal Reserve. The Fed can affect the growth of the money supply in several ways. First, it can engage in open market operations, the buying and selling of government securities. When the Fed buys securities, it injects money into the system; conversely, when it sells securities, it pulls money out. Second, the Fed can alter certain features of the banking system that affect the ability of banks to "create" money. Banks take in deposits, from which they make loans. The supply of loanable funds, however, is larger than the stock of deposits because banks are required only to keep a fraction of deposits as reserves. The Fed can alter the reserve ratio, or it can alter the rate of interest that it charges itself to lend money to banks.
Most economists believe that the Federal Reserve, when deciding upon monetary policy, faces a short-run trade-off between inflation and unemployment. In the long run, unemployment tends toward a "natural" rate that reflects basic frictions in the labor market and that is independent of the rate of inflation. If the goal in the short run is to reduce unemployment, the Fed may need to tolerate a moderate inflation rate. Conversely, if the goal is to lower the inflation rate, this may require a slowdown in economic activity and a higher unemployment rate. Since World War II, the Federal Reserve has sought to keep inflation at a low to moderate level. This is because a high or accelerating rate of inflation is typically followed by a recession. Some economists believe that, rather than trying to "fine-tune" the economy, the Fed should "grow" the money supply at a steady, predictable pace.
It is sometimes argued that inflation is good for debtors and bad for creditors, and bad for persons on fixed incomes. A debtor, so goes the argument, benefits from inflation because loans are taken out in today's dollars, but repaid in the future when, because of inflation, a dollar will be worth less than today. However, to the extent that inflation is correctly anticipated—or "rationally expected"—the rate of interest charged for the loan—the "nominal" rate—will be the "real" rate of interest plus the expected rate of inflation. More generally, any fixed income contract expressed in nominal terms can be negotiated in advance to take proper account of expected inflation. However, if inflation or deflation is unanticipated, it can have severe distributional effects. During the Great Depression millions of Americans lost their homes because their incomes fell drastically relative to their mortgage payments.
Inflation in American History
In the eighteenth and nineteenth centuries and, indeed, in the first half of the twentieth century, inflation was uncommon. Major bouts of inflation were associated with wars, minor bouts with short-term economic expansions ("booms").The booms usually ended in financial "panics," with prices falling sharply. During the nineteenth century this pattern played itself out several times, against a backdrop of long-term deflation.
The first wartime experience with inflation in U.S. history occurred during the American Revolution. Prior to the Revolution inflation did occur periodically when colonial governments issued bills of credit and permitted them to circulate as money, but these were banned by Parliament between 1751 and 1764.When war broke out, bills of credit were again circulated in large numbers. Be-cause the increase in the money supply far exceeded the growth of output during this period, the price level rose sharply.
Wartime inflations in American history have typically been followed by severe deflations, and the Revolution was no exception. After dropping by two-thirds between 1781 and 1789, prices rebounded and eventually stabilized. The next big inflation occurred with the War of 1812.Briefer and less intense than its revolutionary counterpart, prices fell sharply after peaking in 1814.The price level continued to trend downward in the 1820s but reversed course in the mid-1830s during a brief boom. A financial panic ensued, and the country plunged into a severe downturn accompanied by an equally severe deflation. The economy began to recover after 1843, and the price level remained stable until the mid-1850s, when, fueled by the recent gold discoveries in California, inflation returned. Again, however, a financial panic occurred and prices fell. In 1860, the eve of the Civil War, the price level in the United States was 28 percent below the level in 1800; that is, the preceding six decades were characterized by long-term deflation.
To help finance the war effort, Congress and the Confederacy both issued paper money. Inflation followed, peaking in 1864.The price level dropped sharply after the war and, except for a brief period in the early 1880s, continued on a downward course for the remainder of the nineteenth century.
The discovery of gold in South Africa in the mid-1890s signaled another expansion of the money supply. Prices rose moderately after 1896, stabilizing in the years just prior to World War I. Inflation returned with a vengeance during the war, with prices rising by nearly 228 percent between 1914 and 1920.Once again, a sharp postwar recession was accompanied by deflation, but recovery ensured the price level remained stable for the remainder of the 1920s.
