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TO
LETTERS THETOEDITOR
BASICS

What
Is Inflation?
Ceyda Oner

I
t may be one of the most familiar words in econom- consumers—requires an index with broader coverage, such
ics. Inflation has plunged countries into long peri- as the gross domestic product (GDP) deflator.­
ods of instability. Central bankers often aspire to be The CPI basket is mostly kept constant over time for
known as “inflation hawks.” Politicians have won consistency, but is tweaked occasionally to reflect chang-
elections with promises to combat inflation, only to lose ing consumption patterns—for example, to include new
power after failing to do so. Inflation was even declared hi-tech goods and to replace items no longer widely pur-
Public Enemy No. 1 in the United States—by President chased. Because it shows how, on average, prices change
Gerald Ford in 1974. What, then, is inflation, and why is over time for everything produced in an economy, the
it so important? contents of the GDP deflator vary each year and are more
Inflation is the rate of increase in prices over a given current than the mostly fixed CPI basket. On the other
period of time. Inflation is typically a broad measure, such hand, the deflator includes non-consumer items (such as
as the overall increase in prices or the increase in the cost military spending) and is therefore not a good measure of
of living in a country. But it can also be more narrowly the cost of living.­
calculated—for certain goods, such as food, or for services,
such as a haircut, for example. Whatever the context, infla- The good and the bad
tion represents how much more expensive the relevant set To the extent that households’ nominal income, which they
of goods and/or services has become over a certain period, receive in current money, does not increase as much as
most commonly a year.­ prices, they are worse off, because they can afford to pur-
chase less. In other words, their purchasing power or real—
Measuring inflation inflation-adjusted—income falls. Real income is a proxy
Consumers’ cost of living depends on the prices of many for the standard of living. When real incomes are rising, so
goods and services and the share of each in the house- is the standard of living, and vice versa.­
hold budget. To measure the average consumer’s cost of In reality, prices change at different paces. Some, such as
living, government agencies conduct household surveys the prices of traded commodities, change every day; others,
to identify a basket of commonly purchased items and such as wages established by contracts, take longer to adjust
track over time the cost of purchasing this basket. (Hous- (or are “sticky,” in economic parlance). In an inflationary
ing expenses, including rent and mortgages, constitute the environment, unevenly rising prices inevitably reduce the
largest component of the consumer basket in the United purchasing power of some consumers, and this erosion of
States.) The cost of this basket at a given time expressed real income is the single biggest cost of inflation.­
relative to a base year is the consumer price index (CPI), Inflation can also distort purchasing power over time for
and the percentage change in the CPI over a certain pe- recipients and payers of fixed interest rates. Take pension-
riod is consumer price inflation, the most widely used ers who receive a fixed 5 percent yearly increase to their
measure of inflation. (For example, if the base year CPI pension. If inflation is higher than 5 percent, a pensioner’s
is 100 and the current CPI is 110, inflation is 10 percent purchasing power falls. On the other hand, a borrower who
over the period.) pays a fixed-rate mortgage of 5 percent would benefit from
Core consumer inflation focuses on the underlying and 5 percent inflation, because the real interest rate (the nomi-
persistent trends in inflation by excluding prices set by nal rate minus the inflation rate) would be zero; servicing
the government and the more volatile prices of products, this debt would be even easier if inflation were higher, as
such as food and energy, most affected by seasonal fac- long as the borrower’s income keeps up with inflation. The
tors or temporary supply conditions. Core inflation is lender’s real income, of course, suffers. To the extent that
also watched closely by policymakers. Calculation of an inflation is not factored into nominal interest rates, some
overall inflation rate—for a country, say, and not just for gain and some lose purchasing power.­

