While short-term bouts of inflation can be triggered by anything that would cause aggregate demand to increase more than aggregate supply, long-term inflation can be sustained ONLY through increases in the money supply. The price level, and any "inflation" of the price level, depends directly on the amount of money in circulation. On the flip side of this relationship, inflation leads to a continual erosion in the purchasing power of money.

Historical Numbers

Inflation Rate

The most noted feature of this graph is the double spike of inflation during the 1970s, reaching one spike of about 12 percent in the early 1970s, then after declining during the 1973-75 contraction, hit an even higher peak of 14 percent in 1980. The 1970s is notable as the decade of stagflation, simultaneously high rates of both inflation and unemployment.

Another, perhaps less obvious but also important, feature of this graph is the declining inflation during the expansion of the mid 1980s and through much of the 1990s expansion. Rather than inflation rising during expansions, inflation actually declined. The 1980s decline was likely due, as much as anything, to a reversal of the factors causing the stagflation of the 1970s (energy prices, government regulations) while the 1990s decline was likely attributable to technology-induced economic growth.

Why Study?

Inflation attracts the interest of economists, policy makers, and regular everyday ambling folks for a couple of reasons: uncertainty and haphazard redistribution.

• Uncertainty: First, inflation creates uncertainty, especially when inflation catches people unexpectedly off guard or fluctuates widely from month to month or year to year. The reason that most people, consumers and producers alike, do not like unexpected inflation is that they are risk averse; they prefer a knowable, stable, predictable life. Known, constant, or expected inflation can be integrated into the fabric of the economy. If people KNOW that prices will be increasing by 10 percent, then they can adjust plans accordingly. However, unexpected or changing inflation creates uncertainty, making long-range planning exceedingly difficult.

  For example, a significant amount of household, business, and government activity involves long-term commitments--such as borrowing to purchase cars and homes, investing in multi-year capital construction projects, anticipating tax or revenue collections, and planning expenditure budgets. Not knowing, or not correctly anticipating, inflation makes such commitments difficult at best and might even be financial disastrous. Households and businesses can be forced into bankruptcy. Governments can encounter serious fiscal problems. A worker might not know whether to accept a multi-year employee contract with automatic wage increases of 2 percent or 12 percent. A business might not know whether to plan for a 3 percent or 13 percent increase in raw material prices. A school district might not know whether to issue construction bonds with a 7 percent or 17 percent interest rate.



• Haphazard Redistribution: Second, inflation can haphazardly redistribute income and wealth. The redistribution of income and wealth has always been an inherent part of the economy. For example, income generated by the owners of productive resources has always been transferred to others with little or no ownership of productive resources (such as young, old, or disabled). However, inflation can redistribute income in ways that society might not want.

  While inflation is an increase in the average price level, ALL prices do NOT increase at the same rate. When prices change at different rates, the owners of resource used in the production of goods with above-average price increases receive more real income. Resource owners involved in the production of goods with below-average price increases (even declining prices) get relatively less real income. The end result is the income and wealth are redistributed from some resource owners to others.

  One of the most noted areas of inflation-induced redistribution is between borrowers and lenders. When borrowers and lenders correctly anticipate inflation over the life of a loan, they adjust the interest rate to ensure that the purchasing power of the money loaned is equal to the purchasing power of the money repaid. However, income and wealth are redistributed between borrowers and lenders when inflation is not correctly anticipated. If inflation is more than expected, then the purchasing power of the repayment is less than the original loan, so income and wealth are redistributed from lenders to borrowers. If inflation is less than expected, then the purchasing power of the repayment is more than the original loan, so income and wealth are redistributed from borrowers to lenders.

Measures

• Consumer Price Index: The Consumer Price Index (CPI) is an index of prices of goods and services typically purchased by urban consumers. This index, compiled and published monthly by the Bureau of Labor Statistics, provides a relatively accurate indication of the average price level in the economy, and thus inflation. The CPI is based on a market basket of goods and services that are identified in an extensive survey of urban consumers. It is then assumed that urban consumers repurchase this market basket each month. The CPI compares the total expenditures on this market basket from month to month. If expenditures rise, then prices, on average, increase.

  The best feature of the CPI is monthly estimation, it is usually reported within two weeks after a month has ended. This provides timely information for consumers, businesses, and government leaders who make decisions that are sensitive to inflation.

  One main failing of the CPI is that it only measures goods typically purchased by urban consumers. It ignores goods that might be bought only by rural consumers, governments, businesses (such as capital goods), or the foreign sector. While this captures perhaps two-thirds of the economy's total production, it does ignore an important one-third.

  A second failing is the fixed market basket of goods used to derive the CPI. It assumes that the mix of goods purchased by consumers at one time are also purchased in other years. To the extent the consumers buy a different mix of goods, the CPI gives undo importance to prices that are not relevant to economic activity.