Following the stock market crash in October 1929, a deep and prolonged deflation accompanied the dramatic bust that became the Great Depression. Prices fell by one-third between 1929 and 1932.Nominal hourly wages did not fall as much as prices, however, and unemployment rose sharply, to nearly a quarter of the labor force. Convinced that higher wages and higher prices were the key to renewed prosperity, the "New Deal" administration of President Franklin D. Roosevelt adopted a multipronged attack: raising prices directly via the National Recovery Act, reforming the banking system, and expanding the money supply. The price level did turn around beginning in 1933 but fell once again in 1938 during a brief recession.
It took the Nazis and the Japanese invasion of Pearl Harbor to reinvigorate the inflationary process in the United States. Unemployment dropped sharply, putting considerable upward pressure on wages and prices. To some extent this pressure was abated through the use of wage and price controls that lasted from 1942 to 1946, although it is widely believed that official price indexes for the period understate the true inflation because many transactions took place at high "black market" prices, and these are not incorporated into the official indexes.
In the years since World War II the United States has experienced almost continuous inflation, the only exception being very slight deflation in the early 1950s. The inflation rate was nonetheless quite moderate until the expansion of the Vietnam War in the late 1960s. A reluctant President Richard Nixon mandated a series of price controls from 1971 to 1974, but these did little to stem the tide of rising prices, particularly after an international oil embargo in 1973–1974 caused energy prices to skyrocket. Overall in the 1970s the consumer price index rose at an average annual rate of nearly 7.5 percent, compared with 2.7 percent per year in the 1960s. A sharp recession in the early 1980s coupled with activist monetary policy cut the inflation rate to an average of 4.6 percent between 1980 and 1990.Inflation fell further in the 1990s, to an average of 2.7 percent (1990–1999).
As noted, the federal government reports the inflation rate on a monthly basis. Recent data may be found in the U.S. Census Bureau's publication, Statistical Abstract of the United States, and on-line at the Bureau's Web site (www.census.gov) or the Web site of the Bureau of Labor Statistics (www.bls.gov). For long-term historical data on the price level, readers should consult the various editions of Historical Statistics of the United States or the volume by McCusker (2001).
Friedman, Milton, and Anna Jacobson Schwartz. A Monetary History of the United States. Princeton, N.J.: Princeton University Press, 1963.
Hanes, Chris. "Prices and Price Indices." In Historical Statistics of the United States, Millennial Edition. Edited by Susan B. Carter, Scott S. Gartner, Michael Haines, Alan L. Olmstead, Richard Sutch, and Gavin Wright. New York: Cambridge University Press, 2002.
McCusker, John J. How Much Is that in Real Money? A Historical Price Index for Use as a Deflator of Money Values in the Economy of the United States. Worcester, Mass.: American Antiquarian Society, 2001.
Parkin, Michael. "Inflation." In The New Palgrave: A Dictionary of Economics. Edited by John Eatwell, Murray Milgate, and Peter Newman. Vol 2.New York: Stockton Press, 1987.
Rolnick, Arthur J., and Warren E. Weber. "Money, Inflation, and Output Under Fiat and Commodity Standards." Journal of Political Economy 105 (December 1997): 1308–1321.
U.S. Department of Commerce. Historical Statistics of the United States from Colonial Times to 1970. Washington, D.C.: Government Printing Office, 1975.
———. Statistical Abstract of the United States: The National Data Book. 120th ed. Washington, D.C.: Government Printing Office, 2000.
High inflation not only paralyzes economic growth, but also wreaks personal devastation on those with fixed incomes or frozen wages, whose lifetime savings can be wiped out literally overnight. These factors have contributed to middle-class unrest leading to the overthrow of governments in Brazil in 1964 and 1992, Argentina in 1966 and 1975, Uruguay in 1971, and Chile in 1973.
