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Understanding Inflation

Updated on September 8, 2009

Prices of goods and services move upward and downward, sometimes violently. In popular usage, rising general prices are called "inflation" and falling general prices are called "deflation".

Most of the sharp inflation in the 19th and 20th centuries has been associated with major wars. Thus price peaks were attained in the United States at war's end, or soon thereafter, in the War of 1812, the Civil War, and World Wars I and II. Price declines followed these spectacular upswings, but usually the postwar declines fell short of the prewar price levels. Between wars, prices dropped to very low levels in the depressions of 1849, 1896, and 1932.

In the decades following  World War II, the main price pressure in the United States was upward. Other nations similarly have encountered rising price trends.

Meaning of Inflation

Precision of definition is required in order to understand the complex movements of prices, general price changes and their effects, and the methods of controlling some kinds of inflation and deflation.

A distinction first must be made between open and suppressed (or repressed) inflation. Open inflation simply means an upward movement of the price level. Suppressed inflation refers to a situation in which an upward movement of the price level would occur if maximum limits established by law for prices, wages, rents, and the like were removed. Several kinds of evidence indicate this potential upward movement of prices. Long queues of shoppers waiting to make purchases, often without success, are common sights during suppressed inflation. Such inflation exists when stocks of goods available are much less than consumers are willing to buy at controlled prices, and are sold on a first-come-first-served basis. Rationing laws commonly are established so that some of the frustration and loss of time in shopping queues can be avoided. They provide maximum limits for the amounts of certain things purchased per person per month or other specified period. Also, government subsidies sometimes are paid for making certain essential commodities available at prices less than cost. The prevalence of a black market, in which buyers obtain illegally things at prices often greatly in excess of those stipulated as the maximum in legislation, is definite evidence of suppressed inflation.

In open inflation certain features of an upward price movement may vary significantly. Thus open inflation takes a number of forms:

  1. Gross Inflation. The relation of an economy's total output to rising prices is a significant variable. If rising prices are encouraging an increase in output—a basic function of a price increase in a competitive system—and therefore are bringing about a fuller utilization of the labor force and production facilities, the situation is termed gross inflation.
  2. Pure Inflation. Once the capacity of the economy is fully utilized, rising prices cannot bring forth additional output but can only ration output to the highest bidders. This situation is termed pure inflation.
  3. Creeping Inflation. Another important variable is the rate and duration of an upward price movement. For instance, a gradual rise in the price level over a long period with approximately full utilization of capacity might be held by increasing productivity to an average of 1% a year - a situation of creeping inflation.
  4. Galloping Inflation or Hyperinflation. A sharply accelerating rise in the price level with approximately full utilization of capacity may, within a year or two, render money virtually worthless and compel resort to awkward barter transaction, a situation called galloping inflation or hyperinflation.

Deflation is not the exact opposite of inflation. Deflation, of course, involves a downward movement of prices, but usually any appreciable deflation also involves increasing unemployment and lessening of output. A general decrease in demand for many goods and services lowers the price of some goods and services in competitive markets rather quickly with little change in output. In monopolistic markets, however, prices and wage rates tend to be maintained by reducing output and employment.

On the other hand, prices can be raised much more readily than lowered. Although rising prices often increase output and employment (the opposite of deflation), one land of inflation (pure inflation) does not. Moreover, in the process of deflation there is no counterpart to suppressed inflation.

Inherent Tendency Toward Inflation

There is a tendency in capitalism for prices to rise whenever the economy is expanding rapidly. This is because of the immediate expansion in investment in equipment and labor, and hence in the money supply, and the delayed expansion in the supply of goods and services. However, inflation may also occur at a time of recession.

Measurement of Inflation

It is relatively simple to describe inflation and deflation in terms of changes in the general price level and related conditions of output and employment. The measurement, however, of price-level changes and production-capacity utilization is difficult and unprecise- a circumstance of considerable importance in controlling price-level changes.

The level of prices, monthly and yearly, is expressed as an average that obviously cannot include all prices in such an average. Only a representative sample of prices is obtained. Not all prices move in the same direction at the same time, the price of automobiles may rise $300 and the price of meat may fall 10 cents per pound. The influence of these diverse price changes of two unlike commodities on the price level depends on the relative change in the two prices and the importance or weight assigned to them in the price average.

In addition, over a period of time new products appear and old ones decline in importance, so that a revision is necessary in some items included in the average. When the prices of some commodities are eliminated and others are substituted the average is not measuring the prices of an identical group of items over a long period. However, a careful revision involves less inaccuracy in measuring price-level changes than continuation of items whose prices are no longer of any or very little significance.

Price Indexes

Averages for measuring price-level changes include die consumer price index and the wholesale price index of the Bureau of Labor Statistics of the U.S. Department of Labor. Other nations prepare and publish similar indexes.

The purchasing power of the dollar is measured in the consumer and wholesale price indexes. The dollar buys less of the same commodities when wholesale prices rise and more when they fall. Thus, an index of purchasing power is the reciprocal of a price index. For example, a wholesale price index of 150 means that the price level increased 50% as compared with the base period, and the reciprocal of this index, 66.7, means that the purchasing power of the dollar decreased 33.3% as compared with the same base period. Such changes in the value of the dollar for wholesale purchases are likely to reflect roughly its value for many other business costs.

Also, the purchasing power of the dollar varies reciprocally in terms of retail prices paid by a representative group of consumers for the same selection of typical goods and services. These changes in the value of the dollar reflect generally for many families changes in the cost of living for a specified standard of consumption- not higher or lower costs for raising or lowering one's standard of living.

