Managing the Economy III
Inflation - definition and measurement. Causes and
cures. Keynesian and Monetarist explanations.
What caused the significant rise in inflation at the
end of the 1980's in the U.K.
Inflation is an increase in the general, average, price level of goods
and services in the economy.
Inflation's opposite is deflation. Deflation is a decrease in the
general, average, price level of goods and services in the economy.
Note: inflation is an increase in the overall average level of prices
and not in an increase in the price of any specific product.
The most widely reported measure of inflation is the CONSUMER PRICE
INDEX. The consumer price index (CPI) is an index that measures changes
in the average price of consumer goods and services. The CPI is also
known as the cost-of-living index. The CPI includes only consumer goods
and services in order to determine how rising prices affect the income
In every modern country a similar procedure is followed by the
authorities to gather information to build the CPI.
For example, in the United States, the Bureau of Labour Statistics(BLS)
(you can visit it from RRojas Databank) of the Department of Labor
prepares the CPI. Each month, the bureau's "price collectors" contact
retail stores, homeowners, and tenants in selected cities throughout
The United States. Based on these monthly inquiries, the BLS records
average prices for a "market basket" of different items purchased by
the typical family. Below that "market basket" is described:
USA.-The Composition of the Consumer Price Index
All items 100.0%
Food and beverage 17.4
At home 9.8
Away from home 6.0
Alcoholic beverages 1.6
Renters' cost 8.0
Homeowners' costs 19.8
Apparel and upkeep 5.9
New vehicles 9.5
Used vehicles 1.3
Public transportation 1.7
Medical care 7.0
Other goods and services 6.9
source: U.S. Department of Labor, CPI Detailed Report: January 1994,
In the United Kingdom, the index is called INDEX OF RETAIL PRICES, and
is calculated with the prices of the following items:
Clothing and footwear
Fuel and light
Personal goods and services
Fares and other travel costs
The weights which are used to calculate the index are based on the
pattern of household expenditure derived from the continuing Family
Expenditure Survey. Since 1962 the weights have been revised in
February of each year.
The general index of retail prices measures the changes month by month
in the level of the commodities and services purchased by all types of
households in the United Kingdom, with the exception of certain high
income households and households of retired people mainly dependent on
state benefits. These households are:
the 4 per cent (approximately) where the total household recorded
income exceeds a certain amount (£960 a week in 1993/1994).
those in which at least three quarters of the total income is
derived from state pensions and benefits and which include at least
one person over the national insurance retirement age.
Expenditure patterns of one-person and two-person pensioner households
differ from those of the households upon which the general index is
based. Separate indices have been compiled for such pensioner households
since 1968. ( Social Trends, 1996 Edition, HMSO, 1996)
CONSEQUENCES OF INFLATION
The most obvious consequence is that inflation reduces income. Economist
Arthur Okun stated, "this society is built on implicit and explicit
contracts...They are linked to the idea that the dollar means something.
If you cannot depend on the value of the dollar, this system is
undermined. People will constantly feel they've been fooled and
cheated". ('How Inflation Threatens the Fabric of U.S. Society', in
"Business Week", May 22, 1978)
Inflation tends to reduce the standard of living of those on fixed
income through declines in the purchasing power of money. The greater
the rate of inflation, the greater the decline in the quantity of goods
we can purchase with a given NOMINAL INCOME or money income. Nominal
income is the actual number of currency received over a period of time.
The source of income can be from WAGES, SALARY, RENT, INTEREST, or
INFLATION AND WEALTH
Income is one measure of economic well-being, and wealth is another.
Income is a flow of money earned by selling labour or using capital
and labour to produce goods. Wealth is the value of the stock of assets
owned at some point in time. Wealth includes real estate, stocks, bonds,
bank accounts, life insurance policies, cash, and cars. A person can
a high income and little wealth, or great wealth and little income.
Inflation can benefit holders of wealth because the value of assets
tends to increase as prices rise.
On the other hand, the impact of inflation on wealth penalizes people
without it...Consider a person wishing to buy a home. As price rise,
it becomes more difficult for them to buy a home or acquire other
Borrowers and savers may be winners or losers depending on the rate
of inflation. Understanding how this might happen requires making a
distinction between NOMINAL INTEREST RATE and the REAL INTEREST RATE.