Since 1950 Latin America has experienced several inflationary crises followed by the introduction of numerous innovative governmental plans and reforms designed to combat the threat. The period spanning 1950 to 1960 was marked by import substitution, a policy of encouraging domestic industrial growth through a combination of import tariffs, quotas, price controls, and government subsidies. The following decade saw the exhaustion of that growth strategy and the beginning of an outward-looking (export-promoting) developmental model. From 1971 to 1981 the region pursued a debt-led development plan as nations continued to mix import-substitution and export-promotion strategies financed primarily by foreign borrowing. This policy brought Mexico and Brazil to the brink of defaulting on their foreign debts in the early 1980s, followed by large negative resource transfers from Latin America to the industrialized world to service the debts. Throughout the 1980s and into the early 1990s, Latin America experienced an upward trend in inflation rates, and even traditionally low-inflation countries such as Nicaragua and Peru experienced crippling bouts of hyperinflation (monthly rates exceeding 50 percent).
Monetarist theory dictates that growth in the money supply and fiscal deficits cause inflation. Most Latin American countries went through the import-substitution period without a central bank, leaving monetary issues directly in the hands of the treasury or of a central bank subservient to financing the needs of the treasury. Given the weak markets for government bonds, budget deficits became the primary source of monetary expansion and cause of inflation. Monetarists believe that inflation interferes with economic growth by diverting investment to unproductive assets as a hedge; shifting resources away from projects with long gestation periods in favor of those that promise lower returns in the shorter term; increasing real exchange rates; and prompting government intervention in the foreign-exchange markets and trade flows. Inflation also leads to higher government deficits by decreasing the real income of public utilities, while provoking shortages and underinvestment in wholly or partially privatized companies.
Latin American countries signed policy packages with the International Monetary Fund (IMF) to receive balance-of-payments assistance and agreed to prescribed commitments including real currency depreciation, fiscal austerity coupled with increased prices for public transportation and basic commodities, monetary austerity, and wage freezes. The political and economic impacts of such prescriptions were enormous in that they usually provoked long and deep recessions with a corresponding increase in unemployment. Many think the IMF inflation stabilizations fell too heavily on the working class, which responded with demonstrations and strikes.
Raúl Prebisch, Hans W. Singer, and their successors at the U.N. Economic Commission for Latin America and the Caribbean (ECLAC or CEPAL) postulated that inflation was caused by an inelastic food supply, chronic lack of foreign exchange, and structural government deficits arising from the necessary expansion of social overhead infrastructure. Structuralists believed that inflation (at reasonable levels) benefited economic growth by leading to the transfer of savings into productive investment rather than into financial markets. However, they also noted the inflationary pressure of chronic balance-of-payments deficits that arose from periods when rising demand for imported, manufactured goods from industrialized nations surpassed primary goods exports. More specifically, foreign exchange deficits pressured governments to engage in inflationary-related activities such as imposing trade restrictions, devaluing currency, and increasing social spending.
RATIONAL EXPECTATIONS AND EXPECTATIONS MANAGEMENT APPROACHES
The rational expectations school agreed that inflation came from the money supply, but was rooted in present and future expected government deficits. In the view of such economists, governments could end inflation by undertaking credible reforms. In Latin America, this approach was generally associated with the Chicago Boys in Argentina and Chile, who believed that a credible fiscal reform coupled with trade liberalization and slowing in the rate of devaluation of the currency would simultaneously stabilize the inflation rate at low levels and improve the balance of payments. Over time, the currency devaluation would fall to zero and the domestic inflation rate would come to equal that of the average for the country's trading partners. This framework propelled the so-called tablita (tablet) and the corresponding liberalization policies imposed on Argentina, Chile, and Uruguay in the late 1970s.
Unfortunately, the slowing of the depreciation rate led to overvalued exchange rates, large trade deficits, and increased foreign debts. Because domestic inflation did not converge to foreign inflation, the "credibility" of the exchange-rate policy declined, producing devaluation expectations and a predictable run on the Central Bank's reserves followed by a large devaluation and a repudiation of the stabilization policy. A similar policy was undertaken in Mexico in 1988 at the end of the Miguel de la Madrid administration, with its Economic Solidarity Pact, and continued into the Carlos Salinas de Gortari administration with the Pact for Economic Stability and Growth. In any event, Mexico's plan collapsed in late 1994 in a fashion similar to the collapses in the Southern Cone. But what distinguished Mexico's pacts is the incorporation of wage and price guidelines similar to those recommended by the new structuralists.
