INFLATION

INFLATION. The definition of "inflation" cannot be separated from that of the "price level." Economists measure the price level by computing a weighted average of consumer prices or so-called "producer" prices. The value of the average is arbitrarily set equal to one (or one hundred) in a base year, and the index in any other year is expressed relative to the base year. The value of the consumer price index in 1999 was 167, relative to a value of 100 in 1982 (the base year). That is, prices in 1999 were 67 percent higher on average than in 1982.

Inflation occurs when the price level rises from one period to the next. The rate of inflation expresses the increase in percentage terms. Thus, a 3 percent annual inflation rate means that, on average, prices rose 3 percent over the previous year. Theoretically, the rate of inflation could be by the hour or the minute. For an economy suffering from "hyperinflation"—Germany in the 1920s is an example—this might be an appropriate thing to do (assuming the data could be collected and processed quickly enough). For the contemporary United States, which has never experienced hyperinflation, the rate of inflation is reported on a monthly basis.

Deflation is the opposite of inflation: a fall in the price level. Prior to World War II deflation was quite common in the United States, but since World War II, inflation has been the norm. Prewar deflation took two forms. First, the price level might decline very sharply during an economic downturn. This happened, for example, in the early 1840s, when the country was hit by a severe depression, as well as during the Great Depression of the 1930s. Second, deflation might occur over long periods of time, including periods of economic expansion. For example, the price level in the United States in 1860 was lower than in 1820, yet during these four decades the economy grew rapidly and experienced much structural change.

Measuring Inflation

The measurement of the price level is a difficult task and, therefore, so is the measurement of the inflation rate. For example, many economists believe that the consumer price index has overstated the rate of inflation in recent decades because improvements in the quality of goods and services are not adequately reflected in the index. An index that held quality constant, according to this view, would show a smaller rate of price increase from year to year, and thus a smaller average rate of inflation.

It is important to recognize that a positive rate of inflation, as measured by a price index, does not mean that all prices have increased by the same proportion. Some prices may rise relative to others. Some might even fall in absolute terms, and yet, on average, inflation is still positive.

The distinction between absolute and relative price change is important in understanding the theory behind the effects of inflation on economic activity. In the simplest "static" (one-period) economic model of consumer behavior, a fully "anticipated" (understood and expected by consumers and producers) doubling of all prices—the prices of the various consumer goods and the prices of the various productive "inputs" (factors of production, like labor)—does not change the structure of relative prices and therefore should have no effect on the quantities of goods demanded. Similarly, the conventional model of producer behavior predicts that a doubling of all prices would not affect output price relative to the cost of production and therefore would not affect the quantity of goods supplied. The nominal value of GNP (gross national product) would double, but the real value would remain constant. In such a model, money is said to be "neutral," and consumers and producers are free of "money illusion." In more complex, dynamic models, it is possible that a sustained, higher rate of inflation would alter consumers' desired holds of money versus other assets (for example, real estate) and this might change real economic activity.

When inflation is unexpected, however, it is entirely possible—indeed, almost inevitable—that real economic activity will be affected. Throughout American history there is evidence that money wages are "sticky" relative to prices; that is, changes in money wages lag behind (unexpected) changes in the price level. During the early years of the Great Depression of the 1930s, nominal hourly wages fell but not nearly as much as prices. With the real price of labor "too high," unemployment was the inevitable result. When inflation is unexpected, consumers or producers may react as if relative prices are changing, rather than the absolute price level. This can occur especially if the economy experiences a price "shock" in a key sector—for example, an unexpected rise in the price of oil—that sets off a chain of price increases of related products, and a downturn in economic activity.

Causes of Inflation

All of which begs the underlying question: What ultimately causes inflation (or deflation)? Although this is still a matter of dispute among economists in the details, most believe that inflation typically occurs when the supply of money increases more rapidly than the demand for money; or equivalent, when the supply of money per unit of output is increasing. This might occur within a single country; in a global economy, it can also spill over from one country to another. The supply of money per unit of output can increase either because the "velocity" at which it circulates in the economy has increased or, holding velocity constant, because the stock of money per unit of output has increased.

