Notes on Inflation

 

Inflation is the general tendency of prices to rise over time. It is not simply an increase in one or two prices, or a temporary ‘blip’ upwards. There are three elements which students and writers on the topic must always grasp and build into any definition;

·         Prices rise, or the value of money falls

·         In general or on average

·         In a sustained way over time

Such a definition puts an emphasis on the measurement of prices, of course, and also allows for types and causes of inflation to be separated out.

Measurement is usually via some form of weighted index of average prices. This is sometimes referred to as a ‘basket of goods and services.´  

The CPI and RPI

There are several measurements which the UK Government uses. These include the Consumer Price Index, (CPI), the CPI including Housing costs (CPIH), the Retail Price Index (RPI), the Producer Price Index, and the House Price Index. The main one is the CPI.

The CPI is composed of a representative sample of 700 goods, and 180 000 price checks of those goods from around 20 000 UK outlets. This is compiled every month, and each item is given a ‘weight’ for its importance to households. So, for instance, if 5% of income was spent on bread, bread would have a ‘weighting’ of 0.05. This means that, if there were a 1% change in the price of bread, the weighted change would be 0.05 to prices. If enough goods and services were rising in price, there would be a significant rise in prices overall; if some were going up and some were going down, the actual effect would depend on their weighting.

The Office of National Statistics regularly considers which goods and services to include and which to exclude in the CPI. It would make no sense to keep tracking CDs, for instance, and to not track downloads, if no one is buying CDs and everyone is streaming. So, regularly, some items join, and some leave, the CPI.

The CPI is of course an index of consumer goods, so it does not include housing or council tax. These are important costs for people and so the CPIH, which is now the preferred measure, includes them.

The Producer Price index is one that is an indicator of the price of goods and raw materials, and often is quite useful to see inflation ‘coming down the pipe.’ Similarly, the house price index is useful as an indicator of how much money people have, as people tend to spend savings and raise credit for house purchases, so the wealthier they feel, and the more optimistic banks feel, the more people will demand houses and the higher the price of houses will rise. It is also a good idea to have a broad general indicator of energy, raw material, and food prices.

The RPI is a much older measure of inflation. Unlike the CPI, the RPI concentrates on households, and not individuals—which means that it might fail to fully reflect the impact of inflation on students, tourists, and people who are individual consumers within households. The RPI also uses a different formula to the CPI (the RPI is an arithmetic mean and the CPI is a geometric mean) and it includes different items to the CPI. The effect of this is usually to make the RPI higher than the CPI. It is now seen as less reliable, but is still used for some government calculations.

Causes of Inflation

Inflation does not have any one simple ‘cause.’ There are three;

·         ‘Demand Pull’ Inflation is caused by a rise in Aggregate Demand which causes the price level to rise as AD moves upwards along LRAS. This can happen because of an increase in one of the components of AD (which is made up of C+I+G+(X-M))

 

·         ‘Cost-Push’ Inflation is caused by a rise in costs, which causes producers to raise prices and therefore lifts the price level by shifting the SAS or LRAS upwards. The typical way for costs to rise is because of rises in energy (usually oil) or wage costs, though food costs can have a significant impact as can falls in the exchange rate which make imported items more expensive.[1]

 

·         Monetary Inflation occurs when the value of money falls. This can be because there has been an expansion in the money supply which is bigger than any expansion in GDP, or can be caused by interest rates deliberately set at a rate lower than the market rate. This is not always true, however, as the experience of Japan and the West have suggested over the past twenty years. If AD is low, if there is a negative output gap, if there is a liquidity trap where investors do not want to invest and consumers hold back from spending, increasing money supply and lowering interest rates might not, in some theories, cause inflation.

 

 

Types of Inflation

Before listing the various types of inflation, it is necessary to note that deflation and disinflation are also connected to the concept in most syllabi. Deflation exists when the price level is falling, usually because of a fall in the ability of suppliers to sell anything, leading to slightly desperate selling. It is usually associated with falls in income, profits, and economic capacity, and therefore with depressions caused by collapses in AD. Deflation will be associated with a negative inflation rate. Very occasionally deflation can be caused by increases in supply or productivity.[2]

Disinflation is a more benign process associated with a slowing or low rate of inflation. It typically happens because of gains in productivity, increases in supply, or falls in ‘core inflation’ because raw materials, energy, and food, get cheaper.

There are specific terms for various types of inflation. The principal ones are:

·         Creeping inflation

·         Hidden inflation or ‘shrinkflation’

·         Stratoinflation

·         Hyperinflation

·         Stagflation (or, occasionally, ‘Slumpflation.’)

These terms may take a little explanation. Creeping Inflation is that which steals up on people, usually at or below 4% or so as a rule of thumb. Remember, four months of 4% inflation do not mean 12% rises in prices; instead, prices rise by 1.04*1.04*1.04, or nearly 13%. Rates like that eat into family incomes and producer costs and are not really noticed until the process has accelerated, and it’s too late. A good example might be US Lumber prices in New England in 2021. Lumber is the basic building material of many New England houses, and price increases in the early months of 2021 translated into changing monthly, then weekly, quotes from suppliers, and added slowly but then massively to the cost of housing. By the time it was obvious, it was too late to restrain.[3]

Shrinkflation has been a feature of the early twenty first century. This occurs when goods and services stay the same price, or become a little more expensive, but are smaller or shorter. So, for instance, a bar of chocolate which retails at fifty pence moves from being fifty grammes to forty, or bread loaves get smaller, or baguettes thinner. This happens because, instead of passing costs directly along to consumers, producers take advantage of consumer habit or indifference to small changes to save on materials in bulk. It is in effect a price rise. Few consumers pay attention or keep records of the cost per gramme or litre for an item. Overall, however, consumers get less for their money.