The new structuralists, or neostructuralists, articulated the theory of "inertial" inflation that concentrated on the role of formal and informal indexation of incomes, and asserted that competing income sectors made claims on domestic product in excess of its capacity. Inflation brought the claims into alignment with gross domestic product. Inertial inflation resulted from the fact that indexing reflected the last period's inflation as automatic inflation correction occurred on an economy-wide scale, making it difficult to shift. A policy of inflation stabilization based on incomes policy (wage and price freezes) that removed the inertial aspects of inflation was supposed to reduce inflation at a lower cost to society. The heterodox stabilization measures of the Austral Plan (1985–1987) in Argentina and the Cruzado Plan (1986–1987) in Brazil presumably combined the policies of eradicating inertial inflation using incomes policies and monetary reform with the more orthodox policies of austere monetary and fiscal policy. Although these policies failed because of their reliance on wage, price, and exchange-rate pegging, stabilization attempts in Brazil (1964–1972) and in Mexico (1988–1994) were more successful.
The new monetarist-fiscalists shifted the focus away from the usual aspects of fiscal reform and onto the growth in the internal government debt. Faced with the need to repay foreign loans, governments that increased public debt levels accelerated the growth of the monetary base. Brazil and Argentina responded with successive plans that effectively repudiated parts of the internal debt by pegging their currencies to the dollar. The plans succeeded in "confiscating" a large portion of real liquidity of the economies and temporarily reducing inflation rates from hyperinflationary ones to high ones. But in early 1991, in response to deteriorating macroeconomic situations and a fall in investor confidence, both plans collapsed and hyperinflation resumed.
Argentina boldly introduced a currency regime board in 1991 that strictly pegged the peso to the dollar. Brazil followed in 1994 with its Real Plan, which initially floated its currency, but introduced stronger controls to defend against the collateral fallout of the 1994 Mexican peso crisis. Although both plans successfully reduced inflation to moderate levels, efforts to sustain the monetary pegs proved too costly for either country to sustain. Beginning in 1998 Brazil gradually released its peg in response to the successive Asian and Russian economic crises, which pushed hedge fund and emerging market managers to pull "hot money" investments from Brazilian markets to cover their losses. The recession that ensued was exacerbated by doubts about Brazil's ability to continue servicing its foreign and internal debts, which had risen dramatically in response to years of maintaining foreign reserves through higher interest rates. Faced with a similar dilemma, Argentina was forced to release its hard peg in the midst of a debt default in 2002. A severe recession and high employment immediately followed.
THE END OF HYPERINFLATION
Since the turn of the twenty-first century, inflation has largely dissipated in Latin America owing to several factors. First, an international economic boom has increased the demand for natural resources and emerging market bonds, which has contributed to economic growth, decreased pressure on interest rates, and given governments more leverage to institute sound macroeconomic policies throughout the region. Second, the increasingly independent central banks of Brazil, Mexico, Colombia, Peru, and Argentina have inspired international and domestic confidence in their currencies by following Chile's model of setting inflation targets with phased-out exchange bands. Third, Ecuador and El Salvador have each successfully adopted the U.S. dollar as their national currency, forcing those countries to adhere to rigid macroeconomic standards.
Unfortunately, the economic cost of instituting these policies has hampered economic growth through much of the region. In elections in 2006, Brazil, Peru, Colombia, and Mexico narrowly succeeded in combating political reversals in the midst of a rising surge of "reform fatigue"—as occurred in Venezuela, Argentina, and Bolivia between1998 and 2005. If Latin American countries continue to decrease debt levels, global demand for natural resources remains strong, political and social reform initiatives continue to progress, and lower interest rates lead to greater domestic-led economic growth, inflation levels will likely remain low for the foreseeable future.