The nominal interest rate is the rate of interest actually observed.
The real interest rate is the nominal rate of interest minus the
inflation rate. The occurrence of inflation means that the real rate
of interest will be less than the nominal rate. Suppose the inflation
rate during the year is 5 percent. This means that a 10 percent annual
interest rate pais on a £10,000 loans amounts to a 5 percent REAL
Thus, inflation can make those who borrow winners, and have them paying
"negative" rate of interest, if the rate of inflation is higher than
the rate of interest.
Of course, when the real rate of interest is negative, lenders and
savers lose because interest earned does not keep up with the inflation
DEMAND-PULL AND COST-PUSH INFLATION
The most familiar type of inflation is called demand-pull inflation.
Demand-pull inflation is a rise in the general price level from an
excess of total spending (demand):
Two outcomes, depending on the speed at which supply respond to the
excess of demand:
1) if supply does not respond then "too much money will
be chasing too few goods". When sellers are unable
to supply all the goods and services buyers demand,
sellers respond by rising prices. In short, the
general price level in the economy is "pulled up"
by the pressure from buyers' total expenditures.
This situation is called "money inflation" and it
creates a dynamic of devaluating the national
Demand-pull inflation as "money inflation" occurs
at or close to full employment where the economy
is operating at or near full capacity. At full
employment all but the frictionally and structurally
unemployed are working and earning income. Therefore,
total aggregate demand is high. Businesses find it
profitable to expand their plants and production to
meet the buyer's demand, but cannot in the short run.
As a result, national output remains fixed, and prices
rise as buyers try to outbid one another for the
available supply of goods and services. If total
spending subsides, so will the pressure on the
available supply of products, and prices will not rise
Also, if supply responds fairly soon, more output will
occur, keeping prices high but the value of the money
will not fall.
2) if supply responds fairly soon, maintaining an
upward slopping supply curve, then price per unit
of output will increase, but so output will increase,
which will lead to more employment (less unemployment)
in the short- and medium-term. In this situation,
there will be 'trade-off' between unemployment and
inflation. This situation is called "output inflation".
Keynesians take that this is the most common status
of the national economy, and it does happen in the
stage of recovery (boom) in the business cycle.
Cost-push inflation occurs when there is a significant increase in the
cost of producing goods and services. The increase of the price of oil
in 1973, and then in 1979, are cases in point. Thus, cost-push inflation
is an increase in the general price level resulting from an increase in
the cost of production.
The source of many cost-push inflations is not such a dramatic event
as the rise of oil prices. Any increased costs to businesses are a
potential source of cost-push inflation. This means that upward pressure
on prices may be caused by cost increases for labour, raw materials,
construction, equipment, borrowing, and so on. Business can also
contribute to cost-push inflation by raising prices to increase
profits. The latter is normal ocurrence when the markets are dominated
by monopolieas and/or oligopolies, which is the general case in the
The influence of expectations on both demand-pull and cost-push
inflation is an important consideration. Suppose buyers see prices rise
and believe they should purchase that new house or car today before
these items cost much more tomorrow. At or near full employment, this
demand-pull results in a rise in prices. On the suppliers' side, firms
might expect their production costs to rise in the future and this
causes them to raise prices in anticipation of the higher costs. The
result is cost-push inflation.
Hyperinflation is an extremely rapid rise in general price level.
This kind of inflation is conducive to rapid and violent social and
political change. The cause could be grouped as follows:
1) individuals and businesses develop an 'inflation psychosis', causing
them to buy quickly today in order to avoid paying more tomorrow.
The pressure is on everyone to spend earnings before their purchasing
2) huge unanticipated inflation jeopardizes debtor-lender contracts
such as credit cards, home mortgages, life insurance policies,
pensions, bonds, and other forms of savings.
3) hyperinflation sets a wage-price spiral in motion. A wage-price
spiral occurs in a series of steps when increases in nominal wages
rates are passed on in higher prices, which, in turn, result in even
higher nominal wage rates and prices.
4) because the future rate of inflation is dificult or impossible to
anticipate, people turn to more speculative investments that might
yield higher financial returns. Funds flow into gold, silver, stamps,
jewels, art, antiques, and other currencies, rather than new
factories, machinery, and technological research that expand an
economy's production possibilities frontier.