44   Finance & Development March

December
2010
2009
 Indeed, many countries have grappled with high as high oil prices, can reduce overall supply and lead to “cost-
inflation—and in some cases hyperinflation, 1,000 percent or push” inflation, in which the impetus for price increases
more a year. In 2008, Zimbabwe experienced one of the worst comes from a disruption to supply. The food and fuel infla-
cases of hyperinflation ever, with estimated annual inflation tion of 2008 was such a case for the global economy—sharply
at one point of 500 billion percent. Such high levels of infla- rising food and fuel prices were transmitted from country to
tion have been disastrous, and countries have had to take dif- country by trade. Conversely, demand shocks, such as a stock
ficult and painful policy measures to bring inflation back to market rally, or expansionary policies, such as when a central
reasonable levels, sometimes by giving up their national cur- bank lowers interest rates or a government raises spending,
rency, as Zimbabwe has.­ can temporarily boost overall demand and economic growth.
Although high inflation hurts an economy, deflation, or If, however, this increase in demand exceeds an economy’s
falling prices, is not desirable either. When prices are falling, production capacity, the resulting strain on resources is
consumers delay making purchases if they can, anticipat- reflected in “demand-pull” inflation. Policymakers must
ing lower prices in the future. For the economy this means find the right balance between boosting demand and growth
less economic activity, less income generated by producers, when needed without overstimulating the economy and
and lower economic growth. Japan is one country with a causing inflation.­
long period of nearly no economic growth, largely because Expectations also play a key role in determining inflation.
of deflation. Preventing deflation during the global finan- If people or firms anticipate higher prices, they build these
cial crisis that began in 2007 is one of the reasons the U.S. expectations into wage negotiations and contractual price
Federal Reserve and other central banks around the world adjustments (such as automatic rent increases). This behav-
have kept interest rates low for a prolonged period and have ior partly determines the next period’s inflation; once the
instituted other monetary policies to ensure financial sys- contracts are exercised and wages or prices rise as agreed,
tems have plenty of liquidity. Today global inflation is at one expectations have become self-fulfilling. And to the extent
of its lowest levels since the early 1960s, partly because of the that people base their expectations on the recent past, infla-
financial crisis.­ tion will follow similar patterns over time, resulting in infla-
tion inertia.­
Policymakers must find the right
How policymakers deal with inflation
balance between boosting demand The right set of anti-inflation policies, those aimed at reducing
inflation, depends on the causes of inflation. If the economy
and growth when needed without has overheated, central banks—if they are committed to en-
overstimulating the economy and suring price stability—can implement contractionary policies
that rein in aggregate demand, usually by raising interest rates.
causing inflation. Some central bankers have chosen, with varying degrees of
success, to impose monetary discipline by fixing the exchange
Most economists now believe that low, stable, and—most rate—tying its currency to another currency and, therefore,
important—predictable inflation is good for an economy. If its monetary policy to that of the country to which it is linked.
inflation is low and predictable, it is easier to capture it in However, when inflation is driven by global rather than do-
price-adjustment contracts and interest rates, reducing its mestic developments, such policies may not help. In 2008,
distortionary impact. Moreover, knowing that prices will be when inflation rose across the globe on the back of high food
slightly higher in the future gives consumers an incentive and fuel prices, many countries allowed the high global prices
to make purchases sooner, which boosts economic activity. to pass through to the domestic economy. In some cases the
Many central bankers have made their primary policy objec- government may directly set prices (as some did in 2008 to
tive maintaining low and stable inflation, a policy called prevent high food and fuel prices from passing through).
inflation targeting (see “Inflation Targeting Turns 20,” in this Such administrative price-setting measures usually result in
issue).­ the government’s accrual of large subsidy bills to compensate
producers for lost income.­
What creates inflation? Central bankers are increasingly relying on their ability
Long-lasting episodes of high inflation are often the result of to influence inflation expectations as an inflation-reduction
lax monetary policy. If the money supply grows too big rela- tool. Policymakers announce their intention to keep eco-
tive to the size of an economy, the unit value of the currency nomic activity low temporarily to bring down inflation, hop-
diminishes; in other words, its purchasing power falls and ing to influence expectations and contracts’ built-in inflation
prices rise. This relationship between the money supply and component. The more credibility central banks have, the
the size of the economy is called the quantity theory of money, greater the influence of their pronouncements on inflation
and is one of the oldest hypotheses in economics.­ expectations.­ n
Pressures on the supply or demand side of the economy
can also be inflationary. Supply shocks that disrupt produc- Ceyda Oner is an Economist in the IMF’s Asia and Pacific
tion, such as natural disasters, or raise production costs, such Department.

Finance & Development March 2010   45

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 Solution to Numerical: Demand and Supply Analysis

Given:

a)
At equilibrium: Qd = Qs

=
18P = 67.5
P = $3.75
Substituting price in demand/supply function:
Qd = 50 – (8 x 3.75)
= 50 – 30
= 20
(P*, Q*) = ($3.75, 20)

b)
Quantity supplied at $2.75: -17.5 + (10 x 2.75) = - 17.5 + 27.5
Qs = 10
Quantity demanded at $2.75: 50 – (8 x2.75) = 50 – 22
 Qd = 28
Price of $2.75 is lower than equilibrium price and hence it would lead to shortage of the good in the
market. At this price, buyers will demand a higher quantity and suppliers will supply lower quantity
as compared to equilibrium

c)
Quantity supplied at $4.25: -17.5 + (10 x 4.25) = - 17.5 + 42.5
Qs = 25
Quantity demanded at $4.25: 50 – (8 x4.25) = 50 – 34
Qd = 16
Price of $4.25 is higher than equilibrium price and hence it would lead to surplus supply of the good
in the market. At this price, buyers will demand a lower quantity and suppliers will supply a higher
quantity as compared to equilibrium

d)
At equilibrium: Qd = Qs

=
18P = 76.5
P = $4.25
Substituting price in demand/supply function:
Qd = 59 – (8 x 4.25)
= 50 – 34
= 16
(P*, Q*) = ($4.25, 16)
e)
At equilibrium: Qd = Qs

