BASICS
Inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year.
“It may be one of the most familiar words in economics. Inflation has plunged countries into long periods of instability. Central bankers often aspire to be known as “inflation hawks.” Politicians have won elections with promises to combat inflation, only to lose power after failing to do so. Inflation was even declared Public Enemy No. 1 in the United States.”
by President Gerald Ford in 1974
What, then, is inflation, and why is it so important?
- Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. But it can also be more narrowly calculated.
- Whatever the context, inflation represents how much more expensive the relevant set of goods and/or services has become over a certain period, most commonly a year.
MEASURING INFLATION
- Consumers’ cost of living depends on the prices of many goods and services and the share of each in the household budget. To measure the average consumer’s cost of living, government agencies conduct household surveys to identify a basket of commonly purchased items and track over time the cost of purchasing this basket. (Housing expenses, including rent and mortgages, constitute the largest component of the consumer basket in the United States.) The cost of this basket at a given time expressed relative to a base year is the consumer price index (CPI), and the percentage change in the CPI over a certain period is consumer price inflation, the most widely used measure of inflation. (For example, if the base year CPI is 100 and the current CPI is 110, inflation is 10 percent over the period.)
- Core consumer inflation:
- Focuses on the underlying and persistent trends in inflation by excluding prices set by the government and the more volatile prices of products, such as food and energy, most affected by seasonal factors or temporary supply conditions. Core inflation is also watched closely by policymakers.
- Calculation of an overall inflation rate
- For a country, say, and not just for consumers, requires an index with broader coverage, such as the GDP deflator.
- The CPI basket is mostly kept constant over time for consistency, but is tweaked occasionally to reflect changing consumption patterns
- For example, to include new hi-tech goods and to replace items no longer widely purchased. Because it shows how, on average, prices change over time for everything produced in an economy, the contents of the GDP deflator vary each year and are more current than the mostly fixed CPI basket. On the other hand, the deflator includes nonconsumer items (such as military spending) and is therefore not a good measure of the cost of living.
What creates inflation ?
- Lax Monetary Policy:
- Long-lasting episodes of high inflation are often the result of lax monetary policy. If the money supply grows too big relative to the size of an economy, the unit value of the currency diminishes; in other words, its purchasing power falls and prices rise.
- This relationship between the money supply and the size of the economy is called the quantity theory of money and is one of the oldest hypotheses in economics.
- Cost Push Inflation:
- Pressures on the supply or demand side of the economy can also be inflationary. Supply shocks that disrupt production, such as natural disasters, or raise production costs, such as high oil prices, can reduce overall supply and lead to “cost-push” inflation, in which the impetus for price increases comes from a disruption to supply.
- Food and fuel inflation of 2008:
- It was a case for the global economy; sharply rising food and fuel prices were transmitted from country to country by trade. Conversely, demand shocks, such as a stock market rally, or expansionary policies, such as when a central bank lowers interest rates or a government raises spending, can temporarily boost overall demand and economic growth.
- If, however, this increase in demand exceeds an economy’s production capacity, the resulting strain on resources is reflected in “demand-pull” inflation. Policymakers must find the right balance between boosting demand and growth when needed without overstimulating the economy and causing inflation.
How inflation is dealt with ?
- The right set of disinflationary policies, those aimed at reducing inflation, depends on the causes of inflation.
- If the economy has overheated, central banks, if they are committed to ensuring price stability they can implement contractionary policies that rein in aggregate demand, usually by raising interest rates.
- Some central bankers have chosen, with varying degrees of success, to impose monetary discipline by fixing the exchange rate; tying the value of its currency to that of another currency, and thereby its monetary policy to that of another country.
- However, when inflation is driven by global rather than domestic developments, such policies may not help. In 2008, when inflation rose across the globe on the back of high food and fuel prices, many countries allowed the high global prices to pass through to the domestic economy. In some cases the government may directly set prices (as some did in 2008 to prevent high food and fuel prices from passing through).
- Such administrative price-setting measures usually result in the government’s accrual of large subsidy bills to compensate producers for lost income.
The more credibility central banks have, the greater the influence of their pronouncements on inflation expectations.
