Friday, January 7, 2011

What is Inflation?

The basic idea of inflation is deceptively simple.  It describes a phenomena where the price of everything tends to rise. However, understanding what inflation is, what does and doesn't cause it, and even just trying to measure it, are incredibly difficult and leads to lots of really smart, educated people to argue and vehemently disagree. In fact, if you were to know everything there is about inflation, then you'd probably know everything there is to know about macroeconomics. I'm just going to lay out the generally accepted concepts.

Definition

Here's three definitions of inflation from three different sources.  The Merriam-Webster dictionary defines inflation as "a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services". Whereas Wikipedia defines it as "a rise in the general level of prices of goods and services in an economy over a period of time". Finally, the International Monetary Fund defines inflation as "A sustained increase in the general price level, often measured by an index of consumer prices. The rate of inflation is the percentage change in the price level in a given period."  These definitions are pretty much the same with one subtle difference.  The dictionary and IMF define inflation as "continuing" or "sustained", Wikipedia doesn't give that stipulation. I think the difference here is how economists define inflation and how the general public defines it.  On this blog I'll try to use the more correct term of inflation as being "sustained" or "continuing".

So what causes inflation?

There are several things that can cause inflation, however, they all boil down to 1 of the following 3 situations:
  1. An increase in the money supply
  2. A decrease in the amount of goods in the economy (or "aggregate supply")
  3. An increase in the demand for goods in the economy ( or "aggregate demand")
1) An increase in the money supply is just a fancy way of saying "everybody has more money".  If the amount of money everyone has increases but the amount of goods doesn't, then all you've really done is made money worth less.  This is best demonstrated by an example:  If 10 people live on an island, and on this island there is nothing but coconuts.  Let's also say that there are only 20 coconuts and $20 on the island.  Therefore each coconut is worth $1.  But let's say everybody wakes up the next day and find an extra $10.  People who want to buy coconuts will be willing to offer more than 1$ for a coconut so as to outbid other buyers, but those other buyers will also have more money, so they too will offer more than a dollar and the bidding will continue to "inflate" the value of coconuts until price stability is achieved.

Every economist agrees that expanding the money supply can cause inflation.  In fact, it is the original definition of inflation.  Back in the days when money was backed by gold or silver, private and public banks would print paper money that could then be redeemed at their bank for a set amount of gold.  "Inflation" referred to the practice of banks printing more money than they could back.  They "inflated" the amount of gold they claimed to have.

2) A decrease in the amount of goods in the economy (or "aggregate supply") can also cause inflation.  Aggregate supply is, again, a fancy term economists use.  It means all the goods and services that are produced within an economy.  Going back to the coconut island example, let's say that, instead of everyone finding more money, they all wake up one day and half the coconuts are gone.    The value of the remaining coconuts would go up.  People would be less willing to sell their coconuts and buyers would have to offer more money until the sellers finally agree to sell.

In a modern economy, this would have to happen on a large scale to lots of products.  For instance, if the amount of DVDs decreased because a DVD factory burned down it wouldn't really cause inflation because only DVDs would be affected and inflation, by definition, is a "General Rise" in prices.  An example would be a natural disaster destroying a large portion of crops and factories.  If this were to happen, the number of goods being produced in the economy would go down, if the amount of money doesn't also go down, it can cause inflation.

3)  An increase in the demand for goods in the economy ( or "aggregate demand").  Aggregate demand is, again, a fancy term economists use to mean all the stuff that people are offering money to buy.  Taking one last trip to our coconut island.  Let's say that everyone needs only 1 coconut a day to live.  But, they all wake up one morning to find their metabolism has changed and they all need 2 coconuts a day to live.  The price of coconuts would go up because people will want more coconuts.  In a modern economy this can only happen if a very large number of people are demanding more goods and services from a variety of industries.

What inflation isn't.

Inflation is not, by definition, the event of the price of a single good going up.  For instance, in a large, complex economy, if the price of pianos suddenly skyrocketed, that would not be inflation because it is only one good.  Inflation must be a "general rise" in all prices.  For instance if the cost of milk, gas, and DVDs rise that would be better described as inflation.  (This doesn't mean that a rise in the price of a commodity can't lead to inflation)

How to measure inflation?

There are several different ways to measure inflation.  Here in the U.S. the two most common are the Consumer Price Index(CPI) and the Producers Price Index(PPI).  The difference is that the CPI measures what consumer's pay for goods that they consume, and the PPI is a measure of what businesses pay for the goods they use or consume to make other goods that they sell.  Both indexes require exhaustive research, adjustment, and calculation.  If I understood everything that goes into figuring out these indexes, I would be seriously underpaid.

You might think it would be as easy to measure inflation.  One would only have to select a few random stores and see how much they charge for a few "random" items and see if the prices go up or down every month.  That might seem simple, until some common problems come up.  Just to give you an idea of how hard it is to measure inflation on a large scale, let's give some example problems.

1.) Obsolete items:  Let's say that one of the items that you're measuring the price of is typewriters.  Circa 1975 this might have made sense.  However, 20 years later, nobody is buying a typewriter because they've been replaced with computers.  You could substitute computer's, but they're more expensive because they do more things.

2.) Combined items:  Let's say that two of the items that you're measuring the price of are DVD players and VCR players.  How do you measure DVDVCR combos?

3.) Replacement:  Let's say that one of the items that you're measuring is iceberg lettuce.  For some reason, there is a shortage from drought or flooding.  The price of iceberg lettuce would go up and consumers instead decide to buy romaine lettuce instead.  Would you continue measuring the price of iceberg lettuce or switch to romaine or some combination of both?

I hope this gives you an idea of how hard it must be to measure inflation.
My Next post will explore the negative impacts of inflation and why it's considered an economic pariah among economists and politicians alike.
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