Alesina, Alberto. "Political Models of Macroeconomic Policy and Fiscal Reforms." In Voting for Reform: Democracy, Political Liberalization, and Economic Adjustment, edited by Stephan Haggard and Steven B. Webb. New York: Oxford University Press, 1994.
Baer, Werner, and John H. Welch, eds. "The Resurgence of Inflation in Latin America." World Development 15, no. 8 (1987): 989-990.
Bernanke, Ben S. "Inflation in Latin America: A New Era?" Presentation at Stanford Institute for Economic Policy Research Economic Summit. Stanford, CA, February 11, 2005. Available from http://www.federalreserve.gov/boarddocs/speeches/2005/20050211/default.htm.
Bruno, Michael, et al., eds. Inflation Stabilization: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico. Cambridge, MA: MIT Press, 1988.
Calderón Villarreal, Cuauhtémoc, and Thomas M. Fullerton, Jr., eds. Inflationary Studies for Latin America. Ciudad Juárez, Chihuahua: Texas Western Press, 2000.
Drake, Paul W. Money Doctors, Foreign Debts, and Economic Reforms in Latin America from the 1890s to the Present. Wilmington, DE: SR Books, 1994.
Fernández, Roque B. "The Expectations Management Approach to Stabilization in Argentina during 1976–1982." World Development 13, no. 8 (1985): 871-892.
Heyman, David, and Fernando Navajas. "Conflicto distributivo y deficit fiscal: Notas sobre la experiencia Argentina, 1970–1987." Working Paper, Oficina de la CEPAL, Buenos Aires, 1989.
Kirkpatrick, Colin, and Frederick Nixson. "Inflation and Stabilization Policy in LDCs." In Surveys in Development Economics, edited by Norman Gemmell. Oxford and New York: B. Blackwell, 1987.
Salvatore, Dominick, James W. Dean, and Thomas Willett, eds. The Dollarization Debate. Oxford and New York: Oxford University Press, 2003.
Sargent, Thomas J. Rational Expectations and Inflation, 2nd edition. New York: HarperCollins College Publishers, 1993.
Taylor, Lance. Structuralist Macroeconomics: Applicable Models for the Third World. New York: Basic Books, 1983.
John H. Welch
Christopher L. Murchison
What It Means
Inflation is a sustained increase in the average level of prices across the economy. It causes money to lose value over time.
The value of a dollar (or any country’s currency) is not constant; it is measured in terms of what it can purchase. During a period of inflation, each dollar in a person’s possession decreases in purchasing power. At the beginning of one year, the average American may regularly spend $50 a week on groceries. If prices increase during that year at a rate of 4 percent (this is another way of saying that the inflation rate is 4 percent), he or she would theoretically pay $52 for the same groceries at the beginning of the following year.
As long as inflation is under control, people whose wages or salaries keep pace with the rate of inflation generally have little to worry about. Inflation is more of a concern for those who live on their savings or on fixed incomes (which are set at a certain amount), such as the elderly, but effective retirement planning takes mild inflation into account. Mild inflation, in fact, is generally consistent with healthy economic growth.
Severe inflation, by contrast, is a problem for most individuals, most businesses, and the overall economy. Quality of life can suffer as people lose the power to purchase what they want and need. This is especially true for those on a fixed income. If inflation causes workers to lose purchasing power, they may demand higher wages, but this may cause inflation to spiral even higher, because their employers will have to pass those wage increases on to consumers in the form of higher prices. Out-of-control inflation can cause money to become worthless, or nearly so, which can lead to the collapse of a nation’s economy, as people cannot afford to buy what they need and want and companies lose the incentive to produce anything.
When Did It Begin
Inflation became a persistent concern in the United States and the rest of the developed world in the late twentieth century. People and governments in the nineteenth and early twentieth centuries had been more worried about such phenomena as depressions (periods of severe economic decline). After the Great Depression of the 1930s, during which nearly 25 percent of Americans lost their jobs and the economy ground to a halt, the U.S. government began asserting more power over the economy.
