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In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.[1] When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also 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 percentage change in a general price index (normally the Consumer Price Index) over time.[4]

Inflation can have many effects that can simultaneously have positive and negative effects on an economy. Negative effects of inflation include a decrease in the real value of money and other monetary items over time; uncertainty about future inflation may discourage investment and saving, or may lead to reductions in investment of productive capital and increase savings in non-producing assets. e.g. selling stocks and buying gold. This can reduce overall economic productivity rates, as the capital required to retool companies becomes more elusive or expensive. 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 a mitigation of economic recessions,[5] and debt relief by reducing the real level of debt.

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 in real 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.[5] 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 prevents monetary policy from stabilizing the economy.[9] The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.[10]

Contents

History

Inflation rates around the world in 2007

Inflation originally referred to increases in the amount of money in circulation. For instance, when gold was used as currency, the government could collect gold coins, melt them down, mix them with other metals such as silver, copper or lead, and reissue them at the same nominal value. By diluting the gold with other metals, the government could issue more coins without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in seigniorage.[11] This practice would increase the money supply but at the same time the relative value of each coin would be lowered. As the relative value of the coins becomes less, consumers would need to give more coins in exchange for the same goods and services as before. These goods and services would experience a price increase as the value of each coin is reduced.[12]

From second half of the 15th century to the first half of the 17th, Western Europe experienced a major inflationary cycle referred to as "price revolution"[13][14], with prices on average rising perhaps sixfold over 150 years. It was thought that this was caused by the increase in wealth of Habsburg Spain, with a large influx of gold and silver from the New World[15]. The spent silver, suddenly spread throughout a previously cash starved Europe, caused widespread inflation.[16][17] Demographic factors also contributed to upward pressure on prices, with European population growth after depopulation caused by the Black Death pandemic.

By the nineteenth century, economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the value or resource costs of the good, a change in the price of money which then was usually a fluctuation in the commodity price of the metallic content in the currency, and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. Following the proliferation of private bank note currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable bank notes outstripped the quantity of metal available for their redemption. The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods.[18]

This relationship between the over-supply of bank notes and a resulting depreciation in their value was noted by earlier classical economists such as David Hume and David Ricardo, who would go on to examine and debate to what effect a currency devaluation (later termed monetary inflation) has on the price of goods (later termed price inflation, and eventually just inflation).[19]

Related definitions

The term "inflation" usually refers to a measured rise in a broad price index that represents the overall level of prices in goods and services in the economy. The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some examples of broad price indices. The term inflation may also be used to describe the rising level of prices in a narrow set of assets, goods or services within the economy, such as commodities (which include food, fuel, metals), financial assets (such as stocks, bonds and real estate), and services (such as entertainment and health care). The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Asset price inflation is a rise in the price of assets, as opposed to goods and services. Core inflation is a measure of price fluctuations in a sub-set of the broad price index which excludes food and energy prices. The Federal Reserve Board uses the core inflation rate to measure overall inflation, eliminating food and energy prices to mitigate against short term price fluctuations that could distort estimates of future long term inflation trends in the general economy.[20]

Other related economic concepts include: deflation – a fall in the general price level; disinflation – a decrease in the rate of inflation; hyperinflation – an out-of-control inflationary spiral; stagflation – a combination of inflation, slow economic growth and high unemployment; and reflation – an attempt to raise the general level of prices to counteract deflationary pressures.

Measures

Annual inflation rates in the United States from 1666 to 2004.

Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price Index.[21] The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer".[22] 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

\left(\frac{211.080-202.416}{202.416}\right)\times100%=4.28%

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007.[23]

Other widely used price indices for calculating price inflation include the following:

  • Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes.
  • 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 most statistical 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 markets, central banks rely on it to better measure the inflationary impact of current monetary policy.

Other common measures of inflation are:

  • 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 nominal GDP measure divided by its real GDP measure.
  • 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 real standard of living for the presence of technology.
  • 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 might be more successful in avoiding bubbles and crashes in asset prices.

Issues in measuring

Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. For example, if the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price difference represents inflation. This single price change would not, however, represent general inflation in an overall economy. To measure overall inflation, the price change of a large "basket" of representative goods and services is measured. This is the purpose of a price index, which is the combined price of a "basket" of many goods and services. The combined price is the sum of the weighted average prices of items in the "basket". A weighted price is calculated by multiplying the unit price of an item to the number of those items the average consumer purchases. Weighted pricing is a necessary means to measuring the impact of individual unit price changes on the economy's overall inflation. The Consumer Price Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price.[10]

Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Over time adjustments are made to the type of goods and services selected in order to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time in order to keep pace with the changing marketplace.[citation needed]

Inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost shifts. For example, home heating costs are expected to rise in colder months, and seasonal adjustments are often used when measuring for inflation to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices.[citation needed]

When looking at inflation economic institutions may focus only on certain kinds of prices, or special indices, such as the core inflation index which is used by central banks to formulate monetary policy.[citation needed]

Most inflation indices are calculated from weighted averages of selected price changes. This necessarily introduces distortion, and can lead to legitimate disputes about what the true inflation rate is. This problem can be overcome by including all available price changes in the calculation, and then choosing the median value.[24]

Effects

General

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.[25] 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.[10]

Increases in the price level (inflation) erodes 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-monetary items, (e.g. goods and commodities, gold, real estate).[26]

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.[10] Uncertainty about the future purchasing power of money discourages investment and saving.[27] 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 incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation.[10] This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its 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.

Cost-push inflation
Rising inflation can prompt employees to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral.[28] In a sense, inflation begets further inflationary expectations.
Hoarding
People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.
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.
Allocative efficiency
A change in the supply or demand for a good will normally cause its price to change, signalling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, genuine price signals get lost in the noise, so agents are slow to respond to them. The result is a loss of allocative efficiency.
Shoe leather cost
High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.
Menu costs
With high inflation, firms must change their prices often in order to keep up with economy wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly.
Business cycles
According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.[29]

Positive

Labor-market adjustments
Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster.
Debt relief
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. (R=n-i) 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.
Room to maneuver
The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.
Tobin effect
The Nobel prize winning economist James Tobin at one point had argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects. See Tobin monetary model[30][Unclear: See Discussion]

Causes

The Bank of England, central bank of the United Kingdom, monitors causes and attempts to control inflation.

Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. The quality theory of inflation rests on the expectation of a seller 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 quantity equation of money, that relates the money supply, its velocity, and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.[citation needed]

Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.[31] The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. 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.

Keynesian view

Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices. The supply of money is a major, but not the only, cause of inflation.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":[32]

  • Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
  • Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. 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 is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Demand-pull theory states that the rate of inflation accelerates whenever aggregate demand is increased beyond the ability of the economy to produce (its potential output). Hence, any factor that increases aggregate demand can cause inflation.[33] However, in the long run, aggregate demand can be held above productive capacity only by increasing the quantity of money in circulation faster than the real growth rate of the economy. Another (although much less common) cause can be a rapid decline in the demand for money, as happened in Europe during the Black Death, or in the Japanese occupied territories just before the defeat of Japan in 1945.

The effect of money on inflation is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively. This sometimes leads to hyperinflation, a condition where prices can double in a month or less. 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 economists, 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 Keynesian economists also disagree with the notion that central banks fully control the money supply, arguing that central banks have little control, since the money supply adapts to the demand for bank credit issued by commercial banks. This is known as the theory of endogenous money, and has been advocated strongly by post-Keynesians as far back as the 1960s. It has today become a central focus of Taylor rule advocates. 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, central banks can influence the money supply by making money cheaper or more expensive, thus increasing or decreasing its production.

A fundamental concept in inflation 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 Phillips 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 concept of note 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.[34]

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.

Monetarist view

Monetarists believe the most significant factor influencing inflation or deflation is the management of money supply through the easing or tightening of credit. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation.[35] According to the famous monetarist economist Milton Friedman, "Inflation is always and everywhere a monetary phenomenon."[36]

Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. This theory begins with the identity:

M \cdot V = P \cdot Q

where

M is the quantity of money.
V is the velocity of money in final expenditures;
P is the general price level;
Q is an index of the real value of final expenditures;

In this formula, the general price level is affected by the level of economic activity (Q), the quantity of money (M) and the velocity of money (V). The formula is an identity because the velocity of money (V) is defined to be the ratio of final expenditure ( P \cdot Q ) to the quantity of money (M).

Velocity of money is often assumed to be constant, and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With constant velocity, the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not constant, and can only be measured indirectly and so the formula does not necessarily imply a stable relationship between money supply and nominal output. However, in the long run, changes in money supply and level of economic activity usually dwarf changes in velocity. If velocity is relatively constant, the long run rate of increase in prices (inflation) is equal to the difference between the long run growth rate of money supply and the long run growth rate of real output.[7]

Unemployment

A connection between inflation and unemployment has been drawn since the emergence of large scale unemployment in the 19th century, and connections continue to be drawn this today. In Marxian economics, the unemployed serve as a reserve army of labour, which restrain wage inflation. In the 20th century, similar concepts in Keynesian economics include the NAIRU (Non-Accelerating Inflation Rate of Unemployment) and the Phillips curve.

Rational expectations theory

Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.

A core assertion of rational expectations theory is that actors will seek to "head off" central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession.

