What is inflation and how can it be controlled?

What is inflation?

There are several meaning of inflation , we will discuss two definitions of it. First, The term inflation means a process with a continual increase in the general price level. As prices go up, individuals try to protect their purchasing power and take actions which inadvertently perpetuate the inflation. For example, employees may try to protect themselves from inflation by having their wages tied to the cost of living(Livingston, 2000) . As price rise, wages are forced up, which raises production costs, which raises selling prices, and so on, in a never ending cycle. Throughout history, inflation has occurred frequently. Second, Inflation is the term used to describe a rise of average prices through the economy. It means that money is losing its value. The underlying cause is usually that too much money is available to purchase too few goods and services, or that demand in the economy is outpacing supply(What is inflation, 2010) . In general, this situation occurs when an economy is so buoyant that there are widespread shortages of labor and materials. People can charge higher prices for the same goods or services.

Brief history of inflation

Increases in the quantity of money or in the overall money supply (or debasement of the means of exchange) have occurred in many different societies throughout history, changing with different forms of money used.

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 seignior age (Kenneth, 1996) 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 (Roger, 2002).

From the 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”, 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 ( Walton 1994). The spent silver, suddenly spread throughout a previously cash starved Europe, caused widespread inflation ( Walton, 1994). Demographic factors also contributed to upward pressure on prices, with European population growth after depopulation caused by the Black Death pandemic.

The adoption of fiat currency (paper money) by many countries, from the 18th century onwards, made much larger variations in the supply of money possible. Since then, huge increases in the supply of paper money have taken place in a number of countries, producing hyperinflations– episodes of extreme inflation rates much higher than those observed in earlier periods of commodity money (Roger, 2002). The hyperinflation suffered by the Weimar Republic of Germany is a notable example.

Causes of inflation

There are many reasons that can cause inflation in goods and service. Based on the quality theory of inflation and quantity theory of inflation, inflation is a result of the amount of money people will be able to use that money to buy the goods they want and the amount of money supplied and exchanged.

Another reason of inflation is Demand-pull inflation which means that the economy actual demands more goods and services than available. This shortage of supply enables sellers to raise prices until an equilibrium is put in place between supply and demand (inflation, 2010). For example, low employment rates against increase in demand. Secondly, The cost-push inflation also known as “supply shock inflation”( inflation, 2010). This Can take place when goods become harder to get the price increases as a result, people try to increase the amount of money they earn to maintain the change in price. Inflation can be made by the circulation of increase in the wages of employees and the increase in the producers cost which will lower the value of the money (Stiqall R. March 29, 2010).

Effects of Inflation

The most immediate effects of inflation are the decreased purchasing power of the dollar and its depreciation. A second destabilizing effect is that inflation can cause consumers and investors to change their speeding habits. When inflation occurs, people tend to spend less meaning that factories have to lay off workers because of a decline in orders. A third destabilizing effect of inflation is that some people choose to speculate heavily in an attempt to take advantage of the higher price level. Because some of the purchases are high-risk investments, spending is diverted from the normal channels and some structural unemployment may take place. Finally, inflation alters the distribution of income. Lenders are generally hurt more than borrowers during long inflationary periods which means that loans made earlier are repaid later in inflated dollars (the effect of inflation on your money, March 19, 2009).

Measuring inflation

It is necessary to have some kind of an accurate measure of the increase in the price level. The most widely used statistic to measure inflation is known as the consumer price index (CPI). Other measurement is Producer Price Indexes (PPI), Commodity price indices and Core price indices.

Consumer Price Index (CPI)

A measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles. The CPI measures price change from the perspective of the purchaser. U.S. CPI data can be found at the Bureau of Labor Statistics.

The three main CPI series are:

• CPI for All Urban Consumers (CPI-U)

• Chained CPI for All Urban Consumers (C-CPI-U)

• CPI for Urban Wage Earners and Clerical Workers (CPI-W)

According to (Dubai Statistics Center, 2010) Consumer Price Index was 114.63 in the first half of 2009, and in the first half 2010 it was 115.36. The formula for calculating the annual percentage rate inflation in the CPI is,

115.36 – 114.63 Ã- 100 â„… = 0.64 â„…

114.63

Producer Price Indexes (PPI)

Families of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller. U.S. PPI data can be found at the Bureau of Labor Statistics.

For instance, (Bureau of Labor Statistics, 2010) stated that the U.S Monthly percent changes in the Producer Price Index for Finished Goods which is finished food, finished energy and finished core for October 2009 – October 2010 is shown in chart 1

However, the Monthly percent changes in the Producer Price Index for Intermediate Goods which is intermediate food, intermediate energy and intermediate, for October 2009 – October 2010 is shown in chart 2

Commodity price indices

Index or average, which may be weighted, of selected commodity prices, intended to be representative of the markets in general or a specific subset of commodities, e.g., grains or livestock.