During the middle decades of the twentieth century, the U.S. government primarily used spending programs (which move money out of public coffers and into private hands) and taxes (which move money out of private hands and into public coffers) to regulate the economy. For example, when the economy seemed to be stagnating, the government could increase its spending or cut taxes, either of which would increase the amount of money in private versus public (government) possession. More money in citizens’ pockets typically leads to more consumer demand for the products that companies make. When companies increase production to meet this demand, the economy grows. Thus, by the middle of the twentieth century, the U.S. government had developed methods for protecting the economy from extreme crises like the Great Depression. But spurring economic growth by increasing demand increased the likelihood that rising prices could become a problem.
At the same time, changed conditions in the private sector made the country more susceptible to inflation. The transition in the United States from a primarily agricultural economy in the nineteenth century to an economy based on industry (manufacturing) and service (the providing of intangible products such as health care, legal assistance, and insurance) in the twentieth century increased the tendency to experience inflation. One reason for this is that inflation tends to be low in agricultural economies; the prices of agricultural crops are more subject to fluctuation, and especially downward movement, than are the prices of manufactured goods or services. Additionally, companies in the nineteenth and early twentieth centuries were generally freer to cut wages in order to keep prices low, thereby preventing inflation, but by the mid-twentieth century workers had won more protection from wage cuts. It was a victory for workers’ rights, but it also resulted in the tendency for wages to rise over time and rarely to decline. Increasing wages generally lead to increased prices, or at least the inability to cut prices.
More Detailed Information
Economists disagree about the ultimate causes of inflation, but there are at least three commonly accepted factors. The first is an increase in consumer demand. When there is more demand for goods and services (that is, when people have more money to spend and a greater desire to spend it than there are products available for purchase), producers will naturally be able to set high prices. This can cause inflation across the economy.
Inflation can also occur when the costs of doing business rise. This can be the result of such phenomena as increases in taxes on companies, increases in workers’ wages, or increases in the prices of raw materials. Companies will pass these cost increases on to consumers in the form of higher prices. Another possible cause of inflation is an increase in the size of the money supply (the amount of money circulating in the economy).
These factors are often inseparable, with one leading to another. For instance, an increase in the money supply translates into an increase in money per person. When more people have money, there tends to be higher consumer demand for goods and services, which leads to higher prices. And when prices rise, workers are likely to call for higher wages in order to pay their increased costs of living. Companies pass their increased wage costs on to consumers, causing even more inflation.
To measure inflation in one way, governments group together different products that are believed to be representative of the overall economy into what are known as “market baskets.” They track the price of these baskets over time in order to observe any changes. The cost of a particular basket today versus the cost of the same basket at a previous point in time yields what is known as a price index. The percentage change in the price index is the inflation rate.
In the United States the most commonly used price index is the Consumer Price Index (CPI). This is calculated using a market basket of consumer goods, such as food, clothing, automobiles, and gasoline. When people in the media make statements such as “inflation rose by 4 percent last year,” they are usually referring to the CPI.
Another important price index is the Producer Price Index (PPI). This measures changes in the wholesale prices that producers of goods charge when they sell them to retailers or other intermediaries. Foods, metals, oil, and lumber are among the wholesale products in the PPI market basket. Usually the PPI and the CPI rise together over the long term, but in the short term there can be big differences in their rates of change, because price increases of wholesale goods may take some time to be passed on to consumers. Increases in the PPI are often good predictors of increases in the CPI.
Most people think of rising prices as a negative development, but in fact inflation is desirable within certain limits and when it is balanced by other factors. The increased demand associated with inflation can be positive as long as it is accompanied by similar increases in the production of goods and services. When the economy is growing at a healthy rate, production increases at a rate of 3 to 5 percent a year. An optimal inflation rate of 2 to 3 percent, under these conditions, represents a sustainable balance between production and consumer demand. With inflation and production at these levels, wages can generally keep pace with increases in prices, and businesses can continue to expand at similar rates.
By contrast, falling prices, or deflation, can be a cause for serious concern. When prices fall, businesses make less money, and they are likely to lay off workers. Unemployed workers have less money to spend, so they buy fewer products. This decreased demand for products can lead companies to scale back their operations even further, continuing the downward spiral. Persistent deflation is characteristic of economic depressions.
