The Term
The Term
The Term
use the word in this way. However, most economists today use the term "inflation" to refer to a rise in the price level.
An increase in the money supply may be called monetary inflation, to distinguish it from rising prices, which may also
for clarity be called 'price inflation'.[23] Economists generally agree that in the long run, inflation is caused by increases
in the money supply. However, in the short and medium term, inflation is largely dependent on supply and demand
Other economic concepts related to inflation include: deflation – a fall in the general price level; disinflation – a
inflation, slow economic growth and high unemployment; and reflation – an attempt to raise the general level of prices
In economics, inflation is a rise in the general level of prices of goods and services in aneconomy over a period of
time.[1] When the general price level rises, each unit of currency buys fewer goods and services. Consequently,
inflation also reflects an erosion in the purchasing power of money – a loss of real value in the internal medium of
exchange and unit of account in the economy.[2][3] A chief measure of price inflation is the inflation rate, the annualized
Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative effects of
inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future
inflation may discourage investment and savings, and high inflation may lead to shortages of goods if consumers
begin hoarding out of concern that prices will increase in the future. Positive effects include ensuring central banks
capital projects.
Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of
the money supply.[6] Views on which factors determine low to moderate rates of inflation are more varied. Low or
moderate inflation may be attributed to fluctuations inreal demand for goods and services, or changes in available
supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a
long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.[7][8]
Today, most mainstream economists favor a low, steady rate of inflation.[9] Low (as opposed to zero or negative)
inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a
downturn, and reduce the risk that a liquidity trap preventsmonetary policy from stabilizing the economy.[10] The task
of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary
authorities are thecentral banks that control the size of the money supply through the setting of interest rates,
Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price Index.
[26]
The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical
consumer".[4] The inflation rate is the percentage rate of change of a price index over time.
For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080.
The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is
The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for
Other widely used price indices for calculating price inflation include the following:
Producer price indices (PPIs) which measures average changes in prices received by domestic producers
for their output. This differs from the CPI in that price subsidization, profits, and taxes may cause the
amount received by the producer to differ from what the consumer paid. There is also typically a delay
between an increase in the PPI and any eventual increase in the CPI. Producer price index measures the
pressure being put on producers by the costs of their raw materials. This could be "passed on" to
consumers, or it could be absorbed by profits, or offset by increasing productivity. In India and the United
States, an earlier version of the PPI was called the Wholesale Price Index.
Commodity price indices, which measure the price of a selection of commodities. In the present
commodity price indices are weighted by the relative importance of the components to the "all in" cost of
an employee.
Core price indices: because food and oil prices can change quickly due to changes in supply and demand
conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when
those prices are included. Therefore moststatistical agencies also report a measure of 'core inflation',
which removes the most volatile components (such as food and oil) from a broad price index like the CPI.
Because core inflation is less affected by short run supply and demand conditions in specific
GDP deflator is a measure of the price of all the goods and services included in Gross Domestic
Product (GDP). The US Commerce Department publishes a deflator series for US GDP, defined as its
Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions
of the US.
Historical inflation Before collecting consistent econometric data became standard for governments, and
for the purpose of comparing absolute, rather than relative standards of living, various economists have
calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on
the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in
Asset price inflation is an undue increase in the prices of real or financial assets, such as stock (equity)
and real estate. While there is no widely accepted index of this type, some central bankers have suggested
that it would be better to aim at stabilizing a wider general price level inflation measure that includes some
asset prices, instead of stabilizing CPI or core inflation only. The reason is that by raising interest rates
when stock prices or real estate prices rise, and lowering them when these asset prices fall, central banks
An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when
the general level of prices rises, each monetary unit buys fewer goods and services.[29] The effect of inflation is not
distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from
this decrease in the purchasing power of money. For example, with inflation, lenders or depositors who are paid a
fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers
benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings.
Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments.
[11]
Increases in the price level (inflation) erode the real value of money (the functional currency) and other items with an
underlying monetary nature (e.g. loans and bonds). However, inflation has no effect on the real value of non-
Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the
inflation rate rises. The “real” interest on a loan is the nominal rate minus the inflation rate (approximately [31] ). For
example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate
that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and
the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this
inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial
stated interest rate or by setting the interest at a variable rate. As the rate of inflation decreases, this has the opposite
[edit]Negative
High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the
market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as
companies are forced to shift resources away from products and services in order to focus on profit and losses from
currency inflation.[11] Uncertainty about the future purchasing power of money discourages investment and saving.