Austrian theory

For more details on this topic, see The Austrian view of inflation

The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation.[37] Austrian economists believe there is no material difference between the concepts of monetary inflation and general price inflation. Austrian economists measure monetary inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time.[38][39][40] This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply.[41] In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.[42]

Austrians argue that the state uses inflation as one of the three means by which it can fund its activities (inflation tax), the other two being taxation and borrowing.[43] Various forms of military spending is often cited as a reason for resorting to inflation and borrowing, as this can be a short term way of acquiring marketable resources and is often favored by desperate, indebted governments.[44]

In other cases, Austrians argue that the government actually creates economic recessions and depressions, by creating artificial booms that distort the structure of production. The central bank may try to avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions or depressions by artificially trying to "stimulate" the economy through "encouraging" money supply growth and further borrowing via artificially low interest rates.[45] Accordingly, many Austrian economists support the abolition of the central banks and the fractional-reserve banking system, and advocate returning to a 100 percent gold standard, or less frequently, free banking.[46][47] They argue this would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth (and inflation) would never spiral out of control.[48][49]

Real bills doctrine

Within the context of a fixed specie basis for money, one important controversy was between the quantity theory of money and the real bills doctrine (RBD). Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. Currency and banking schools of economics argue the RBD, that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the 19th century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as currency boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of the Federal Reserve going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with libertarian principles of laissez-faire, even though almost all libertarian economists are opposed to the RBD.

The debate between currency, or quantity theory, and banking schools in Britain during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.

Anti-classical or backing theory

Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory". The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency.[50] Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions. There are very few backing theorists, making quantity theory the dominant theory explaining inflation.[citation needed]

Controlling inflation

A variety of methods have been used in attempts to control inflation.

Monetary policy

The U.S. effective federal funds rate charted over fifty years.

Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum. A low positive inflation is usually targeted, as deflationary conditions are seen as dangerous for the health of the economy.

There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.

Monetarists emphasize keeping the growth rate of money steady, and using monetary policy to control inflation (increasing interest rates, slowing the rise in the money supply). Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy (increased taxation or reduced government spending to reduce demand).

Fixed exchange rates

Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

Under the Bretton Woods agreement, most countries around the world had currencies that were fixed to the US dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attacks. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e.g. Argentina (1991-2002), Bolivia, Brazil, and Chile).

Gold standard

Under a gold standard, paper notes are convertible into pre-set, fixed quantities of gold.

The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver.

The gold standard was partially abandoned via the international adoption of the Bretton Woods System. Under this system all other major currencies were tied at fixed rates to the dollar, which itself was tied to gold at the rate of $35 per ounce. The Bretton Woods system broke down in 1971, causing most countries to switch to fiat money – money backed only by the laws of the country. Austrian economists strongly favor a return to a 100 percent gold standard.

Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output.[51] Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining,[52][53] which some believe contributed to the Great Depression.[53][54][55]

Wage and price controls

Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands.

In general wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.

Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed (see creative destruction).

Cost-of-living allowance

The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as social security) are tied to a cost-of-living index, typically to the consumer price index.[56] A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually.[56] They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.

Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally-determined indexes. Many economists and compensation analysts consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized world, average wages have increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity and worker bargaining power rather than simply living costs, and (2) most cost-of-living indexes are not forward-looking, but instead compare current or historical data.

See also

Notes

  1. ^ See:
  2. ^ Why price stability?, Central Bank of Iceland, Accessed on September 11, 2008.
  3. ^ Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429. “The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.”
  4. ^ Mankiw 2002, pp. 22–32
  5. ^ a b Hummel, Jeffrey Rogers. "Death and Taxes, Including Inflation: the Public versus Economists" (Jan 2007). [1] p.56
  6. ^ Robert Barro and Vittorio Grilli (1994), European Macroeconomics, Ch. 8, p. 139, Fig. 8.1. Macmillan, ISBN 0333577647.
  7. ^ a b Mankiw 2002, pp. 81–107
  8. ^ Abel & Bernanke 2005, pp. 266–269
  9. ^ "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others" Lars E.O. Svensson, Journal of Economic Perspectives, Volume 17, Issue 4 Fall 2003, p145-166
  10. ^ a b c d e Taylor, Timothy (2008). Principles of Economics. Freeload Press. ISBN 193078905. 
  11. ^ Annual Report (2006), Royal Canadian Mint, p. 4
  12. ^ Frank Shostak, "Commodity Prices and Inflation: What's the connection", Mises Institute
  13. ^ Earl J. Hamilton, American Treasure and the Price Revolution in Spain, 1501-1650 Harvard Economic Studies, 43 (Cambridge, Massachusetts: Harvard University Press, 1934)
  14. ^ John Munro: The Monetary Origins of the 'Price Revolution':South Germany Silver Mining, Merchant Banking, and Venetian Commerce, 1470-1540, Toronto 2003
  15. ^ Walton, Timothy R. (1994). The Spanish Treasure Fleets. Pineapple Press (FL). pp. 85. ISBN 1-56164-049-2. 
  16. ^ The Price Revolution in Europe: Empirical Results from a Structural Vectorautoregression Model. Peter Kugler and Peter Bernholz, University of Basel, 2007 (Demonstrates that it was the increased supply of precious metals that caused it and notes the obvious logical flaws in the contrary arguments that have become fashionable in recent decades)
  17. ^ Tracy, James D. (1994). Handbook of European History 1400-1600: Late Middle Ages, Renaissance, and Reformation. Boston: Brill Academic Publishers. pp. 655. ISBN 90-04-09762-7. 
  18. ^ Michael F. Bryan, "On the Origin and Evolution of the Word 'Inflation'"
  19. ^ Mark Blaug, "Economic Theory in Retrospect", pg. 129: "...this was the cause of inflation, or, to use the language of the day, 'the depreciation of banknotes.'"
  20. ^ Kiley, Michael J. (2008) (PDF). Estimating the common trend rate of inflation for consumer prices and consumer prices excluding food and energy prices. Federal Reserve Board. http://www.federalreserve.gov/Pubs/feds/2008/200838/200838pap.pdf. 
  21. ^ See:
  22. ^ Mankiw 2002, p. 22-32
  23. ^ The numbers reported here refer to the US Consumer Price Index for All Urban Consumers, All Items, series CPIAUCNS, from base level 100 in base year 1982. They were downloaded from the FRED database at the Federal Reserve Bank of St. Louis on August 8, 2008.
  24. ^ http://www.clevelandfed.org/Research/commentary/1991/1201.pdf
  25. ^ Mankiw 2002, p. 81-107
  26. ^ Prof. Dr. Ümit GUCENME, Dr. Aylin Poroy ARSOY, Changes in financial reporting in Turkey, Historical Development of Inflation Accounting 1960 - 2005, Page 9, "Purchasing power of non monetary items does not change in spite of variation in national currency value." [2]
  27. ^ Bulkley, George (March 1981). "Personal Savings and Anticipated Inflation". The Economic Journal 91 (361): 124–135. doi:10.2307/2231702. http://www.jstor.org/pss/2231702. Retrieved 2008-09-30. 
  28. ^ Encyclopedia Britannica, "The cost-push theory".
  29. ^ Thorsten Polleit, "Inflation Is a Policy that Cannot Last", Mises Institute
  30. ^ Tobin, J., Econometrica, V 33, 1965 "Money and Economic Growth"
  31. ^ Federal Reserve Board's semiannual Monetary Policy Report to the CongressRoundtableIntroductory statement by Jean-Claude Trichet on July 1, 2004
  32. ^ Robert J. Gordon (1988), Macroeconomics: Theory and Policy, 2nd ed., Chap. 22.4, 'Modern theories of inflation'. McGraw-Hill.
  33. ^ O'Sullivan, Arthur; Sheffrin, Steven M. (2003) [January 2002]. Economics: Principles in Action. The Wall Street Journal:Classroom Edition (2nd ed.). Upper Saddle River, New Jersey 07458: Pearson Prentice Hall: Addison Wesley Longman. p. 341. ISBN 0130630853. http://www.amazon.com/Economics-Principles-Action-OSullivan/dp/0130630853. Retrieved May 3, 2009. 
  34. ^ Coe, David T. Nominal Wages. The NAIRU and Wage Flexibility.. Organisation for Economic Co-operation and Development. http://www.oecd.org/dataoecd/59/19/33917832.pdf. 
  35. ^ Lagassé, Paul (2000). "Monetarism". The Columbia Encyclopedia (6th ed.). New York: Columbia University Press. ISBN 0-7876-5015-3. 
  36. ^ Friedman, Milton. A Monetary History of the United States 1867-1960 (1963). 
  37. ^ Shostak, Ph. D, Frank (2002-03-02). "Defining Inflation". Mises Institute. http://mises.org/story/908. Retrieved 2008-09-20. 
  38. ^ Ludwig von Mises Institute, "True Money Supply"
  39. ^ Joseph T. Salerno, (1987), Austrian Economic Newsletter, "The "True" Money Supply: A Measure of the Medium of Exchange in the U.S. Economy"
  40. ^ Frank Shostak, (2000), "The Mystery of the Money Supply Definition"
  41. ^ Ludwig von Mises, The Theory of Money and Credit", ISBN 0-913966-70-3 See also: Jesus Huerta de Soto, "Money, Bank Credit, and Economic Cycles", ISBN 0-945466-39-4
  42. ^ Murray Rothbard, "What Has Government Done to Our Money?", ISBN 978-0945466444 [
  43. ^ Lew Rockwell, interview on "NOW with Bill Moyers"
  44. ^ Lew Rockwell, "War and Inflation", Ludwig von Mises Institute
  45. ^ Thorsten Polleit, "Manipulating the Interest Rate", December 13, 2007
  46. ^ Ludwig von Mises Institute, "The Gold Standard"
  47. ^ Ron Paul, "The Case for Gold"
  48. ^ Murray Rothbard, "The Case for a 100 Percent Gold Dollar"
  49. ^ Ludwig von Mises Institute, "Money, Banking and the Federal Reserve"
  50. ^ "www.econ.ucla.edu/workingpapers/wp830.pdf" (PDF). http://www.econ.ucla.edu/workingpapers/wp830.pdf. 
  51. ^ Bordo, M. (2002) "Gold Standard" Concise Encyclopedia of Economics
  52. ^ Barsky, Robert B; J Bradford DeLong (1991). "Forecasting Pre-World War I Inflation: The Fisher Effect and the Gold Standard". Quarterly Journal of Economics 106 (3): 815–36. doi:10.2307/2937928. http://ideas.repec.org/a/tpr/qjecon/v106y1991i3p815-36.html. Retrieved 2008-09-27. 
  53. ^ a b DeLong, Brad. "Why Not the Gold Standard?". http://www.j-bradford-delong.net/Politics/whynotthegoldstandard.html. Retrieved 2008-09-25. 
  54. ^ Hamilton, J.D. (December 12, 2005) "The gold standard and the Great Depression" Econbrowser, citing "The Role of the International Gold Standard in Propagating the Great Depression," published in Contemporary Policy Issues in 1988
  55. ^ Warburton, C. "The Monetary Disequilibrium Hypothesis," in Depression, Inflation, and Monetary Policy, Selected papers, 1945-1953 (Johns Hopkins Press, 1966), pp. 25-35.
  56. ^ a b Flanagan, Tammy (2006-09-08). "COLA Wars". Government Executive. National Journal Group. http://www.govexec.com/dailyfed/0906/090806rp.htm. Retrieved 2008-09-23. 