Governments today generally try to maintain a balance between economic growth and inflation. Instead of responding to decreasing growth with spending programs meant to spur demand, as was common in the mid-twentieth century, governments today tend to use their control over the money supply to regulate the economy. This is a result of events in the 1970s and 1980s.
In the 1970s inflation in the United States became a serious problem. By 1980 the general level of prices in the nation was rising at a rate of 13 percent annually. At that rate it only takes five years for the cost of living to double. Meanwhile, economic growth was sluggish. Unemployment (the number of workers who could not find jobs) was high, and production was stagnant. This combination of stagnation and inflation, which became known as “stagflation,” was unprecedented, and it led many economists to believe that the government’s attempt to stabilize the economy by using fiscal policy (tax and spending programs) had failed.
In the 1980s the Federal Reserve, the central bank of the United States, began using its power over the money supply to battle inflation aggressively. By tightly restricting the amount of money in circulation, the Federal Reserve, commonly called the Fed, forced interest rates (the fees paid by people and companies who borrow money) to all-time highs of more than 20 percent. Under such conditions, people and companies are usually very reluctant to borrow money, and a great deal of economic activity is suppressed. These actions thus had the intended effect of cutting inflation, but they also forced the country into recession (a period of economic decline). By 1982 inflation had fallen to approximately half of its 1980 high, but unemployment had risen to its highest levels since the Great Depression.
By the early 1990s inflation had fallen to about 3 percent, and unemployment had returned to normal. By the next decade inflation still had not risen significantly. Inflation remains, however, one of the primary factors that the Fed, economists, investors, and businesspeople monitor in order to determine how healthy the economy is. One of the Fed’s main priorities remains the balancing of economic growth with inflation.
inflation, in economics, persistent and relatively large increase in the general price level of goods and services. Its opposite is deflation, a process of generally declining prices. The U.S. Bureau of Labor Statistics produces the Consumer Price Index (CPI) yearly, which measures average price changes in relation to prices in an arbitrarily selected base year. While the CPI is usually considered the most reliable estimate of inflation, some economists have questioned whether it overstates inflationary trends.
Inflation results from an increase in the amount of circulating currency beyond the needs of trade; an oversupply of currency is created, and, in accordance with the law of supply and demand, the value of money decreases. Deflation is brought about by the opposite condition. In the past, inflation was often due to a large influx of bullion, such as took place in Europe after the discovery of America and at the end of the 19th cent. when new supplies of gold were found and exploited in South Africa. In modern times wars have been the most common cause of inflation, as government borrowing, the increase in the money supply, and a diminished supply of consumer goods increase demand relative to supply and thereby cause rising prices.
Inflation stimulates business and helps wages to rise, but the increase in wages usually fails to match the increase in prices; hence, real wages often diminish. Stockholders make gains—often illusory—from increased business profits, but bondholders lose because their fixed percentage return has less buying power. Borrowers also gain from inflation, since the future value of money is reduced. Deflation, which historically has occurred in the downward movement of the business cycle, lowers prices and increases unemployment through the depression of business. Persistent deflation in Japan, beginning in the early 1990s, resulted in a drop in consumption, record unemployment, and general economic stagnation. Deflation in home prices after the financial collapse of 2008–9 (as opposed to deflation in goods and services prices) significantly reduced the value of the assets of many American households and proved a significant strain on the U.S. economy. An unusually steep and sudden rise in prices, sometimes called hyperinflation, may result in the eventual breakdown of an entire nation's monetary system. Among the notable examples of hyperinflation have been Germany in 1923, Yugoslavia in 1993–94, and Zimbabwe in 2008.
