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Inflation : Effects and Causes.

2008-02-19 07:32:29

Effects of inflation

A small amount of inflation is generally viewed as having a positive effect on the economy.[3] One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are "sticky downward" and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Efforts to attain complete price stability can also lead to deflation, which is generally viewed as a negative by Keynesians because of the downward adjustments in wages and output that are associated with it. More generally because modest inflation means that the price of any given good is likely to increase over time there is an inherent advantage to making purchases sooner than later. This effect tends to keep an economy active in the short term by encouraging spending and borrowing, and in the long term by encouraging

investments. High inflation, though, tends to reduce long-term capital formation by hurting the incentive to save, and to effectively reduce long-term spending by making products less affordable. Deflation, by contrast, leads to an incentive to save more and encourages less short term spending potentially slowing economic growth.

Inflation is also viewed as a hidden risk pressure that provides an incentive for those with savings to invest them, rather than have the purchasing power of those savings erode through inflation.[citation needed] In investing, inflation risks often cause investors to take on more systematic risk, in order to gain returns that will stay ahead of expected inflation. Inflation is also used as an index for cost of living adjustments and as a peg for some bonds. In effect, inflation is the rate at which previous economic transactions are discounted economically.

Inflation also gives central banks room to maneuver, since their primary tool for controlling the money supply and velocity of money is by setting the lowest interest rate in an economy - the discount rate at which banks can borrow from the central bank. Since borrowing at negative interest is generally ineffective, a positive inflation rate gives central bankers "ammunition", as it is sometimes called, to stimulate the economy. As central banks are controlled by governments, there is also often political pressure to increase the money supply to pay government services, this has the added effect of creating inflation and decreasing the net money owed by the government in previously negotiated contractual agreements and in debt.

However, in general, inflation rates above the nominal amounts required to give monetary freedom, and investing incentive, are regarded as negative, particularly because in current economic theory, inflation begets further inflationary expectations.

Increasing uncertainty may discourage investment and saving.
Redistribution

o It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and profits which may keep pace with inflation.

o Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax.

International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade.
Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.)
Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
Relative Price Distortions: Firms do not generally synchronize adjustment in prices. If there is higher inflation, firms that do not adjust their prices will have much lower prices relative to firms that do adjust them. This will distort economic decisions, since relative prices will not be reflecting relative scarcity of different goods.
Hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.
Bracket Creep (also called fiscal drag) is related to the inflation tax. By allowing inflation to move upwards, certain sticky aspects of the tax code are met by more and more people. For example, income tax brackets, where the next dollar of income is taxed at a higher rate than previous dollars, tend to become distorted. Governments that allow inflation to "bump" people over these thresholds are, in effect, allowing a tax increase because the same real purchasing power is being taxed at a higher rate.
Dual destruction of real value in the economy: Inflation always and everywhere results in the destruction of real value in (1) all monetary items over time (which cannot be updated) and (2) constant real value non-monetary items (historical cost items, eg. retained income) when the latter are never updated as a result of the stable measuring unit assumption which is a generally accepted accounting principle or GAAP.[citation needed]

As noted, some economists see moderate inflation as a benefit; some business executives see mild inflation as "greasing the wheels of commerce."[4][5] Some economists have advocated reducing inflation to zero as a monetary policy goal - particularly in the late 1990s at the end of a long disinflationary period, when the policy seemed within reach; and some have even advocated deflation instead of inflation.

[edit] Problems

High inflation can cause many problems:

1. It hurts people on fixed incomes (e.g. pensioners, students) by reducing their purchasing power. This has a significant effect on GDP.[citation needed]

2. Rising inflation can prompt trade unions to demand higher wages, under the circular logic that wages must keep up with inflation. (Of course, rising wages can help fuel inflation.) In the case of collective bargaining, wages will be set as a factor of price expectations (Pe). Pe will be higher when inflation has an upward trend. This can cause a wage spiral. Also, if strikes occur in an important industry which has a comparative advantage, productivity could decline.[citation needed]

3. If inflation is higher in one country than in its trading partners', and that country maintains fixed exchange rates, then the country's exports will become more expensive abroad and it will tend toward a current-account deficit.[citation needed]

4. High inflation distorts relative prices. The pricing mechanism allows for the efficient allocation of resources and if prices are misaligned this will lead to an economically inefficient allocation of resources.[citation needed]

[edit] Benefits

Inflation is often viewed as the universal enemy however this is not the full story. Inflation may be the enemy of the saver but it is the debtor's friend, ie as money becomes worth less an indebted person's burden is reduced. Given that many people are in debt this other face of inflation is not neglible.

[edit] Causes of inflation

In the long run inflation is generally believed to be a monetary phenomenon while in the short and medium term it is influenced by the relative elasticity of wages, prices and interest rates.[6] The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian schools. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trendline. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.

A great deal of economic literature concerns the question of what causes inflation and what effect it has. There are different schools of thought as to what causes inflation. Most can be divided into two broad areas: quality theories of inflation, and quantity theories of inflation. Many theories of inflation combine the two. The quality theory of inflation rests on the expectation of a buyer accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the equation of the money supply, its velocity, and exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.

Keynesian economic theory proposes that money is transparent to real forces in the economy, and that visible inflation is the result of pressures in the economy expressing themselves in prices.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":

Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending, etc.
Cost-push inflation: presently termed "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively, often leading to hyperinflation, a condition where prices can double in a month or less. Another cause can be a rapid decline in the demand for money, as happened in Europe during the Black Plague.

The money supply is also thought to play a major role in determining moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics, by contrast, typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians the money supply is only one determinant of aggregate demand. Some economists consider this a 'hocus pocus' approach: They disagree with the notion that central banks control the money supply, arguing that central banks have little control because the money supply adapts to the demand for bank credit issued by commercial banks. This is the theory of endogenous money. Advocated strongly by post-Keynesians as far back as the 1960s, it has today become a central focus of Taylor rule advocates. But this position is not universally accepted. Banks create money by making loans. But the aggregate volume of

these loans diminishes as real interest rates increase. Thus, it is quite likely that central banks influence the money supply by making money cheaper or more expensive, and thus increasing or decreasing its production.

A fundamental concept in Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment. The Philips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s.

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.

Another Keynesian concept is the potential output (sometimes called the "natural gross domestic product"), a level of GDP, where the economy is at its optimal level of production given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.

However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under British Prime Minister Margaret Thatcher might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed (also see unemployment), unable to find jobs that fit their skills. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.