=
18P = 90
P = $5
Substituting price in demand/supply function:
Qd = 50 – (8 x 5)
= 50 – 40
= 10
(P*, Q*) = ($5, 10)
The Effect of Taxes on Equilibrium

Example l: Suppose the denrand function is p.,,50 2q. and thc sLrpplr firnction is p.., l0'r 3q
atFrrrd thc equilihrirrnr poirrt
Lr) Sketch a graph

Solution to part a:

Set thc equations cqual to each othcr: 50 2q I 0- 3q

Subtract 10 ll'onr each sidc: 10 lq 3q
Add 2q to cach side: l0 .iq
Dir ide b1 5: 8 q
l'hen. solve fbr pricc: p - 50 l(8) - I I
,\nstt'er to part a: the equilibriurn poirrt is at (8. 3 l). 'f his lnealts *hen thc cluarrtitr is 8. thc price is
si,1.

4 6 8 10 1) 14 16 18

Example 2: Supposc tlte dentaud lirnction is p..50 2c1. and the sLrpplr tirnclion is p.,, l0 + 3q.(sanrc
as the last exanrple). What woLrld bc the efl-ect of a $5 tax?

Solution: I-t,t p "'the neu price. inclLrding thc tax. '['lre consr.lrrer pa\s17 dollars lbr tlre prodLrct. bLrt thc
sLrpplier rcceives onlr,Tr - 5 dollars. since $5 soc-s to the sorerrtrnent.

l'he clcnrand tirnction rerrairrs the sanre:

p''50 2q

But the sLrppll, flnctictn cltanses (replace 7r * itlr 7.r 5):

 p 5=l0r-3q
We can algebraicalll' re-arrange. br putting the 5 on the other side:

p'-15 t'3q
-l-he
ultinate result is the supply cur\ e lroves up by $5

10 1) 11 to 18

lhrs is a general concept in cconorttics. l'lre ell-ec1 of anr ta\ tln a product is ttr rrror e'tlte srrppl-r crrrr e
ru prr a rd s.

llere is one wa)'to think about this: Let's Lrse the point (2. l6) frorn the ori-einal sLrpply clrrve as an
erample. Irnagine a producersaf ing. "lf the price is $16. lam vvillingto produce 2 r.tnits"

Norv. vvith a $5 tax. the sLrpply cLlr\e rroves Lrp $5. so inragine the producer saf irrg "l used to be *illing
topfoduce2itenrsifthesellingprice uas$16.[]utnorr.thepricewill havctobe$21 lbrmeto
prodLrce 2 itenrs. I still onll get $16 and $5 goes to the gorenttlent."

ExampleS: With a $5 tar. uhat is the ues eclLulibriLrm point?

Solution: Set the denrand and supplr lirnctions equal to each otlrcr (but acld $5 to the suppll firnction)

50 2q .. 15 t3q
i5 2q" 3q
35 "' 5q
1 ''q
'fhe neu.'price *ill be: 50 2(7)" $36.

Answer: 'l'he neu' eqLrilibriLrnr poinl u ill be (7. i6)

Notice that the origirlal price *as $3-1. attd it *crt
up to s36 as a resLtrl of the tax. -r'his is a
but the tax \\'as $5' This $2 ircrease.
the producer pars s3 of the tar. uhilc passirg
coIt sU lll er. 'rlearls $2 of tlre ta.r ofFto t6e

l'he consumer pays $36. OLrt of this. $5 is thc

tar ancl the pr.odLrcer keeps $31.

llxample'1: Ilorv ttruclt rcvenLte does thc gorerrrrnent

collect as a resurt ot'this $5 taxr)

$5 per unit. ancl rhe qLranrin ar rtre ne$.equitibrium

il*i:l; il:;l:lJ;;J1;""..'s point is 17.,. 7

Price'quantirr : (5 dollars per Lrnit)(7 units),.,1i35.

Ansuer: the got errrlent * ill collect $j j in re\ elluc.