In the United States, annual price increases of less than about 2% or 3% are not considered indicative of serious inflation. During the early 1970s, however, prices rose by considerably higher percentages, leading President Nixon to implement wage-and-price controls in 1971. Stagflation–the combination of high unemployment and economic stagnation with inflation–became common in the industrialized countries during the 1970s. The costs of the Vietnam War and the social programs of the Johnson administration, plus the oil prices increases in 1974 by the Organization of Petroleum Exporting Countries (OPEC), contributed to U.S. inflation. By the end of the 1970s the Federal Reserve raised interest rates in an attempt to reduce inflation. Following a recession in the early 1980s, there was renewed growth, somewhat lower interest rates, and a decrease in the inflation rate.
During the early 1990s, a downward business turn created an international recession—without significant deflation—that replaced inflation as a major problem; the Federal Reserve lowered interest rates to stimulate economic growth. The mid-1990s saw moderate inflation (2.5%–3.1% annually), even with an increase in interest rates. By the late 1990s, U.S. inflation was low (1.9% by 1998), despite record growth; it tended to be somewhat higher (roughly 2%–3.5%) in subsequent years, due largely to increases in energy costs and, to a lesser degree, to large government deficits since 2001. Beginning in 2009, however, recession and a lackluster recovery led to much lower rates (typically less than 2%) and even to minor deflation in goods and services at times.
See J. Ahmad, Floating Exchange Rates and World Inflation (1984); A. J. Brown, World Inflation since 1950 (1985); T. S. Sargent, The Conquest of American Inflation (1999); R. J. Samuelson, The Great Inflation and Its Aftermath (2008).
Though early sociological studies of inflation claimed to be addressing unexamined residual categories in economic theory, most later accounts sought not to displace, but rather to supplement the work of economists. The inflation—causing factors emphasized as the basis of difference between inflation—prone and price—stable industrial cultures may be classed as normative and structural. The normative argument, clearly influenced by Emile Durkheim's concept of egoism, is that in a market society, inequalities in income are not governed by some moral standard of a fair day's work for a fair day's pay. They reflect, instead, arbitrary variations in the market power of both individuals and organized groups. The extent to which resentment is engendered will depend on the degree to which there is a general acceptance of individualism and competitiveness as values in themselves. Resentment, in turn, sets off leap-frogging attempts by groups to advance their relative standing.
However, the effect of normative causes will be mediated by various structural factors, notably the extent to which the differential ability of groups to enhance their incomes is stabilized or regulated by law and institutional controls that promote trust between groups; the productive capacity of the economy, especially the degree to which claims are pursued against a surplus that is growing rapidly, or is fixed or increasing only slowly; and whether gains in profitability are reinvested in income-earning industrial capacity or siphoned off into financial speculation whose returns are not enjoyed by the workforce at large.
The best summary of the sociological literature on inflation is Michael Gilbert 's Inflation and Social Conflict (1986)
Inflation is a continuous rise in the price of goods and services. It is important to note that a rise in the price of just one or two items does not constitute inflation; nor does a one-time rise in all prices mark an inflationary period. To count as inflation, the price increases must be general throughout the economy and must continue over time. The hallmark of inflation is that money buys less than it once did. A cup of coffee that may have cost a dime at mid-twentieth century may cost a dollar some 50 years later.
Rising prices have been observed in most Western industrialized nations since the end of World War II (1939–1945). Economists, however, debate at which point inflation begins to pose a threat to society. If prices rise steeply and quickly enough, say, in the range of five to ten percent a year, inflation can undermine a nation's economic well being. The value of savings decreases, since the money saved will buy less and less over time. Senior citizens and others living on fixed incomes see their buying power erode. Inflation also means business owners must pay a steadily rising price for labor and raw materials, which cuts into profits. Eventually, rising prices can choke off economic growth, and lead to a recession.
The government can fight inflation by restricting demand for goods and services, usually by raising interest rates or imposing new taxes. Such measures tend to lead to higher unemployment, which dampens demands for goods and services and, in turn, brings down prices. Economists debate whether the cost of fighting inflation, e.g., higher unemployment and less growth, is worth the pain. Certainly a moderate amount of inflationary price increases, in the range of one to two percent per year, is viewed by many economists as not worth worrying about.
Inflation is measured by the government's cost of living index. The opposite of inflation is deflation, a steady decline in the level of prices over time.
See also: Cost of Living Index, Deflation