References

Further reading

External links


1911 encyclopedia

Up to date as of January 14, 2010

From LoveToKnow 1911

"INFLATION. --As with most economic terms in popular use, analysis shows that " inflation " has different meanings with varying contexts. It is sometimes used as equivalent to a general rise in prices, but a general rise in prices may be due to causes primarily associated with commodities, e.g. scarcity. Even if the term is confined to money (metallic and representative) it is possible that a general rise of prices may take place which although due to monetary causes cannot properly be described as due to inflation. In former times a frequent cause of a rise in prices was the debasement of metallic money. Debasement does not of necessity mean depreciation, and the depreciation need not be in exact proportion to the debasement. Much of the reasoning of Thorold Rogers, in his great work on the History of Agriculture and Prices, on the debasement of the English currency by Henry VIII. was vitiated by the failure to recognize that debasement of money in general only acts on prices in so far as the debasement leads to an increase in quantity. Such an increase in the quantity of money consequent on debasement is not usually called inflation, though clearly analogous.

A general rise in prices may also take place through an increase in the metal or metals available for money although there is no debasement of the coinage. The rise in prices in the r 6th century so far as due to the new silver, and in the rgth century the rise due to the new gold in two periods, can hardly be described as caused by inflation. The gold standard implies that values are measured in terms of a certain weight of gold of a certain fineness in any country in which the gold standard is effectively maintained. In different countries values on the gold standard are compared by the amount of fine gold in the standard coins.

Very great discoveries of gold, or even the artificial production of gold, would not of necessity mean any departure from the maintenance of the gold standard. Prices might rise indefinitely and the value of gold relatively to things in general fall indefinitely, but it would seem a misuse of language to speak of the " inflation " of gold. Such an increase of gold may and probably will cause an increase in prices, but in neither case is the increase of gold properly called inflation.

In the interpretation of popular terms there is, of course, no decisive test, as the usage varies; but by the application of the historical method the origins of the different meanings may be traced, and the search for the meanings will, as Sidgwick showed, throw light on the corresponding facts.

Before the World War the term " inflation " was in general applied to paper money. The paper money was thought to be inflated when the amount was greater than if the paper were strictly convertible or definitely related to the metallic standard. From this point of view inflation would now mean an abandonment of the gold standard, together with a consequential increase in the quantity of the currency in which prices are expressed. This is the interpretation given to inflation by Francis A. Walker. " A permanent excess of the circulating money of a country over that country's distributive share of the money of the commercial world, is called inflation " (Political Economy, 1887). His subsequent treatment shows that Walker had in view an excess of paper money consequent on partial or complete inconvertibility.

In theory it is possible to control an inconvertible paper currency in such a way that there should be neither specific nor general depreciation as compared with gold. But experience shows that, in general, when notes have been made inconvertible they have been subjected to over-issue, with consequent depreciation, specific or general, or both. Over-issue in this sense is another name for inflation.

It seems best, however, to distinguish between the fact of over-issue and the consequent depreciation. Over-issue might take place with inconvertibility, but the depreciation, whether specific or general, might be delayed. The annulment of the restraints imposed by the gold standard allows inflation to take place, but the degree of the depreciation (if any) depends on the quantity of the new paper money (with the credit based on it) and the demand for it.

In the natural course of the progress of a nation, with the increase of population and trade, a greater amount of money is required for cash transactions. With the gold standard in effective working order the additional money required might be obtained by the expansion of convertible notes and of the various forms of bankers' credit, without any departure from the effectiveness of the gold standard. Such was the case in the United Kingdom from the definite establishment of the gold standard with the resumption of cash payments (1821) to the outbreak of the World War in 1914. There was also, it is true, an increase in the amount of gold in circulation and held in reserve, but only sufficient to secure the absolute convertibility of the notes and other forms of credit.

In the same way in periods of speculation and of trade activity there is, no doubt, an abnormal demand for currency and credit, and both are extended until the limitations imposed by the gold standard are reached. If these limits are overstepped there is a monetary crisis. We speak of cycles of expansion and of depression of trade (in the widest sense), but it is only when the expansion of the " money " used exceeds certain limits that it can be properly called inflation. There may be a legitimate expansion to meet the legitimate expansion of trade.

We are well advised under modern conditions to confine the term " inflation " to such abnormal increases of currency and credit as transcend the limits imposed by the gold standard. Over long periods there may be a normal increase of money and of money-substitutes, and there may also be normal increases from time to time for short periods according to the activity of trade or exchange in the widest sense. Such increases of currency and of credit would not properly be called inflation.

The term " inflation " as applied to paper money may be compared with the debasement of standard coins. Debasement is in general a symptom of disease or disorder of the monetary system. It is a departure from the standard (or specific depreciation); and if, as usually happens, it is associated with an increase in the quantity of the money after a point it must lead to general depreciation of the currency. If not associated with an increase of quantity the debasement would be simply equivalent to the institution of a seigniorage. In the same way inconvertible notes may be regarded as coins with a seigniorage of 100% (Walker); in other words the amount of fine metal supposed to be attached to the paper is nil. Nothing is left of the standard coin but the name. In this case the value of the paper is determined by its quantity related to the effective demand for it.

It is clear from the foregoing discussion of the meaning of the term that " inflation " is closely associated with other monetary expressions and is sometimes loosely used as equivalent to one or more of them. We speak of inflated values (or prices) of commodities, as for example in comparing present foreign trade, returns with the pre-war figures. In periods of financial speculation it is usual to speak of the inflation of securities. Prof.

W. R. Scott, in his History of Joint Stock Companies, constantly uses the term inflation in describing the rise in the prices of shares in the period of the South Sea Bubble (1720). It may, perhaps, be said that values of securities are inflated when they bear no proper relation to their earning capacity or to their exchange value under normal conditions.

The term " inflation " is also commonly associated with depreciation, and the terms are loosely used as synonymous. Here, however, it is necessary to distinguish between the different meanings of depreciation. A currency might be specifically depreciated as regards gold (the standard) simply through discredit, although there was no abnormal increase of quantity. The terms depreciation and appreciation are often applied to gold itself. Gold was said to be depreciated in the third quarter of the z9th century through the gold discoveries, and appreciated in the last quarter through the falling-off in production. But it would be straining the use of words to speak of the inflation and deflation of gold in these periods. During the World War and afterwards there was a great rise in world prices (measured in gold) and in the United States there was a vast increase of the amount of gold for monetary uses. In the United States there was no specific depreciation of paper money relatively to the gold. Gold there had no premium.

The rise in American prices in terms of gold is partly accounted for by the expulsion of gold from Europe by the floods of inconvertible paper. The question arises whether it is correct to speak of this increase in the American gold currency as inflation. There has been, no doubt, an abnormal increase of gold currency as compared with pre-war periods, but there has been no abandonment of the gold standard. Coincidentally, however, with this great influx of gold the passing of the Federal Reserve Act enabled a given amount of gold to support a larger amount of credit, and this extension of credit facilities may be regarded as equivalent to a partial abandonment of the gold standard as compared with pre-war conditions.

At this point the general question arises as to variations in the meaning of convertibility and inconvertibility. There have been in the past all kinds and degrees of suspended and deferred convertibility. The beginnings in Europe of the goldexchange standard (so well described by Mr. J. M. Keynes in Indian Currency and Finance, ch. 2) show also the beginnings of inconvertibility. These incipient gold-exchange standards prepared the way for the ready acceptance of inconvertible paper on the outbreak of the World War (see " Essay on the Abandonment of the Gold Standard," by Prof. J. S. Nicholson, in War Finance, p. 34). In the same way the Federal Reserve Act may be said to have prepared the way for an inflation of credit (see E. W. Kemmerer, High Prices and Deflation). In the preceding account of inflation it was implied that under modern conditions the term was only properly applied to cases in which the abnormal increase of money was due to inconvertibility or to the abandonment of the gold standard. The application, however, of the idea of continuity to convertibility and inconvertibility shows that the term inflation may be extended so as to cover the expansion of credit and currency which has taken place in the United States. And in practice most writers speak of inflation in that country as being only less in degree as compared with Europe.

In the United Kingdom during the war the transition from convertible to inconvertible paper was made by such gradual and concealed steps, both in law and in practice, that it is hardly possible to say when the virtual abandonment of the gold standard was officially recognized, - if indeed it ever was.' It was only after the war when the foreign exchanges had been decontrolled and when war demands and war scarcities no longer seemed sufficient to account for the great rise in prices, that the abnormal increase of paper money consequent on the abandonment of the gold standard came to be regarded as one of the principal contributory causes of the rise in prices, and it began also to be acknowledged that the currency had been inflated.