Stratoinflation was last seen in the nineteen seventies in the west, and refers to inflation rates in double figures.  This is highly destructive and also has great political repercussions, as governments tend to react by trying to freeze prices, restrict wage growth, raise interest rates, or control capital flight. Over time, it encourages a cycle of illegal market growth, government crackdowns, political and social instability, and emigration.

Hyperinflation is where prices go completely out of control, quickly, often by thousands of percentage points. Money loses value, and the economy breaks down, leading to social crisis. It usually emerges because a long period of price controls ends, or (more typically) because government money printing and ultra-loose money policy results in a devaluation of the currency. Very rarely, it can occur because of food or energy crises. Usually, states have to replace currency, and often to borrow at high rates from other states, to escape hyperinflation, as for example Zimbabwe and Venezuela did in recent times.

There is an argument that hyperinflation is not necessarily wholly bad in the long run. Provided that citizens have access to food and housing, hyperinflation can function as a kind of purge or fever, destroying economic bubbles, currency and monetary policies which are too corrupt and established to remain, and expectations of ‘free money’ and endless growth without productivity. Hyperinflation can also remove the burden of debts, or foreign claims (as in Weimar Germany, which experienced good years after the horrible inflation of 1921-3) and can help to build in a culture of ‘responsible monetary policy’ that encourages work, asset growth, and productivity, for several generations. Those who have experienced hyperinflation, in Russia, Eastern Europe, Southern Africa, or South America, are however more inclined to describe it as a nightmare on a par with severe natural disasters.

Stagflation is a depressing and destructive condition in which the economy stagnates—GDP slows, or falls, and unemployment rises—at the same time as prices rise significantly. The last serious western experience of the process (until the 2020s) came during the late nineteen sixties through the nineteen seventies. An expansion of money, and rising growth, encouraged high wage demands, spending, and a housing boom in Britain and America. This was complemented by Governments spending large amounts of money and running budget deficits. At the same time, competition overseas from more productive countries caused exports to decline, and, because of war or borrowing, currencies declined on international markets.

This led to an unpleasant inflationary situation. In 1971, the USA could not exchanged the dollar for gold anymore as it had not earned enough gold, and therefore the dollar—and the currencies linked to it—broke away from any ‘real world’ store of value. This ‘primed’ an inflationary situation for trouble, which duly came in 1973 as a massive cost-push inflation began when the OPEC oil cartel in the middle east shoved oil prices up by 300% in one week. [4]

The massive inflationary effects were very disorienting, and led to strikes, shortages, rationing of petrol, and vast changes in car and house design, as well as having a major impact on the plastics and textile industries, the products of which were everywhere in the economy. Governments became unstable and reached for policies of marketisation, monetarism, price controls, and neo-Keynesianism during a great deal of confusion and controversy. In 1975, the USA also started using computer technology and law to turn federal assets into derivatives, which kicked off a later market that led ultimately to the 1987 and 2008 crashes. In Britain, the ‘post war settlement’ of a Keynesian welfare state ended and was replaced by Thatcherite ideas.

It is not too difficult to see Stagflation historically as being associated with the end of ‘waves’ of technological or financial activity such as Kondratiev, Schompeter, or Kuznets cycles. In 2021, automation leading to higher structural unemployment, growing inflation, ultra-loose monetary policy, and fiscal deficits caused by covid-19 policies and financial stimulus created an environment in which any outside factor could in theory touch off a stagflation or even hyperinflation, just as old technologies began to reach the end of the productivity gains they offered, and new ones were still not fully developed or in use.

 

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[1] Exchange rate falls will also of course boost exports and lower imports, driving up AD if everything else remains the same. Think of imports as money given to foreigners, and exports as foreigners giving you money. If your exchange rate falls, you need more of your own money to buy foreign cash to get foreign goods or services, so they are more expensive. But they need less of their own cash to buy yours, to get your exports, so exports are cheaper. This also applies in reverse and explains why foreign tourists are an export, whilst you going on a foreign holiday is the same as an import. Always follow the money!

[2] Note that a Deflationary Government policy is one to reduce Aggregate Demand, and might not necessarily cause deflation. Similarly, a reflationary policy seeks to revive or stimulate AD and is again not necessarily inflationary.

[3] Many monetarist economists would suggest that the demand for housing, though a basic need, was in fact derived from a demand for assets and a transfer of stimulus checks and an expanded money supply into real assets (the money did not all go into bitcoin!)

[4] Single events, like the Wall Street crash or the oil shock do not generally cause massive economic problems any more than a match ‘causes’ a forest fire. The conditions for the crash have to be there to start with. In ‘good’ times, things that would have caused trouble beforehand, often go unnoticed, and even ‘big’ events become smaller in retrospect.