This leads to another question: What factors determine the rate of growth of the money supply relative to money demand? The demand for money depends on the overall scale of economic activity, along with interest rates, which measure the opportunity cost of holding money balances. The supply of money depends on the so-called "monetary regime"—the institutional framework by which money is created.

During the nineteenth century and part of the twentieth, the United States adhered to the gold standard and, at times, a bimetallic (silver) standard. Under the gold standard, the money supply was "backed" (guaranteed) by holdings of gold, so the supply of money could grow only as rapidly as the government's holdings of specie. If these holdings increased more slowly than the demand for money, the price level would fall. Conversely, if holdings of specie increased more rapidly than the demand for money, the price level could rise. Generally, the latter would occur with the discovery of new deposits of gold (or silver) in the United States—or elsewhere, because gold flowed across international borders—as occurred in California in the late 1840s, or in South Africa in the late 1890s.

During periods of war the money supply was augmented with paper money. For example, during the Civil War, both the Union and Confederate governments issued greenbacks as legal tender. The price level rose sharply during the war years. Real wages fell, producing an inflation "tax" that both sides used to help pay for the war effort.

In the contemporary United States, the main institutional determinant of the money supply is the Federal Reserve. The Fed can affect the growth of the money supply in several ways. First, it can engage in open market operations, the buying and selling of government securities. When the Fed buys securities, it injects money into the system; conversely, when it sells securities, it pulls money out. Second, the Fed can alter certain features of the banking system that affect the ability of banks to "create" money. Banks take in deposits, from which they make loans. The supply of loanable funds, however, is larger than the stock of deposits because banks are required only to keep a fraction of deposits as reserves. The Fed can alter the reserve ratio, or it can alter the rate of interest that it charges itself to lend money to banks.

Most economists believe that the Federal Reserve, when deciding upon monetary policy, faces a short-run trade-off between inflation and unemployment. In the long run, unemployment tends toward a "natural" rate that reflects basic frictions in the labor market and that is independent of the rate of inflation. If the goal in the short run is to reduce unemployment, the Fed may need to tolerate a moderate inflation rate. Conversely, if the goal is to lower the inflation rate, this may require a slowdown in economic activity and a higher unemployment rate. Since World War II, the Federal Reserve has sought to keep inflation at a low to moderate level. This is because a high or accelerating rate of inflation is typically followed by a recession. Some economists believe that, rather than trying to "fine-tune" the economy, the Fed should "grow" the money supply at a steady, predictable pace.

It is sometimes argued that inflation is good for debtors and bad for creditors, and bad for persons on fixed incomes. A debtor, so goes the argument, benefits from inflation because loans are taken out in today's dollars, but repaid in the future when, because of inflation, a dollar will be worth less than today. However, to the extent that inflation is correctly anticipated—or "rationally expected"—the rate of interest charged for the loan—the "nominal" rate—will be the "real" rate of interest plus the expected rate of inflation. More generally, any fixed income contract expressed in nominal terms can be negotiated in advance to take proper account of expected inflation. However, if inflation or deflation is unanticipated, it can have severe distributional effects. During the Great Depression millions of Americans lost their homes because their incomes fell drastically relative to their mortgage payments.

Inflation in American History

In the eighteenth and nineteenth centuries and, indeed, in the first half of the twentieth century, inflation was uncommon. Major bouts of inflation were associated with wars, minor bouts with short-term economic expansions ("booms").The booms usually ended in financial "panics," with prices falling sharply. During the nineteenth century this pattern played itself out several times, against a backdrop of long-term deflation.