[32]
And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates
With high inflation, purchasing power is redistributed from those on fixed nominal incomes, such as some pensioners
whose pensions are not indexed to the price level, towards those with variable incomes whose earnings may better
keep pace with the inflation.[11] This redistribution of purchasing power will also occur between international trading
partners. Where fixed exchange rates are imposed, higher inflation in one economy than another will cause the first
economy's exports to become more expensive and affect the balance of trade. There can also be negative impacts to
trade from an increased instability in currency exchange prices caused by unpredictable inflation.
DEFLATION
What Does Deflation Mean?
A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused
also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side
effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an
economic depression. Central banks attempt to stop severe deflation, along with severe inflation, in an attempt to
annual inflation rate falls below 0% (a negative inflation rate). This should not be confused with disinflation, a slow-
down in the inflation rate (i.e. when inflation declines to lower levels).[2] Inflation reduces the real value of money over
time; conversely, deflation increases the real value of money – the currency of a national or regional economy. This
allows one to buy more goods with the same amount of money over time.
Economists generally believe that deflation is a problem in a modern economy because of the danger of
as banks defaulted on depositors. Additionally, deflation may cause the economy to enter a liquidity trap. However,
historically not all episodes of deflation correspond with periods of poor economic growth.[4]
Effects
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6. Recessions and unemployment
Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid
assets, to the benefit of savers and of holders of liquid assets and currency. In this sense it is the opposite of inflation,
which is similar to taxing currency holders and lenders (savers) and using the proceeds to subsidize borrowers. Thus
inflation may encourage short term consumption. In modern economies, deflation is usually caused by a drop in
aggregate demand, and is associated with recession and (more rarely) long term economic depressions.
While an increase in the purchasing power of one's money sounds beneficial, it amplifies the sting of debt. This is
because after some period of significant deflation, the payments one is making in the service of a debt represent a
larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be
thought of as a phantom amplification of a loan's interest rate. If, as during the Great Depression in the United States,
deflation averages 10% per year, even a 0% loan is unattractive as it must be repaid with money worth 10% more
each year. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a
short-term interest rate — the overnight federal funds rate in the US — and enforcing that target by buying and selling
securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease
In recent times, as loan terms have grown in length and loan financing (or leveraging) is common among many types
of investments, the costs of deflation to borrowers have grown larger. Deflation discourages investment and
spending, because there is no reason to risk on future profits when the expectation of profits may be negative and the
expectation of future prices is lower. Consequently deflation generally leads to, or is associated with a collapse
in aggregate demand. Without the "hidden risk of inflation", it may become more prudent just to hold on to money,
Hard money advocates argue that if there were no "rigidities" in an economy, then deflation should be a welcome
effect, as the lowering of prices would allow more of the economy's effort to be moved to other areas of activity, thus
Since deflationary periods favor those who hold currency over those who do not, they are often matched with periods
of rising populist sentiment, as in the late 19th century, when populists in the US wanted to move off the gold
standard and onto a silver or bimetal standard because the supply of silver was increasing relatively faster than the
Historical examples
[edit]In Hong Kong
Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of deflation which did not end
until the 4th quarter of 2004 [2]. Many East Asian currencies devalued following the crisis. The Hong Kong
dollar however, was pegged to the US Dollar, leading to an adjustment instead by a deflation of consumer prices. The
situation was worsened by the increasingly cheap exports fromMainland China, and weak consumer confidence in
Hong Kong. This deflation was accompanied by an economic slump that was more severe and prolonged than those
of the surrounding countries that devalued their currencies in the wake of the Asian financial crisis.[16][17]
[edit]In Ireland
In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced
deflation, with prices falling by 0.1% from the same time in 2008. This is the first time deflation has hit the Irish
economy since 1960. Overall consumer prices decreased by 1.7% in the month.[18]
Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's
account, "Minister for Finance Brian Lenihan has said that deflation must be taken into account when Budget cuts in
child benefit, public sector pay and professional fees are being considered. Mr Lenihan said month-on-month there
has been a 6.6% decline in the cost of living this year."[citation needed]
This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the
interview. The Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits.
The alleged economic harm caused by deflation is not alluded to or mentioned by this member of government. This is
a notable example of deflation in the modern era being discussed by a senior financial Minister without any mention
Annual inflation (in blue) and deflation (in green) rates in the United States from 1666 to 2004.