In the United Kingdom the great use of cheques and bankers' credits concealed the progress of the inflation as regards the notes. It was commonly said that the increase in the notes was not sufficient to explain the increase in the prices, and that only sufficient notes were issued to provide the small charge for the governmental credits. In this way we arrive at the position that the inflation in the United Kingdom was primarily an inflation of credit and not of currency. In other countries, e.g. Russia, Austria, France and Germany, the enormous issue of inconvertible notes had the usual effects in a more direct manner. The case of the United Kingdom, however, is not so different when analyzed as at first sight may appear. Before the war, when the gold standard was effectively maintained, the necessity of securing the absolute convertibility of all forms of credit, and of keeping London a free market for gold, imposed rigid limits (after a point) on the expansion of credit. If in the war the bankers had not been able to provide notes for the cheques presented (for funds for wages and other cash transactions) the whole system of credit expansion would have broken down. The notes took the place of gold for all internal payments, and for many foreign payments borrowing was resorted to.

Once the notes had effectively taken the place of gold in the United Kingdom, that is to say when gold was no longer used by the public as money for cash purposes, the principle of convertibility was maintained as regards all the other forms of credit and " representative " money. There was never after the first week of the war any hint of a banking crisis. No one repudiated the notes, and the whole monetary system was worked with the greatest smoothness. The only difference was that the ultimate convertibility into gold, if required and as and when required, was no longer recognized in practice. But this one exception was fatal to the stability of the monetary system. In normal times before the war the action of the gold standard was so effective and so quiet that even bankers and those engaged in high finance took it for granted, just as a perfectly healthy man takes for granted the circulation of the blood and the other vital processes. To the present generation the real working of the gold standard was only revealed when the abandonment had been effected. This abandonment gave to the monetary system the power of indefinite expansion, and the necessities of the State in the war and its extravagances after the war made the potential expansion an actuality.

The real meaning of the gold standard and the dangers of abandonment or relaxation were admirably expressed in his own day by Ricardo. Ricardo was all his life engaged in high finance, and in monetary affairs was the leading practical authority. Although he is commonly regarded as the founder of abstract economics, always at the back of his mind was the practical working of the principles which he propounded. He 1 At no time during the war would it have been definitely admitted by the governor of the Bank of England that the gold standard had been "abandoned" (Ed. E.B.).

lived through the period of the bank restriction when the notes of the Bank of England were made inconvertible, and he had this experience to test his reasonings. Two sentences bring out very clearly Ricardo's conception of a standard and of the limitations imposed by a standard on the expansion (or inflation) of paper money. " In the present state of the law [he is referring to the bank restriction on the conversion of paper into gold] the bank directors have the power of increasing or reducing the circulation in any degree they think proper: a power which should neither be entrusted to the State nor to anybody in it " (Ricardo's works, McCulloch's edition, p. 406). The second text is: " The only use of a standard is to regulate the quantity, and by the quantity the value of the currency - and without a standard it would be exposed to all the fluctuations to which the ignorance or the interests of the issuers might subject it." In other words the use of a standard is to provide safeguards against the dangers of inflation. The best and most effective safeguard is convertibility. All the forms of currency and of bankers' credit ought to be convertible into one another and into gold without let or hindrance. Such convertibility is only guaranteed when the principle of limitation is applied in each case in a way effective according to the circumstances of the case. In some parts of the system the limitation is applied in a very rigid manner, as for example with the token coins. The essence of " Gresham's law " in the case of token coins is that only by limitation can the nominal value be kept up. In the United Kingdom it used to be thought that to support this limitation effectively the legal tender ought also to be limited. Experience (as observed by Prof. Cannan) has shown that the limitation may be secured in other ways. In the case of banknotes, whether issued by the State or by banks with delegated powers, the principle of limitation has been applied in different ways. In the United Kingdom before the war the limitation of the issues of bank-notes was far more stringent than in any other country. The Bank Act of 1844 came to be known as the cast-iron system. The essence of it was that, after a point, no notes could be issued unless in exchange for an equivalent amount of gold. In normal times there was no elasticity. In times of crisis elasticity was provided by the suspension of the Act. Other countries had other methods of regulating the issues of their paper money. When Jevons wrote his book on Money in 1875 he was able to describe in his Chapter XIV. on " Methods of Regulating Paper Currency " no less than 14 different methods, and since that time other important varieties have been introduced. In these different systems the elasticity in normal and in abnormal times varies, but it is only in the case of inconvertible notes that the principle of limitation by reference to the metallic standard is abandoned altogether, and even in that case there is in general some kind of hope deferred that some time or other the link with gold will be restored.

During the World War, in all the belligerent countries except the United States and Japan, the connexion of the notes with gold, that is to say the effective convertibility, was abandoned in practice. No other effective method of limitation was discovered or applied. Instead of limitation there was expansion, in order to make the Government loans effective in monetary purchasing power. The greater the expenditure by the State, so much greater became the volume of the forms of purchasing power, and the issues of notes had to conform to other increases if recurrent banking crises were to be avoided.

Historical Examples

Before the World War there were three notable outstanding cases of inflation in connexion with issues of inconvertible paper. They throw light on the processes and consequences of the inflation after 1914.

The assignats of the French Revolution long formed the classical example in the text-books of the dangers of inconvertible paper. The issues began on what appeared to be, having regard to the circumstance of the time, a reasonable basis. The confiscated lands were more than sufficient in estimated value to meet the deficits of former years and to provide a surplus for the immediate budgets. In Dec. 1789 the Assembly issued assignats of 1,000 livres (&40) each, bearing interest at 5%, to be accepted from purchasers of the nationalized lands. These notes were part of the floating debt, and were, to begin with, not legal tender. It may be observed that the first notes of the Bank of England (1694) were for high denominations and bore interest. In the course of time the interest on the assignats was abolished, the denomination was lowered, the notes were made legal tender as currency, and any pretence of " representing " lands or any other assets was abandoned. In brief, all effective limitation ceased, and the depreciation both specific and general became excessive. In spite of severe penalties against dealings in specie, culminating at last in the death penalty, in the course of time the notes were refused, and by 1796 had become practically worthless. Attempts had been made to substitute other notes mandats or promises of mandats, but there was no effective withdrawal and no real limitation, and the mandats followed the lead of the assignats. In Feb. 1797 all the paper money was demonetized, the mandats being receivable for taxes or land purchase at r % of their face-value.

The refusal of the paper money began in the French provinces and the circulation was most effective and prolonged in Paris. The analogy with Bolshevist Russia is instructive. There the refusal of the paper money began with the peasants. It is indeed remarkable that the leaders of the Russian Revolution took no warning from the example of revolutionary France. In fact, they advanced more rapidly to monetary destruction. And in Russia there do not seem to have been any of the compensating temporary advantages of inflation. " It is worthy of remark," says a recent writer (R. G. Hawtrey), " that so long as the Paris workmen were ordinarily paid in assignats there were no complaints of unemployment; the high prices attributed to the knavery of speculators were the principal grievance." In Russia unemployment increased with the inflation.

The next great example of inconvertible paper and inflation is furnished by the Bank Restriction in England which began in the year in which inconvertible paper was abandoned in France (1797). The contrast with France is remarkable, and, to begin with, confirms on the positive side the effectiveness of the fact of limitation even when the actual practice is not based on any reasoned principle. The notes of the Bank of England, though inconvertible, were not made legal tender until 1812. They were at first simply debts due by the Bank of England which the bank was not allowed to pay in legal currency. But the notes were accepted by the Government in payment of taxes, and also by the bankers and merchants under a formal agreement amongst themselves. In 1811 Lord King demanded payment of his rents in coin (not paper), and an Act was passed forbidding any differentiation between coin and paper - that is, making illegal the quotation of two prices. Full legal tender was only granted to the notes the next year (1812).

The specific depreciation of the Bank of England notes began in 1800. At this time (and practically up to 1873) gold and silver were ranked equally as precious metals, and the variations in the ratio of their values never departed widely from 151 to r. From 1797 to 1818 at Hamburg the highest ratio is 16.25 in 1813 and the lowest 15.04 in 1814. The maximum specific depreciation of the notes in 1813 compared with gold was 136.4, and with silver 134.7 (see table in Hawtrey's Currency and Credit, p. 269). By 1816 the specific depreciation relative to the precious metals had practically disappeared. As measured by the exchange on Hamburg the depreciation reached a maximum in 181 r and was about par by 1816.

It is more difficult to estimate the general depreciation as compared with commodities. In 1801 the index number of prices, calculated by Jevons, based on a standard taken as Ioo in 1782, had risen from rto in 1797 to 153 in 1801, after which there was a fluctuating fall followed by a rise to the maximum of 164 in 1810. It is impossible to say how much of this general rise in prices is to be attributed to the inconvertible paper and how much to causes primarily affecting demand and supply of the commodities taken as the basis of the index numbers. The great argument of Tooke (History of Prices) was intended to show, by examining the actual records of the circu lation and of prices, that the influence of the currency was of little importance compared with demand and supply. Tooke's general argument was weakened by the fact that he laid the chief stress on commodities which were largely affected by the course of the seasons. The modern view from Jevons onwards is that the general rise in prices was in part due to the issues of the inconvertible notes. A reference to the figures shows (Hawtrey, p. 269) that there is no exact connexion between the specific depreciation of the paper and its general depreciation as measured by general prices. Two questions arose in this period on which there was a prolonged controversy which has been revived nautatis mutandis by the World War. It was maintained by some that there was no specific depreciation of notes but only an appreciation of gold owing to the exceptional demands for it in connexion with the war. Now, it is argued, there is depreciation of gold. The other allied question was whether the specific depreciation of the notes was the exact measure of the fall in their purchasing power (or general depreciation). Another point of interest in this period was the influence of economic opinion on economic action. The celebrated Report of the Bullion Committee in England (r8ro) 1 put the case for the resumption of specie payments and a return to convertibility in the strongest way. The principles of the report were due to the influence of Ricardo, although he was not a member of the committee. Later economists have in general approved of the report, both as explaining the facts and as suggesting the only adequate remedy. But the resolutions founded on the report were not only rejected by the House of Commons at the time (1811), but in opposition to them resolutions were carried by Vansittart which it is now agreed were " abundantly foolish." The answers given by the governor and directors of the Bank of England before the committee were described by Bagehot as " almost classical by the nonsense." By some recent economists, however, the policy of the report has been condemned, notably by Prof. Foxwell, in the introduction to the History of the Bank of England by Prof. Andreades. It is also now generally admitted that the questions involved in the report are more complex than the framers of the report considered. It is noteworthy that the principles of the report were eventually adopted and became the foundation of the Bank Act of 1844. It is remarkable that Lord Cunliffe's Committee on Currency and Foreign Exchanges, in their " first interim " report (1918), strongly approved of the practical return to the principles of 1844.