Core price indices

A measure of inflation that excludes certain items that face volatile price movements. Core inflation eliminates products that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation. Core inflation is most often calculated by taking the Consumer Price Index (CPI) and excluding certain items from the index, usually energy and food products. Core inflation is thought to be an indicator of underlying long-term inflation. 

The challenge of measuring inflation

There is no internationally agreed standard methodology of measuring inflation since such indices are generally used for national purposes, such as wage arrangements and price stabilization policies, and are frequently subject to heated discussions and social and political negotiations. Countries measure their rate of inflation in different ways, and include different components. This can make it problematic to make international comparisons. For instance, the European HICP differs from the US CPI in two major respects. First, the HICP includes the rural population. Second, and probably more importantly, the HICP excludes owner-occupied housing, mainly because the methods used to measure price changes for this component are controversial and difficult to calculate. Besides, in using CPI the purchasing habits of different people will vary greatly. For example, the purchasing of a family with children will be very different from that of an elderly couple or a single person with no children. And this may not be an accurate reflection for a particular area. Furthermore, if the national average is used as the basis for wage negotiations or pension changes, then these might not accurately reflect the price changes for a particular group. Errors in collecting data could be very important because it reflects the accuracy of the results. For instance, it would be difficult to obtain the prices of all the goods bought by the household so it is necessary to take a sample item and measure it. Thus, sampling is likely to lead to some degree of inaccuracy. (Donald G. & Jerome P. & Ted G., 2004)

How to Control Inflation

Economists offer several ways to control or limit inflation.  The methods are primarily through setting monetary policy and price controls, though there are some less popular theories on stopping inflation.

Those who suggest using monetary policy to stop inflation place an emphasis on the role of the central bank, like the U.S. Federal Reserve System, in setting that policy.  The Federal Reserve can use traditional methods such as setting high interest rates, using unemployment and declining production to slow or stop rising prices.  

Even among those that believe monetary policy should be used to stop inflation, various theories abound as to how the policy should be wielded (Federal, 2010).  For instance, those who subscribe to Neo-Classical monetary theory want to see the money supply decreased, while Neo-Keynesians would rather reduce the overall demand through fiscal policy like higher taxes or lower government spending.  Neo-Keynesians focus on monetary policy’s role, especially as it relates to basic commodities inflation as outlined by Robert Solow.  Finally, supply-side economists believe that the exchange rate needs to be fixed so that the exchange rate is tied to a reference currency (gold, for instance).  They also believe that, in a floating currency regime, that there can be a reduction in marginal tax rates to that capital formation is promoted.

Yet there is even a philosophical difference between those running the various central banks.  For instance, at the European Central Bank, the target is to control inflation when it gets too high rather than using symmetrical inflation as other central banks do.  The result is that the European Central Bank has come under great criticism for increasingly high unemployment rates.

While some believe that changing monetary policy is the way to control or stop inflation, a few others subscribe to the idea that controlling prices is the best method.  Also, price supports are used to set minimum prices.  The price supports help to prevent deflation and to allow for the continued production of certain goods.  However, not many economists subscribe to the idea of using price controls as a way to control inflation, as there are many counterproductive effects.

Using price controls to stop or control inflation means that shortages are created.  When shortages happen, the quality of production decreases and black market operations increase.  Also, price controls only work as long as they are in place, and when they are removed inflation often moves at an accelerated rate.  

The exception to the criticisms of price controls is during times of war, when shortages are bound to happen anyhow.  The government needs to borrow more money at lower rates during wartime, and profiteering needs to be discouraged.  In World War II, price controls were used effectively both during and after the war to control inflation.  Yet sometimes the wartime price controls are continued too long after the end of the war, so people will over-consume the things that have price controls imposed.  

A common example of price controls is rent controlled buildings.  These rent-controlled areas tend to remain so for decades, which allows owners to control the new building rate.  It maintains capital parity, and since inflation lowers the burden of a fixed rental price, allows renters to gain a net reduction in rental costs.  

However, sometimes price controls do make a recession more efficient.  The recession and prices controls both complement one another, because the recession prevents the distortion of high demand while price controls lower the need to increase unemployment.

The solution? In my opinion, there is no easy, painless solution. Those who bought houses they couldn’t afford will lose those houses. The banks who end up with those houses will either go under (forcing the government to print money to cover the deposits lost), or will get bailed out (Bear Sterns). In about 3 or 4 years, the loans made at the peak will be done resetting, those homes that cannot be afforded will be lost, and stability will slowly return. The only thing that will muck up that return to stability is if we spend a lot of money helping people to stay in houses they cannot afford. If we really try to help them, they will end up bleeding the system until they can’t bleed it any more, then they will lose their house. If we try to bail them out, we will ease the pain, but prolong the disease.