Both measures of the purchasing power of monetary units are commonly used, but often more emphasis is given to wholesale price indexes. This is preferred because of their broader coverage as compared with consumer price indexes, less difficulty in obtaining wholesale prices of things with rather definite specifications, and the occasional use of government subsidies to depress arbitrarily the retail prices of some essential consumer goods. 

Capacity and Utilization

Another important measurement consists of estimating the production capacity of an economy and its degree of utilization. This is important because pure inflation is defined as rising prices after full capacity output is reached, and a vital part of the analysis of the effect of inflation and deflation (beneficial or not) hinges on the degree of production-capacity utilization.

Estimates of capacity are almost entirely in terms of the total labor force. Only for a few basic industries are there some statistics of plant capacity, but the amount of employment and unemployment in the economy is reported frequently. For instance, monthly sample surveys by the Bureau of the Census, US Department of Commerce, provide estimates of civilians 16 years of age or over who are employed (that is, at work, or with a job but temporarily absent), or unemployed (not working but seeking employment). Other civilians in this age group of the population are classified as "not in the labor force". The sum of the employed and the unemployed constitutes the civilian labor force. Usually the percentage of unemployment is used to indicate the degree of labor utilization and the approximate partial or full-capacity operation of the economy.

Excess Demand and Excess Money as Causes of Inflation

One basic cause of inflation is an imbalance between supply and demand in which the demand for goods and services exceeds the supply. In pre-19th century Europe, when supplies of basic commodities were often precarious, scarcity of goods often caused drastic price rises. In the 19th and early 20th centuries, there was often excess demand in the countries that were industrializing.

When investment prospects are good, businessmen, seeking to increase profits, buy more machines and build more factories, creating a strong demand for goods and bidding up prices. They borrow money from banks to finance their purchases and make many deposits, enabling banks to add to the supply of money in circulation. The money supply may be further expanded if the government's central bank, in order to encourage the business expansion, reduces the amount of reserves that other banks are required to hold against the loans that they issue. The businessmen also may hire more workers, and to obtain them may have to pay higher wages. Workers therefore have more money to spend, increasing the pressure of demand. Thus at a time of business expansion both demand and the money supply may grow faster than production, thereby causing inflation.

During the 19th century, inflation was rarely prolonged, largely because businesses were small and competitive, and prices responded quickly to pressures of supply and demand. When prices were rising, employers and workers would buy less, thereby easing demand, and prices would fall. As demand for loans increased, the price of loans (interest rate) would rise, thereby dampening demand for loans and slowing the expansion of the money supply. Another barrier to inflation existed in the gold standard, which was observed by most nations in the 19th and early 20th centuries. Because banks had to redeem paper currency in gold on demand, they had to maintain a set reserve of gold for all the paper currency they loaned. A bank could compete for customers by lowering its reserve ratio only at the risk of massive withdrawals by its depositors, resulting in its bankruptcy. Thus there was a built-in limit to the expansion of the money supply.

An inflationary expansion of demand and the money supply may result from massive military expenditures or a large-scale transfer of resources, military or non-military, to another country. The inflation may be aggravated by deficit financing.

Inflation often occurs during or immediately after a war. A government that must equip an army buys huge quantities of goods and services, causing investments and incomes to rise while supplies of goods wanted by nonmilitary consumers remain restricted. Even if inflation is controlled during the war, it may erupt immediately afterward as a result of the release of pent-up demand. During the war, when employment and earnings were high, workers may have accumulated large savings because there was a shortage of consumer goods. If, when peace returns, workers spend their savings before stocks of consumer goods are fully replenished, there may be a severe inflation.

In addition, a government may add to the disparity between demand and supply if it pays for the war simply by expanding the supply of money rather than raising additional revenue (and restricting demand) through taxation of the expanded incomes. This occurred in the United States during the Vietnam War. The government was reluctant to raise taxes to pay for an unpopular war.

An inflationary expansion of demand and the money supply may also occur in a country if it becomes a creditor of another country through the international monetary (payments) system. Throughout the 1950's and 1960's the United States spent more abroad than it earned. It could do this because its currency was the principal medium for international payments. The result was that other countries, especially West Germany and Japan, accumulated claims on the United States in the form of vast earnings of dollars. Partly because they were unable to redeem these dollar reserves for usable commodities, they also suffered from inflation. Their supplies of goods and services were not expanded in proportion to their money supplies.

Why Inflation Is a Problem

The reduction in the buying power of money that accompanies inflation would not be a problem if the money income of every person and business rose at the same time and at the same rate. When there is a very slow rise in the general price level, the money incomes of most individuals and businesses often keep pace. In a period of rapid inflation, however, there is usually a much slower rise in the money incomes of many individuals and some kinds of business. They include persons living off of pensions or savings, persons who work in industries where labor is in a very weak bargaining position, and businesses that are highly competitive. The buying power of their incomes is thus sharply reduced.

Inflation also weakens a country's international trading position by making its products more expensive than those of other nations. As its export industries lose markets, the country may be pushed into a recession.

If the recession occurs in a country that is a major world importer, it may spread to the countries that export to it. As their export markets contract, their economic growth slows.

Inflation may spread from one country to another via international trade. Inflation that occurs in a country that is a major world exporter spreads to the countries that are dependent on it for their imports.

Inflation can seriously disrupt international trade, if it occurs in a country whose currency is a principal medium of international payments. That is because such a country is able to sustain indefinitely the balance of payments deficit that inflation, by impairing the competitiveness of the country's exports, is apt to produce.

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      Howard Schneider 4 years ago from Parsippany, New Jersey

      Excellent informational Hub, Suit n Tie. Many people know the term inflation but not what its underlying causes are.