The third great historical example of inflation of inconvertible paper is furnished by the American Civil War. The period (1862-79) used to be called by American economists " the inflationist period." In about a year, owing to the stress of the war, 450,000,000 dollars of "greenbacks" were issued, and in the next two years other 200,000,000 dollars of interest-bearing, legal-tender notes were added. In the last year of the Civil War the paper had suffered a specific depreciation as compared with gold of 50%, and there had also been a great rise in prices, partly at least due to the inflation of the currency. In this case the inflation was primarily an inflation of currency and not of credit. At the close of the war steps were taken to reduce the paper money, and the interest-bearing notes were cancelled. The reduction of the greenbacks, however, was made gradual - a monthly maximum of withdrawals being enforced in 1866. From this time onwards to the final restoration of specie payments in 1879 there was a contest between the inflationists and the supporters of " hard " money. The main argument of the inflationists rested on the hardships that follow on a contraction of the currency and consequent fall in prices. For a time the inflationists were successful, and in 1874 a bill was passed through both Houses of Congress actually increasing the paper issues by about 400,000,000 dollars. This bill was vetoed by President Grant and prepared the way for the Resumption Act of 1875, which provided for the resumption of specie payments in 1879. After this year the advocates of what was called " soft " money turned their attention to the coinage of silver.

'Reprint. edited by Prof. Cannan, The Paper Pound (1919).

The American experience after the Civil War is of special interest as applied to the case of the United Kingdom after the World War. The same arguments were advanced in 1920-1 as regards the hardships and the dangers of any deflation and the relative advantages of rising or at least stable prices. The less extreme supporters of inflation, like their American predecessors, thought that there should be no actual contraction, and that trade and production should be allowed to overtake the extra supplies of money and in that way bring about a gradual restoration to the normal. In the United States, after the Civil War, the actual resumption of specie payments was delayed for 14 years. Although the American inflation at that time was, to begin with, specially an inflation (or abnormal increase) of inconvertible paper, after the Civil War credit influences not only in the United States but in other countries had considerable influence on the extent of the depreciation of the paper. In the first months of the peace the gold value of too paper dollars was 70. But although the paper was reduced in three years by over 15% o the effect on the specific depreciation was insignificant, too paper dollars being worth only 71.6 in gold. After 1869 for three years there was a great rise in the gold value of the paper to 89.5 in 1871, in spite of an absence of contraction. After 1871 there was another reaction followed by another and more marked revival. This want of conformity between contraction and appreciation of the paper (in terms of gold) is explained by Mr. Hawtrey (op. cit., p. 309) as due to the variations in the value of gold consequent on credit movements in Europe. In 1866 there was the Overend and Gurney banking crisis in England. In 1871-3 there was the boom in trade following on the Franco-German War. This boom was accompanied in the United States by an excess of imports, due to the advance of European capital for railway construction.

Enough has been said to show that the relation of the quantity of paper money, even when inconvertible, to changes in specific or general depreciation is by no means simple. Nor is such a result opposed to the " quantity theory " of money in its extended modern form. The value of paper money in terms of gold depends partly on causes affecting the paper (not only its quantity but its credit or discredit), and partly on causes affecting the gold itself - not only the supply available for monetary purposes but the various elements of demand both for monetary and non-monetary purposes. The premium on gold is accounted for by various causes, and it is not the exact measure of the fall. in purchasing power of the paper as regards commodities.

This brief survey of the three notable cases of inflation before 1914 shows very clearly that the inflation of the World War period was due to similar causes acting with varying force. The precise effect of the increase in the quantity of the inconvertible paper cannot be isolated. The main point is the abandonment of the effective working of convertibility through which the gold standard makes operative the principle of limitation. But even when convertibility is maintained apparently and by law in the most effective manner, as for example under the Bank Act of 1844, it is quite possible that for the time being de facto convertibility may be restrained, and there may be an inflation of paper money and of the credit that rests on paper money for cash payments. The old question as to the possibility of the over-issue of convertible notes has been answered in the affirmative by the practical legislators of every country. In other words every country has imposed special restrictions on the issues of notes. But in the course of monetary progress the over-issue of convertible notes has become of relatively small importance as compared with the over-expansion of credit, at all events in highly developed countries. The connexion of credit with the gold standard is not only through the note issues. In the United Kingdom the cheque has for long been the most important form of currency or means of payment. It is possible that even wages might be paid by means of cheques (a beginning has been made by Messrs. Lever), though still forms of legal tender would be necessary for other kinds of cash payments.

Once, however, convertibility has been definitely abandoned as regards the notes, then one of the great restraints on the increase of credit also has been abandoned. It is one thing for banks to provide the gold necessary to meet an internal drain, and quite another to get the notes required in exchange for some form of bankers' credit. It is one thing to keep a free market for gold, and quite another for the government of a country to meet the foreign demands for payment by borrowing abroad instead of sending gold. It is one thing to control the movements of gold by changes in the rate of interest, and quite another to let the movements of gold depend on the governmental regulations regarding import and export.

The World War Period

In tracing the progress of inflation during the World War, the case of the United Kingdom is the most instructive and important. It is also the most difficult, because the abandonment of the gold standard which opened the way for inflation was not definitely announced or admitted, and was only realized some time after the f act had been accomplished in practice. The first authoritative recognition that the gold standard was no longer operative in the United Kingdom was that made in the first report of the Cunliffe Committee issued Aug. 1918. It begins with an account of the currency system which had been effectively maintained in the United Kingdom before the war, and it points out that " under these arrangements the country was provided with a complete and effective gold standard." But the report goes on to state: " The course of the war has, however, brought influences into play in consequence of which the gold standard has ceased to be effective." The main steps in this practical abandonment are also well stated in the report. On the outbreak of war it was considered necessary by the Government not merely to give permission for a suspension of the Act of 1844, as had been done on some earlier occasions, but also to empower the Treasury to issue its own currency notes for £r and sos. as legal tender throughout the United Kingdom. It may be noted that before the war only Bank of England notes were legal tender (not the notes of other banks), and Bank of England notes were not legal tender by the bank itself. In the bank restriction (see above) full legal tender was only conferred on the notes in 1812, i.e. 15 years after the beginning of the restriction.

Under the powers given by the Currency and Bank Notes Act of 1914, the Treasury undertook to issue the new notes through the Bank of England to bankers, as and when required, up to a maximum not exceeding for any bank 20% of its liabilities on current and deposit accounts. The amount of notes issued to each bank was to be treated as an advance bearing interest at the current bank rate. Later on, certificates of larger denominations were issued to banks in lieu of notes, to save trouble, and it became the practice for the banks to pay for the notes in other forms of bankers' credit. In this way the principle of limitation as applied to the notes was practically abandoned. What ought to have been barriers to expansion became elastic bands that yielded at the slightest pressure. The reserves were adjusted to the liabilities and not the liabilities to the real reserves. In place of a limited amount of gold that could only be increased by being attracted from other countries, the real banking reserve was now a mass of notes which could be increased on the demand of the banks themselves. It must be said in justification of these very elastic provisions regarding the notes that it was never anticipated that the demand for internal currency would have necessitated extensive recourse to these provisions. At the beginning of Aug. 1914 an extended bank holiday was sufficient to restore confidence in the currency situation. The danger, as events showed, lay in another direction. The banks were made so secure that they imposed no restraints on the demands of the Government. The inflation was made possible by the issues of the notes - but the real inflation began with the expansion of credit. The credits created by the Bank of England in favour of its depositors, under the arrangements by which the bank undertook to discount approved bills of exchange, and other measures taken at the same time for the protection of credit, caused a large increase in the deposits of the bank. At the same time the needs of the Government for funds to finance the war in excess of what was raised by taxa tion and by real borrowing from the public made it necessary for the bank to create credits in favour of the Government in the shape of Ways and Means advances. The consequence was that the total amount of the deposits of the bank increased from about £56,000,000 in July 1914 to £273,000,000 in July 1915. The balances created by these operations passed, by means of payments to contractors and others, to the Joint Stock banks, and caused an increase in their deposits, which were also expanded by credits created in connexion with the various war loans. The consequence was that the total deposits of the banks of the United Kingdom other than the Bank of England increased from £1,070,681,000 in Dec. 31 1913 to £1,742,902,000 in Dec. 31 1917. This process of credit inflation is correctly described in the Cunliffe report (note, p. 4.): " Before the war these processes if continued compelled the Bank of England to raise its rate of discount, but the unlimited issue of currency notes has now removed this check upon the expansion of credit." The great increase in bank deposits represented a corresponding increase in purchasing power, which in conjunction with other causes (e.g. war demands, war obstructions, war scarcities, etc.) caused a rise in prices. The rise of prices in its turn brought about a demand for legal-tender currency for cash payments of all kinds (wages, transport, retail trade, etc.). The war contractors and others had to break up their large credits into smaller credits, and these again were transmuted into legal tenders. " The unlimited issue of currency notes in exchange for credits at the Bank of England is at once a consequence and an essential condition of the methods which the Government found necessary to adopt in order to meet this war expenditure." On June 30 1914 the fiduciary issue of the Bank of England was under £19,000,000, but by July to 1918 there had been added £230,452,000 in Treasury currency notes not covered by gold.