The first wartime experience with inflation in U.S. history occurred during the American Revolution. Prior to the Revolution inflation did occur periodically when colonial governments issued bills of credit and permitted them to circulate as money, but these were banned by Parliament between 1751 and 1764.When war broke out, bills of credit were again circulated in large numbers. Be-cause the increase in the money supply far exceeded the growth of output during this period, the price level rose sharply.

Wartime inflations in American history have typically been followed by severe deflations, and the Revolution was no exception. After dropping by two-thirds between 1781 and 1789, prices rebounded and eventually stabilized. The next big inflation occurred with the War of 1812.Briefer and less intense than its revolutionary counterpart, prices fell sharply after peaking in 1814.The price level continued to trend downward in the 1820s but reversed course in the mid-1830s during a brief boom. A financial panic ensued, and the country plunged into a severe downturn accompanied by an equally severe deflation. The economy began to recover after 1843, and the price level remained stable until the mid-1850s, when, fueled by the recent gold discoveries in California, inflation returned. Again, however, a financial panic occurred and prices fell. In 1860, the eve of the Civil War, the price level in the United States was 28 percent below the level in 1800; that is, the preceding six decades were characterized by long-term deflation.

To help finance the war effort, Congress and the Confederacy both issued paper money. Inflation followed, peaking in 1864.The price level dropped sharply after the war and, except for a brief period in the early 1880s, continued on a downward course for the remainder of the nineteenth century.

The discovery of gold in South Africa in the mid-1890s signaled another expansion of the money supply. Prices rose moderately after 1896, stabilizing in the years just prior to World War I. Inflation returned with a vengeance during the war, with prices rising by nearly 228 percent between 1914 and 1920.Once again, a sharp postwar recession was accompanied by deflation, but recovery ensured the price level remained stable for the remainder of the 1920s.

Following the stock market crash in October 1929, a deep and prolonged deflation accompanied the dramatic bust that became the Great Depression. Prices fell by one-third between 1929 and 1932.Nominal hourly wages did not fall as much as prices, however, and unemployment rose sharply, to nearly a quarter of the labor force. Convinced that higher wages and higher prices were the key to renewed prosperity, the "New Deal" administration of President Franklin D. Roosevelt adopted a multipronged attack: raising prices directly via the National Recovery Act, reforming the banking system, and expanding the money supply. The price level did turn around beginning in 1933 but fell once again in 1938 during a brief recession.

It took the Nazis and the Japanese invasion of Pearl Harbor to reinvigorate the inflationary process in the United States. Unemployment dropped sharply, putting considerable upward pressure on wages and prices. To some extent this pressure was abated through the use of wage and price controls that lasted from 1942 to 1946, although it is widely believed that official price indexes for the period understate the true inflation because many transactions took place at high "black market" prices, and these are not incorporated into the official indexes.

In the years since World War II the United States has experienced almost continuous inflation, the only exception being very slight deflation in the early 1950s. The inflation rate was nonetheless quite moderate until the expansion of the Vietnam War in the late 1960s. A reluctant President Richard Nixon mandated a series of price controls from 1971 to 1974, but these did little to stem the tide of rising prices, particularly after an international oil embargo in 1973–1974 caused energy prices to skyrocket. Overall in the 1970s the consumer price index rose at an average annual rate of nearly 7.5 percent, compared with 2.7 percent per year in the 1960s. A sharp recession in the early 1980s coupled with activist monetary policy cut the inflation rate to an average of 4.6 percent between 1980 and 1990.Inflation fell further in the 1990s, to an average of 2.7 percent (1990–1999).

As noted, the federal government reports the inflation rate on a monthly basis. Recent data may be found in the U.S. Census Bureau's publication, Statistical Abstract of the United States, and on-line at the Bureau's Web site (www.census.gov) or the Web site of the Bureau of Labor Statistics (www.bls.gov). For long-term historical data on the price level, readers should consult the various editions of Historical Statistics of the United States or the volume by McCusker (2001).

INFLATION

Measuring Inflation

Causes of Inflation

Inflation in American History

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