• GDP Price Deflator: The GDP price deflator is an index of prices calculated as a ratio of nominal gross domestic product to real gross domestic product. This index, estimated quarterly in conjunction with the wide range of production and income measures contained in the National Income and Product Accounts generated by the Bureau of Economic Analysis (BEA), provides the best overall indicator of the average price level. Because it is based on gross domestic product, it includes the prices of ALL FINAL GOODS AND SERVICES, not just those purchased by urban consumers. It is also based on prices of business investment in capital, government purchases, and exports to the foreign sector.

  The GDP price deflator is possible because economists at the BEA estimate both nominal GDP (current production at current prices) and real GDP (current production at constant, base year prices). The key difference between nominal GDP and real GDP is the change in prices from the base year to the current year. As such, the ratio of nominal GDP to real GDP provides an index of the average price level and consequently an indicator of inflation.

  The best feature of the GDP price deflator is the inclusion of ALL goods and services produced in the economy in a given year. Unlike the CPI, which is based on goods purchased by urban consumers, the GDP price deflator also includes goods purchased only by rural consumers, governments, businesses (such as capital goods), or the foreign sector. As an indicator of inflation of the OVERALL price level, the GDP price deflator is better.

  Another noted feature of the GDP price deflator is that it is based on CURRENT production. Only the prices of the goods that comprise CURRENT production are used in the estimation of the GDP price deflator. The CPI, in contrast, relies on prices of goods typically purchased during a base year, which could be 5 to 10 years earlier.

  Unfortunately, the GDP price deflator is only available quarterly, every three months, rather than monthly like the CPI. For example, the GDP price deflator for the first three months of the year (January, February, and March) is not available until April or May. The year is almost half over before the GDP price deflator can be used to document the price level or inflation. For consumers, businesses, and especially government policy makers who need to make timely decisions based on inflation, such a delay can be troublesome.

  A somewhat lesser problem with the GDP price deflator is that it provides an average for a three-month period. For example, it provides NO specific information about the price level in January, only for the combined months of January, February, and March.

Causes

• Demand-Pull Inflation: Demand-pull inflation is inflation attributable to increases in aggregate demand. This inflation results when the four macroeconomic sectors (household, business, government, and foreign) collectively try to purchase more output than the economy is capable of producing. In effect, the demand side of the aggregate market is "pulling" the price level higher.

  In terms of the simple production possibilities analysis, excessive demand causes the economy to bump against the production possibilities frontier. In the more elaborate aggregate market analysis, aggregate demand increases beyond aggregate supply and causes an economy-wide shortage. As with any market shortage, the result is a rising price (price level), which is inflation.

  While short-term demand-pull inflation can result from anything that would increase aggregate demand, the ultimate long-term source of long-term demand-pull inflation is the money supply. The only way to sustain demand-pull inflation is if one buyer can spend more MONEY without reducing the amount of MONEY spent by others. And this can only happen if the economy has more MONEY. In fact, one of the best documented relationships in economics is that between money and inflation. Inflation simply CANNOT persist for any extended period of time (that is, a year or more) without an increase in the amount of money available to the economy.



• Cost-Push Inflation: Cost-push inflation is inflation attributable to decreases in aggregate supply, primarily due to increases in production cost. This type of inflation results when the cost of using any of the four factors of production (labor, capital, land, or entrepreneurship) increases. In effect, the cost of producing output on the supply side of the aggregate market is "pushing" the price level higher.

  In terms of the production possibilities analysis, the production possibilities frontier shrinks closer to the origin, bumping down against the aggregate demand. In the aggregate market analysis, aggregate supply decreases such that it is less than aggregate demand and an economy-wide shortage is created. As with any market shortage, this causes the price (price level) to rise. The end result is inflation.

  Once again while short-term cost-push inflation can result from anything that would decrease aggregate supply, the ultimate long-term source of long-term cost-push inflation is the money supply. The only way that cost-push inflation can be sustained is if buyers are ABLE to pay the higher prices. And this can only happen if the economy has more MONEY.

Policies

• Fiscal Policy: Fiscal policy is the discretionary use of government spending and taxes to affect business cycle fluctuations. The recommended fiscal policy for reducing or preventing inflation is to decrease government spending and/or to increase taxes. When undertaken by the federal government, either or both of these actions lead to a decrease in the federal deficit or an increase in the federal surplus. This goes by the specific name of contractionary fiscal policy.


• Monetary Policy: Monetary policy is the discretionary use of the money supply and interest rates to affect business-cycle fluctuations. The recommended monetary policy for reducing or preventing inflation is to decrease the money and raise interest rates. This goes by the specific name of contractionary monetary policy.