Compared with the mass of purchasing power indicated by the growth of deposits, and still more effectively by the increase in the clearing-house returns, the increase of notes may seem of relatively small importance. The importance of the currency notes lies not in their mass compared with other forms of purchasing power but in their function as taking the place of gold. Before the war the Bank of England, with a smaller gold reserve than those of other great European banks, supported a far greater mass of credit. Under certain conditions the movement of a few millions of gold was sufficient to threaten a crisis. Severe precautionary measures were taken to prevent the depletion of the ultimate metallic reserves. The quantity of gold was small, but it was necessary. Before the war, periodical warnings were given that the gold reserves were inadequate to bear the possible strain. By substituting currency notes for gold (and by amassing credits abroad), the quantity of gold held by the central bank became of relatively little importance.

The currency notes, as explained above, were never definitely made inconvertible. It was even provided that when they were presented at the Bank of England gold could be demanded. But since it was against the law to make any use of gold money except as currency - i.e. it could lawfully be neither melted down nor exported - the presentation of currency notes for conversion in this way at the bank could only lead to unpleasant questions and possibly incriminating answers. The convertibility was, in fact, only nominal or indefinitely suspended.

The legal prohibition of the melting of gold coin, the control both of the exportation and the importation of gold, and the consequent limitation of dealings in gold, severed the link that formerly existed between the values of coined and uncoined gold. Under normal conditions the market price of gold could only differ from the mint price of £3 17s. r02d. by very small amounts, negligible so far as any premium on gold was concerned. Practically, in London before the war, gold coin and gold bullion were convertible to any extent at very short notice. The actual records of the price of gold in London show the stability of the price within these very narrow variations. Since there was never the least hesitation among the public in accepting the currency notes, the gold coins previously in public use were gradually withdrawn from circulation by gentle persuasion and the voluntary action of the banks (not by compulsion). Under these conditions it was not possible to discover if there was in fact any specific depreciation of the notes relatively to gold within the country. Spasmodic cases occurred of sovereigns being bought at a premium in 1916, and both buyers and sellers were prosecuted, but at the time the cases were considered as of no practical importance, and it was generally believed that the notes were not depreciated as regards gold. In a paper read by Prof. Foxwell to the Institute of Actuaries March 26 1917 he stated that he was not aware of any depreciation of this kind in Great Britain, though he had been on the look-out for it incessantly. The police-court cases noted above must have escaped his vigilance, but it is quite clear that there was no recognized depreciation in the sense of a premium on gold in terms of the notes during the war.

A specific depreciation of British currency might have been evidenced by the course of the foreign exchanges, especially with countries such as the United States which had preserved the gold standard effectively. But the course of the foreign exchanges is influenced especially in war-time by other factors, and we cannot at once argue from a fall in the American exchange to a depreciation of British currency. In Sept. 1915 there was a considerable fall in the sterling exchange on New York, but after that time the exchanges were controlled and an artificial stability at 4.762 dollars to the pound sterling was maintained until the control was taken off after the war (1919). It may be observed that the test which the framers of the Bullion Report (1810) thought of the most importance was not applicable owing to the artificial control. It may be added that this artificial control necessitated the incurring of large indebtedness to the United States by England. After the control of the exchanges was taken off there could be no question that the pound sterling depreciated in terms of the dollar, and this old method of estimating the depreciation was revived.

To the great mass of the people of a country, the specific depreciation of the currency, whether measured by the price of bullion or by the course of the foreign exchanges, is of little interest except in so far as it may be a sign of general depreciation or a fall in the purchasing power of the actual currency. The point was well put in a speech by Mr. Reginald McKenna to the shareholders in the London Joint City and Midland Bank on Jan. 29 1921. In discussing the variations in the meaning of inflation he said that one idea runs through all the meanings, namely that inflation is always associated with rising prices. As already explained, a general rise in prices is not in itself inflation, but it is, as experience shows, always associated with it in the sense of abnormal issues of inconvertible paper.

In considering the effects of the inflation (or abnormal issues) of inconvertible paper on general prices two questions must be carefully distinguished: (1) What is the effect in the country of issue; and (2) what is the effect indirectly on general world prices measured in terms of gold (the old standard).

Under normal conditions, when convertibility of all the forms of currency and credit is effective in the great commercial countries (as before the World War), the level of prices in any one country depends partly on causes operating in that country, e.g. tariffs, demand and supply, and partly on the relation of that country to the rest of the commercial world. When the link between gold and paper is broken in any one country, after a point the local issues become of predominant importance. Russia furnishes an example in an extreme form.

In the United Kingdom during the war there can be little doubt that a rise of prices followed on the issues of the currency notes, as shown by Prof. J. S. Nicholson in a paper to the Royal Statistical Society June 1917 (republished in War Finance). It was not implied that the rise was simply caused by throwing the new paper into circulation (as in the case of issues of notes in countries where credit is relatively little developed), but account had to be taken of the effect of the issues on the abandonment of the restraining influence of the gold standard. In the paper referred to it was shown that every kind of currency and of credit had expanded. There had been, for example, a very great increase in the silver and bronze coins put into circulation, and on the other side a great expansion of the use of cheques. Within the country the principle of convertibility had been maintained, and the relative 'amounts of legal tenders of the various kinds and of bankers' credits had increased more or less in like proportions (not exactly for reasons given in Nicholson's War Finance, p. 92). As already explained, once the gold standard was abandoned the notes took over the function of gold in restraining or not restraining advances of credit. A comparison with the United States shows also that the rise in general prices began sooner and advanced more rapidly in Britain than in America.

In other countries roughly the local rise was proportionate to the expansion of the local currencies (and bank credits). The differences are best seen and most exaggerated in Russia and Austria-Hungary, but also in France and Germany.

Broadly speaking during the war (and after the war up to the middle of 1920) general prices in most countries were related to the inflation of their respective currencies and the credits based on them. Prices in particular countries were determined to a greater extent by local causes on account of the restrictions placed on international trade in consequence of the war. Account must be also taken of the efforts of governments to maintain control over prices of important commodities, which, though by no means completely successful and in general undertaken too late, had on the whole considerable effect. That is to say, the level would have been higher but for the control. Local prices were also to some extent kept down by the government of the country concerned buying in the foreign markets instead of allowing unfettered competition. This attempt to establish a buyers' monopoly amongst the allied belligerents was applied too late, and was not very effective as against the great trusts which established sellers' monopolies. Still, no doubt, this part of governmental control also affected the price levels of particular countries. The general result was in accordance with former experience - namely that governmental control is a feeble remedy against a rise of prices consequent on the abandonment of the standard. The fundamental difficulty is that a government can only attempt control in its own country in so far as in combination with other buyers it may establish some kind of buyers' monoply. In other words, world prices still govern world markets, and the local prices have to be adjusted to the world levels. This consideration leads up to the effects of inflation (in the sense of abnormal issues of inconvertible paper and the consequential expansion of other representative money) in particular countries on world prices. In dealing with this second question it must be observed that in the past this influence had to be considered in estimating changes in world prices (or the purchasing power of gold).

The substitution of paper for gold (or the precious metals when there was de facto a link between gold and silver) liberates a certain quantity of the gold which can be used for monetary purposes in other countries. In the American Civil War the displacement of metallic money, no doubt, had some influence in raising the general level of prices in European countries. In the World War the vast accumulation of gold in the United States tended, no doubt, both directly and indirectly to raise prices in that country and in that way to affect world prices measured in terms of gold. Similar effects were observed in Japan L whilst in Sweden precautions were taken against this 1 In Japan in 1914 the balance of bank-notes issued over the amount withdrawn was 385,000,000 yen against gold coin and bullion of 218,000,000 yen. In 1919 the balance of bank-notes was 1,555,000,000 yen against 951,000,000 yen of gold coin and bullion. In Dec. 1920 the ratio of gold to notes in Japan was 85.6, the highest of any of the 17 principal countries.

It is stated in the official Financial and Economic Annual of J apan for 1920 that in order to make up for the deficiency of subsidiary silver coins caused by the war a large number of paper notes of small denominations were issued of an aggregate value of nearly £ 20,000,000. Elsewhere the demand for silver for coinage raised the price greatly (maximum 89d. per oz. in 1919). In England the standard of fineness was lowered.

depreciation of gold. The indirect effect of this influence was far greater in the World War than on any previous occasion owing to the vast area affected by the issues of inconvertible paper and the importance of the countries concerned. It is obvious from the experience of the United States that the mere preservation of convertibility and the effective maintenance of the gold standard are not sufficient to prevent a general rise in prices as) measured in the gold standard. Gold prices in the sense of " world prices " depend broadly on the quantity of the gold in use for monetary purposes and on the work to be done by it. In the course of the war, paper was largely substituted for gold, and so far as trade was concerned there was less work to be done by the gold. The general effect then of the World War was analogous to that of great discoveries of gold. Such a result was not in itself a necessary consequence of the World War and of the issues of inconvertible paper. It was quite possible as pointed out by Prof. J. S. Nicholson (in a paper of date Aug. 3 1914 - republished in War Finance, Part II. ch. 1), that the destruction of credit would more than counterbalance the influences making for a rise in prices. In fact, however, instead of any destruction of credit there was a universal expansion. All governments financed their war needs by loans. The United Kingdom alone of European countries met any considerable part of its war expenses by taxation. In France and Germany the great issues of inconvertible notes directly raised prices, and prices were also raised by the expansion of governmental credits exercised in purchasing power. The notes displaced gold, and the gold was used for monetary purposes in other parts of the world, notably the United States and Japan. In other countries the notes took the place of gold as reserves in the banks, and the reserves were much more easily replenished and increased than was possible with gold. In that way, indirectly as well as directly, the issues of the notes tended to raise general prices. All the world over, in spite of the war, indeed in a sense in consequence of the war, there was a great expansion of credit. But this expansion of credit was only made possible by a corresponding expansion of inconvertible notes.

