Inflation: Prices on the Rise
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- Authors: Ceyda Oner
- Published: July 30, 2019
What is inflation and how it is measured
- Inflation is the rate of increase in prices over a given period of time; most commonly measured over a year.
- Consumer price inflation: the percentage change in the consumer price index (CPI) over a certain period.
- Example method: "if the base year CPI is 100 and the current CPI is 110, inflation is 10 percent over the period."
- Core consumer inflation: excludes prices set by the government and the more volatile prices of products such as food and energy.
- GDP deflator: an index with broader coverage than the CPI that shows how prices change over time for everything produced in an economy; includes nonconsumer items (such as military spending) and therefore is not a good measure of cost of living.
- CPI basket: mostly kept constant for consistency but occasionally tweaked to reflect changing consumption patterns (for example, to include new hi-tech goods and to replace items no longer widely purchased).
Distributional effects and the "good and the bad"
- Purchasing power and real income:
- If nominal incomes do not increase as much as prices, purchasing power and real (inflation-adjusted) income fall.
- Real income is a proxy for the standard of living.
- Price adjustment heterogeneity:
- Some prices (traded commodities) change every day; others (wages established by contracts) are "sticky."
- Uneven price changes reduce purchasing power for some consumers; this erosion of real income is described as the single biggest cost of inflation.
- Effects on fixed-rate contracts:
- Example: a pensioner receiving a fixed 5 percent yearly increase to their pension loses purchasing power if inflation is higher than 5 percent.
- Example: a borrower with a fixed-rate mortgage of 5 percent benefits from 5 percent inflation because the real interest rate would be zero.
- Lenders’ real income suffers when inflation is not factored into nominal interest rates.
- High inflation and hyperinflation:
- Some countries have experienced hyperinflation, defined here as 1,000 percent or more a year.
- Example: in 2008, Zimbabwe experienced estimated annual inflation at one point of 500 billion percent.
- Extreme inflation has led countries to take painful measures, sometimes including giving up their national currency.
- Deflation risks:
- Falling prices can lead consumers to delay purchases, reducing economic activity and growth.
- Japan cited as an example of long period of nearly no economic growth largely because of deflation.
- Preventing deflation during the global financial crisis that began in 2007 was a motivation for prolonged low interest rates and other monetary policies by the US Federal Reserve and other central banks.
Causes of inflation
- Monetary causes:
- Long-lasting high inflation often results from lax monetary policy: if the money supply grows too big relative to the size of an economy, the currency’s purchasing power falls (quantity theory of money).
- Supply-side pressures:
- Supply shocks that disrupt production (natural disasters) or raise production costs (high oil prices) can produce "cost-push" inflation.
- Example: the food and fuel inflation of 2008 transmitted across countries by trade.
- Demand-side pressures:
- Demand shocks (a stock market rally) or expansionary policies (central bank lowers interest rates or government raises spending) can boost demand; if demand exceeds production capacity, "demand-pull" inflation can result.
- Expectations and inertia:
- If people or firms anticipate higher prices, they build expectations into wages and contractual price adjustments, making expectations partly self-fulfilling and contributing to inflation inertia.
How policymakers deal with inflation
- Policy choice depends on inflation’s cause:
- If the economy is overheated, contractionary monetary policy—usually by raising interest rates—can rein in aggregate demand.
- Some central banks impose monetary discipline by fixing the exchange rate, tying their currency value and monetary policy to another country; effectiveness is limited when inflation is driven by global developments.
- Administrative price-setting (used by some governments in 2008) can prevent pass-through of high global prices but typically leads to large subsidy bills to compensate producers.
- Managing expectations:
- Central banks increasingly rely on influencing inflation expectations as a disinflation tool.
- Policymakers announce intentions to keep economic activity low temporarily to bring down inflation, aiming to shape wage and price-setting behavior.
- The credibility of the central bank enhances the influence of such announcements on expectations.
Inflation: Prices on the Rise — Ceyda Oner, F&D Magazine
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- Inflation: Prices on the Rise - Back to Basics: Economics Concepts Explained - FINANCE & DEVELOPMENT