There have been three significant periods of deflation in the United States.
The first was the recession of the late 1830s, following thePanic of 1837, when the currency in the United States
contracted by about 30%, a contraction which is only matched by the Great Depression. This "deflation" satisfies both
definitions, that of a decrease in prices and a decrease in the available quantity of money.
The second was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold
"The Great Sag of 1873-96 could be near the top of the list. Its scope was global. It featured cost-cutting and
productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by
politicians to understand it, let alone reverse it. It delivered a generation’s worth of rising bond prices, as well as the
usual losses to unwary creditors via defaults and early calls. Between 1875 and 1896, according to Milton Friedman,
[citation needed]
prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year.[22]
(Note: David A. Wells (1890) gives an account of the period and discusses the great advances in
The third was between 1930–1933 when the rate of deflation was approximately 10 percent/year, part of the
United States' slide into theGreat Depression, where banks failed and unemployment peaked at 25%.
The deflation of the Great Depression, as in 1836, did not begin because of any sudden rise or surplus in
environment where cash was in frantic demand, and theFederal Reserve did not adequately accommodate that
demand, so banks toppled one-by-one (because they were unable to meet the sudden demand for cash—
see Fractional-reserve banking). From the standpoint of the Fisher equation (see above), there was a
concomitant drop both in money supply (credit) and the velocity of money which was so profound that price
deflation took hold despite the increases in money supply spurred by the Federal Reserve.
What Does Reflation Mean?
A fiscal or monetary policy, designed to expand a country's output and curb the effects of deflation. Reflation policies
can include reducing taxes, changing the money supply and lowering interest rates.
The term "reflation" is also used to describe the first phase of economic recovery after a period of contraction.
Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. It is the
opposite of disinflation. It can refer to an economic policy whereby a government uses fiscal or monetary stimulus in
order to expand a country's output. This can possibly be achieved by methods that include reducing tax, changing the
money supply, or even adjusting interest rates. Just asdisinflation is considered an acceptable antidote to high
inflation, reflation is considered to be an antidote to deflation (which, unlike inflation, is considered bad regardless
Originally it was used to describe a recovery of price to a previous desirable level after a fall caused by a recession.
Today it also (in addition to the above) describes the first phase in the recovery of an economy which is beginning to
experience increasing prices at the end of a slump. With rising prices, employment, output and income also increase
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate is low. It
raises a dilemma for economic policy since actions designed to lowerinflation may worsen economic stagnation and
vice versa. The portmanteau stagflation is generally attributed to British politician Iain Macleod, who used the term in
The concept is notable partly because, in postwar macroeconomic theory, inflation and recession were regarded as
mutually exclusive, and also because stagflation has generally proven to be difficult and, in human terms as well as
In the political arena one measure of Stagflation termed the Misery Index (derived by the simple addition of the
inflation rate to the unemployment rate) was used to swing Presidential elections in the United States in 1976 and
1980.
Causes
Economists offer two principal explanations for why stagflation occurs. First, stagflation can result when the
productive capacity of an economy is reduced by an unfavorable supply shock, such as an increase in the price of oil
for an oil importing country. Such an unfavorable supply shock tends to raise prices at the same time that it slows the
Second, both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central
banks can cause inflation by permitting excessive growth of the money supply,[8] and the government can cause
stagnation by excessive regulation of goods markets and labor markets,[9] Either of these factors can cause
stagflation. Excessive growth of the money supply taken to such an extreme that it must be reversed abruptly can
clearly be a cause. Both types of explanations are offered in analyses of the global stagflation of the 1970s: it began
with a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to
Recent views
Until recently no macroeconomic policy had been able predict the occurrence of
Stagflation.
After the fact, and several years of research, a convincing explanation was
provided based on the effects of adverse supply shocks on both prices and
output.[19] According to Blanchard (2009), these adverse events were one of two
components of stagflation; the other was "ideas", which Robert Lucas (famous
for the Lucas Supply Curve), Thomas Sargent, and Robert Barro were cited as
expressing as "wildly incorrect" and "fundamentally flawed" predictions
[of Keynesian economics] which, they said, left stagflation to be explained by
"contemporary students of the business cycle".[19] In this discussion, Blanchard
hypothesizes that the recent oil price increases could trigger another period of
stagflation, although this has not yet happened (pg. 152).
[edit]