The evils consequent on inflation which had been exemplified in former historical cases were observed in the World War and in the boom that followed up to the end of 1920. Any general rise in prices, from whatever causes arising, brings difficulties of readjustments, and these difficulties are increased when the main causes are connected with paper money. The reason is that the changes consequent on excessive issues of paper, especially if accompanied by excessive expansion of credits, are much more rapid and intense than when the changes are due to increases in the metal or metals used for standard money. A general rise in prices gives at first a relative advantage to traders and employers of labour, as compared with consumers in general and the receivers of wages and salaries. During the World War wages in industries bearing on the war rose far more rapidly than had been the case in former experiences of inflation. At first the idea prevailed in the United Kingdom that the war would be of short duration, and throughout the dangers of defeat were so appalling that monetary considerations seemed relatively of no importance. No effective restraints were put on inflation. The workers soon learned that they had only to ask in order to have. The employers added any rise of wages to the cost, and to the cost as so determined added on again the usual or unusual percentage of profit. In war contracts the general rule seemed to be to calculate the contractors' profit as a percentage of cost, and with rising nominal cost profits rose automatically. When the enormous rise in profits was observed, an attempt was made to catch the excess above the pre-war normal by the excess profits duty. But under the inflationist conditions that prevailed the imposition of this tax led again in many cases to a further rise in prices. The profit-makers were also imbued with the old belief that any tax that could be evaded ought to be evaded, at any rate by all lawful means. It 'seemed better business to increase expenses of various kinds (e.g. by provision for bonuses, for depreciation, etc.) rather than increase profits if two-thirds had to be surrendered to the State. The " profiteer ing " that arose out of the war was not due entirely to inflation, but it was magnified by the inflation. In many cases, however, the extra profit earned in the war was no more than fair economic remuneration for the services rendered, and in some cases the war profit was low compared with what might have been reasonably expected. In the modern industrial State enterprise cannot be made a matter of routine, and the so-called unearned increment is a necessary and cheap stimulus. In the war the need for speed and quick adjustments was overwhelming. If inflation and excess profits were requisite for the sake of speed, they may indeed be considered as evils but as necessary evils.

It was only after the war when the danger to the national existence had passed away that those who had suffered from the maladjustments of inflation began to complain. Industrial unrest became rampant in every country. The rise in nominal wages in the best of cases had not much exceeded the rise in the cost of living and in some cases it had fallen below. The rise in prices came to be greater in the conventional necessaries of the various classes than in the necessaries commonly so-called. The middle classes suffered far more than the lower wage-earners.

A large part of them passed into the ranks of the new poor. It is the middle classes who provide normally the greater part of the brain power of the country in education and the professions and in the advancement of the arts and sciences. During the war they also had provided the greater part of the brain power for the armies and navies. It was galling to the new poor to observe that in the redistribution consequent on the rise in prices their position had been changed for the worse for the advancement of all kinds of " profiteers." Industrial unrest amongst the manual working classes spread to the brain-working classes. By the beginning of 1 9 21 the new poor had been driven, partly by need and partly by disgust, to rebel against the high prices. There were new poor in all countries. A general crisis arose from the side of demand. The effect on wholesale prices was soon apparent in the fall in the index numbers. But for long there was only a partial readjustment in retail prices. In spite of the buyers' boycott retail prices moved but little. This was mainly due to the absence of bona fide competition. The absence of competition spells the growth of monopoly.

During the war there was in the United Kingdom a great growth of trusts. The report of the Committee on Trusts tried to show that little of the rise in prices was to be attributed to the trusts, and that from the governmental standpoint in carrying on the war the trusts had been useful. It had been found more easy to bargain with a combine than with a number of separate bodies. This view of the trusts also found favour with people of socialist leanings, who thought that the growth of the trusts would be indirectly favourable to the socialistic ideal. When the trusts came to own the business of the nation, it would be time for the nation to own the trusts. Whether these favourable opinions of the growth of trusts were sound or not during the period of the actual war, the popular belief is that the fall in wholesale prices after 1920 was prevented from spreading down to the ordinary consumers largely by the influence of the great combines. No official information is, indeed, available to test this belief. In all times there has been a natural dislike of monopolies. This dislike, however, is largely founded on the belief that monopolies mean high prices. The growth of the trusts has been accompanied by a considerable dilution of capital and by a great rise in the rate of interest. The boom after the war was marked by excessive issues of new companies which were largely amalgamations. These amalgamations involved the payment of high interest to the constituent companies. New capital was attracted to provide the connective tissue for these constituent companies, and this again could only be attracted by high interest. The post-war boom was marked by a great increase of interest on industrial preferences and debentures. Here again was a reason for keeping up prices.

Deflation

The question how prices were to fall when interest had to be higher leads to a consideration of deflation. Deflation, as the name implies, is the reverse of inflation. With this meaning it must involve the restoration of the effective working of the gold standard. An essential part of this process in the United Kingdom must be the actual convertibility of the currency notes. With this object in view Lord Cunliffe's Committee in their Final Report (Dec. 1919) recommended in England that the fiduciary issue of one year should not be exceeded in the next. Under this provision, which was accepted by the Government, the maximum fiduciary issue (i.e. the amount of Treasury notes in circulation not covered by gold) for 1920 was fixed at £320,600,000, and that for 1921 at £317,- 555, 200. In the redemption account of the currency notes the amount of gold held remained at £28,500,000 from Dec. 1915 to 1921, but the gold had been supplemented by the addition of £19,450,000 Bank of England notes (up to Dec. 1920), these notes still being regarded as " as good as gold," owing to their being convertible into gold at the bank. The ratio of the gold holding (plus the Bank of England notes) to the currency notes rose from 8.3 °,o in June 1919 to 14.5% in June 1921. In June 1920 the bank rate was raised to 7%, and this high rate was maintained with the view of limiting the expansion of credit. Consequent on the depression that followed the post-war boom the rate was lowered to 6% in June 1921, and to 51% in July 1921. The high rate must have had some effect in checking speculation and bringing it to an end sooner than otherwise would have been the case. It had little or no effect, however, on the governmental borrowings, and from June 1 9 20 to June 1921 the floating debt actually increased by some £79,000,000. The root cause of the inflation, as already explained, was the governmental expenditure of borrowed (or artificially created) money. It is plain that a high rate for money is not by itself sufficient to check governmental extravagance. Public resentment at the heavy taxation involved by the waste of public money began to be effective at the same time as the resentment against high prices led to a falling-off in demand.

It must be remembered that in case of need - and the Government of the day is the judge of the need - governmental borrowing would be resorted to. In case of need also the amount of currency notes requisite for the smooth working of the credit system must be provided. In case of a financial crisis the banks would always expect the restrictions on the fiduciary issues to be abandoned if necessary. Again, the increase of the reserve against the currency notes cannot of itself insure convertibility. The convertibility could only be effective when the foreign exchanges, especially with the United States, had been restored to the normal. It is not only the notes but all the other forms of credit which must be convertible into gold in case of need if the gold standard is to be effectively reestablished.

Just as the consequences of inflation (e.g. the rise in prices and in nominal wages) must be distinguished from the inflation itself, so also with deflation. The great fall in the index numbers of wholesale prices (United Kingdom) after the spring of 1920 cannot be ascribed to deflation, because in fact there was no deflation in the sense of monetary contraction. The Economist index number for March 1920 was 325 (compared with loo for July 1914), and in Dec. 1920 was 231, whilst from Dec. 1919 to Dec. 1920 the notes in Great Britain had risen from £464,900,000 to £ 509,859,000. During the same year the bank clearings had risen from £28,000,000,000 to £39,000,000,000. In the same way the bank deposits increased during the year. The banking number of the Economist on May 21 1921 showed that the rate of increase of deposits (other than in the Bank of England) was 5.7% in 1920 as compared with 182% in 1919 and 161% in 1918. The actual increase in 1920 over 1919 was £136,000,000 in bank deposits (other than those of Bank of England), £12,000,000 in currency notes and £ 4 1,000,000 in Bank of England note circulation. In 1921, however, up to end of April currency notes declined £30,000.000 and Bank of England notes £4,000,000 and the deposits of 9 joint-stock banks declined by about £120,000,000.

The want of correspondence between the index numbers of wholesale prices in the United Kingdom and the amount of money (notes and bankers' money) has been cited by some writers as destructive to the " quantity theory " of money.

The quantity theory, however, in its modern extended form does not imply that immediately on every increase or decrease of money there must be a proportionate fall in prices. In either case there must be some lag. Even with great gold discoveries it takes time before the effect becomes marked, and similarly as regards a fall in the amount. The opponents of the quantity theory, who assert that the money in use (including notes and bankers' credits) must be adjusted or follow on the movements in prices, are in a worse case. How comes it that when prices have fallen so greatly there has not been a corresponding contraction of " money "? The truth is that the element of time must always be considered. An abnormal increase of money takes time for its full effects to be realized. Similarly any contraction will take time to operate. After a period of inflation when prices begin to fall there will be for a time an apparent abundance of money. An illustration may be taken from what occurred in the great fall in prices from 1873 to 1896. At the depth of the depression of prices there was apparently a superabundance of gold at the great banking centres, and the rates of discount were never so low. Yet the general fall in prices was ascribed to the fall in the production of gold and the greater demand for it for monetary uses consequent on the destandardization of silver.

Not only must time be taken account of, but the survey must be extended to world prices, especially with the restoration of international communications. Prices in the United States after the war had a dominating influence on world prices. In the United States convertibility between the various money forms was maintained during and after the war. The Federal Reserve Act, however, made it possible for a certain amount of gold to support a larger superstructure of credit. At the same time, through the influx of gold from Europe, the gold foundation was also greatly increased. The consequence was that from 1913 to 1919, whilst the physical volume of business (in the United States) increased approximately 9.6%, the monetary circulation increased 71%, and bank deposits 120%. At the same time the percentage of actual cash reserves held against deposits declined from 11.7 in 1913 to 6.6 in 1919. Through the concentration of gold a greater power of expansion was given to the credit within the country, whilst the complete abandonment of the gold standard in Europe took away the restraining effect of a possible foreign drain. In this way, in spite of convertibility being maintained in the United States, the gold standard had not the same limiting effect as before the war. This loosening of the restraints of the gold standard is in fact equivalent to a form of inflation, and American economists (e.g. Prof. Kemmerer) speak of American inflation during the war.

It follows from these considerations that the process of deflation must be slow. It seemed probable in 1921 that for a considerable time the fall in prices would continue in the United Kingdom to precede the process of deflation.

Similar reasoning applies to wages and employment. With the great fall in prices money wages must fall, because in the last resort wages are paid out of the price of the product when there is a definite product, whilst wages that are given for services that perish in the act are proportioned to the corresponding disutilities involved as compared with the work of the productmakers. If the fall in prices in the United Kingdom is not clue to deflation in the sense of monetary contraction, the fall in wages cannot be ascribed to that cause. When the fall in wages is not readily adjusted to the fall in prices there must be an increase of unemployment. But this unemployment cannot be ascribed to deflation.

The process of deflation must begin with a stoppage of inflation, and the effective prevention of the outbreak of renewed inflation. The essential condition is the stoppage of governmental expenditure that depends on borrowed money or the creation of artificial credits. In other words, the gold standard. must be effectively restored.

The assumption that a fall in prices must of necessity be accompanied by a fall in real wages and in employment is not confirmed by the experience of the last quarter of the 19th cen tury. Real wages increased during the great fall in prices, and complaints began to be made of the fall in real wages when prices began to move upwards. The charts constructed by Mr. Kitchin (Times Financial and Commercial Review, 1921) show that there is no close correspondence between movements in employment and movements in prices under ordinary normal conditions. The greatand rapid increase in unemployment in the United Kingdom in 1921 might be partly ascribed to the stoppage of the progress of inflation and the check to speculation.

The fall in prices and in employment may also be partly ascribed to the repudiation of contracts by foreign merchants when they were seen to be unprofitable. This facile repudiation of bargains is symptomatic of the laxity of moral fibre that follows on inflation. This weakening of business moral makes it more difficult for governments to meet the obligations of public indebtedness. There has been a revival of old ideas on lessening the burden of public debts by disguised repudiation. It is said that the debts were incurred in depreciated money and therefore ought to be redeemed in depreciated money. It is proposed to stabilize the present level of purchasing power by changing the unit of value. How far such partial repudiation is necessary or desirable for any particular. country (e.g. Germany) must be decided by the particular country. Even before the war the very moderate proposals for international bimetallism were not found to be practicable.

The essential facts of the situation are that the United States and Japan have effectively kept to the gold standard, qua freedom from specific depreciation, and the departure by the United Kingdom as compared with the United States has not been so great as to make the return to the gold standard impracticable. It seems then that world prices will be reckoned on the gold standard, and the national prices of other countries will in the course of time be adjusted to the specific depreciation of their currencies in terms of gold. International trade in the last resort must be carried on in terms of commodities and services. A country cannot for an indefinite period have a stimulus to its export trade simply through the specific depreciation of its currency. So long as the specific depreciation (e.g. of the German mark) is greater than the general depreciation as regards purchasing power of labour and other things within the country itself, so long excess profits are earned on exports. But such a condition is obviously unstable. The general theory was explained by Prof. J. S. Nicholson in a paper (Jan. 1888) on the " Causes of Movements of General Prices," republished in the Money and Monetary Problems. The argument was primarily applied to the case of gold and silver, and the consequences of the great depreciation of silver relatively to gold, but it was shown that, mutatis mutandis, the same reasoning applied to gold and paper. The silver-standard countries found it desirable to adopt a gold or gold-exchange standard, and by analogy the paper-standard countries at present may be expected in time to revert more or less completely to the gold standard.

The gradual return to the gold standard will no doubt be accompanied by a general fall in prices. The fall, which was very rapid in 1920, slackened by the middle of 1921 but seemed likely to be resumed. One obstacle to the continued fall in wholesale prices and the spread of the fall to retail prices was the action of combination in restraint of competition. It is this reliance on combination to keep up prices which is the great obstacle to the policy of ensuring de facto deflation by increasing the amount of goods so as to use the superabundant money. When the world is suffering from the exhaustion of the World War and when production ought to be increased as much as possible to restore the pre-war standards of material comfort, it is paradoxical that limitation of production should be anywhere in favour. It might seem to Labour that limitation of hours or of days is a remedy for unemployment (the " lump of labour " theory), and it is possible that in some cases Labour and Capital could combine to insist on monopoly prices. The great obstacle, however, to the success of any such policy of artificial limitation to keep up prices is the difficulty of making all the combines world-wide in their reach.

Literature. - There is already a large literature dealing with inflation and its consequences during and after the World War. No doubt, as after the Napoleonic period, there will be prolonged controversy on the best methods to be adopted in restoring economic and financial equilibrium. The Report of the Committee on Currency and Exchange, which was unanimously adopted by the delegates of the 39 nations present at the International Financial Conference at Brussels (Oct. 1920), confirmed the opinions expressed in the report of the Cunliffe Committee, which was drawn up with special reference to the United Kingdom. The Brussels report may be divided into four sections. The first deals with the meaning, causes and progress of the inflation in the World War, and points to the necessity of stopping the growth of inflation by the limitation of governmental expenditure to revenue and the limitation of the creation of credit to bona fide economic needs. The second section calls for increased production. In this connexion the abandonment of governmental control is advocated, but no reference is made to the dangers of limitation of production by the great combines. The third section recommends the return to the gold standard, but the opinion is given that it is useless to attempt to fix the ratio of existing fiduciary currencies to their nominal value. In the fourth section it is stated that deflation must be gradual and that no useful purpose could be served by any attempt to establish an international currency or unit of account to impose artificial control on exchange operations. Supplementary volumes give details affecting various countries of the evidence on which the Report is based.

In the Financial and Commercial Review for 1920, issued by the Swiss Banking Corporation, convenient tables are given on p. 5 of the index numbers of the principal countries of wholesale and retail prices (England, France, the United States, Italy, Japan and Germany), and on p. 13 of the gold reserves and paper circulation of 17 principal countries for 1914, 1918, 1919 and 1920.

The following are useful works of reference : - The Paper Pound of 1797-1821, a reprint of the Bullion Report of 1910 with introduction b y Edwin Cannan (1919); J. S. Nicholson, Inflation (1919); R. G. Hawtrey, Currency and Credit (1919); R. W. Kemmerer, High Prices and Deflation (1920); the four Reports of Section F of the British Association on Currency and Credit in the War, edited by Prof. Kirckaldy, 1916-20, have been collated and brought down to the middle of 1921 in one volume entitled British Finance, 1914-1921, by Mr. A. H. Gibson; Irving Fisher, Stabilising the Dollar (1920); J. S. Nicholson, War Finance (2nd. ed. 1918); J. M. Keynes, Economic Consequences of the Peace (1920). The work by Yves-Guyot and A. Raffalovich, Inflation and Deflation (1921), gives in short compass a very valuable account of former periods of inflation beginning with John Law, and also gives in a short form the leading facts of the actual progress of inflation in the various countries in the World War. The writers reassert the classical opinions on the evils of inflation and advocate as rapid deflation as possible. H. S. Foxwell, Papers on Current Finance (1919), criticizes the generally accepted theories of inflation. The Review of Economic Statistics, issued monthly by the Harvard Committee on Economic Research, gives not only a general analysis of business conditions with probable forecasts (somewhat on the analogy of meteorological observations and deductions) but provides in a convenient form the statistics of changes in production and in financial conditions. (J. S. N.)


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Wiktionary

Up to date as of January 15, 2010

Definition from Wiktionary, a free dictionary

See also inflation

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Pronunciation

Noun

Inflation f. (genitive Inflation, plural Inflationen)

  1. (economics) inflation

Simple English

Inflation means that the general level of prices is going up, the opposite of deflation. More money will need to be paid for goods (like a loaf of bread) and services (like getting a haircut at the hairdresser's). Economists measure inflation regularly to know an economy's state. Inflation changes the ratio of money towards goods or services; more money is needed to get the same amount of a good or service, or the same amount of money will get a lower amount of a good or service. Economists defined certain customer baskets to be able to measure inflation.

Contents

Causes of inflation

When the total money in an economy (the money supply) increases too rapidly, the quality of the money (the currency value) often decreases. Economists generally think that this money supply increase (monetary inflation) causes the goods/services price increase (price inflation) over a longer period. They disagree on causes over a shorter period.

Demand-Pull inflation

The Demand-Pull inflation theory can be said simply as "too much money chasing too few goods." In other words, if the will of buying goods is growing faster than amount of goods that have been made, then prices will go up. This most likely happens in economies that are growing fast.

Cost-Push inflation

The Cost-Push inflation theory says that when the cost of making goods (which are paid by the company) go up, they have to make prices higher to still make profit out of selling that very product. The higher costs of making goods can include things like workers' wages, taxes to be paid to the government or bigger costs of getting raw materials from other countries.

However, Austrian Economists think this is wrong, because if people have to pay higher prices, this just means they have less to spend on other things.

Costs of inflation

Almost everyone thinks inflation is bad. Inflation affects different people in different ways. It also depends on whether inflation is expected or not. If the inflation rate is equal to what most people are expecting (anticipated inflation), then we can adjust and the cost is not as high. For example, banks can change their interest rates and workers can negotiate contracts that include automatic wage hikes as the price level goes up.

Problems arise when there is unanticipated inflation:

  • Creditors lose and debtors gain if the lender does not guess inflation correctly. For those who borrow, this is similar to getting an interest-free loan.
  • Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run.
  • People living off a fixed-income, such as retirees, see a decline in their purchasing power and, consequently, their standard of living.
  • The entire economy must absorb repricing costs ("menu costs") as price lists, labels, menus and more have to be updated.
  • If the inflation rate is greater than that of other countries, domestic products become less competitive.

nominal interest rate rise beacause inflation is anticipated








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