Inflation

In economics, inflation is an increase in the general level of prices of a given kind in a given currency. Inflation is measured by taking a "basket" of goods, and comparing the prices at two intervals, and adjusting for changes in the intrinsic basket. Thus, there are different measurements of inflation, depending on the basket of goods selected. The most common measures are of consumer inflation, producer inflation and GDP deflators, or price indexes. The last measures inflation in the entire economy.

Inflation

In economics, inflation is an increase in the general level of prices of a given kind in a given currency. Inflation is measured by taking a "basket" of goods, and comparing the prices at two intervals, and adjusting for changes in the intrinsic basket. Thus, there are different measurements of inflation, depending on the basket of goods selected. The most common measures are of consumer inflation, producer inflation and GDP deflators, or price indexes. The last measures inflation in the entire economy.

General inflation is a fall in the purchasing power of money within an economy, as compared to currency devaluation which is the fall of the market value of a currency between economies. General inflation is referred to as a rise in the general level of prices. The former applies to the value of the currency within the national region of use, whereas the latter applies to the external value on international markets. The extent to which these two phenomena are related is open to economic debate.

Inflation is the opposite of deflation. Disinflation refers to slowing the rate of inflation, that is, prices are still rising, but at a slower rate than before. Reflation is a term used to denote inflation after a period of deflation, meaning inflation designed to restore prices to a previous level.

Hyperinflation is rapid inflation without any tendency towards equilibrium - that is, an inflation that produces even more inflation. Inflation measurements sometimes exclude volatile goods from the basket to be able to gauge the "core" rate of inflation.

In some contexts the word "inflation" is used to mean an increase in the money supply, which is sometimes seen as the cause of price increases. Some economists (of the Austrian school) still prefer this meaning of the term, rather than to mean the price increases themselves. Thus, for example, some observers of the 1920s in the United States refer to "inflation" even though prices of goods were not increasing at the time. Below, the word "inflation" will be used to refer to a general increase in prices unless otherwise specified.

Contents:
1 Measuring inflation
2 The role of inflation in the economy
2.1 Misery index
3 Causes of inflation
3.1 Monetary Theory
3.2 Neo-Keynesian Theory
3.2.1 Phillips Curve or Demand inflation
3.2.2 Shifts of the Phillips Curve
3.2.3 Productivity
3.2.4 Indexing and inertial inflation
3.3 Other theories of inflation
4 Stopping inflation
4.1 Monetary policy
4.2 Price controls
4.2.1 Price controls as not new
4.2.2 Price controls and their aftermath
4.2.3 Inflation and Money Supply
4.2.4 Wealth redistribution effect of increased money supply
7 References

Measuring inflation

Inflation is measured by observing the change in the price of a large number of goods and services in an economy (usually based on data collected by government agencies, though labor unions and business magazines have also done this job). The prices of goods and services are combined to give a price index measuring an average price level, the average price of a set of products. This price is then adjusted for changes in the underlying basket of goods, a process called hedonic adjustment. For example, if the base model of a car goes up in price, but includes air conditioning, what percentage of the price increase is inflationary, and how much should be counted for the new feature which some consumers may, or may not, want.

The inflation rate is the percentage rate of increase in this index; while the price level might be seen as measuring the size of a balloon, inflation refers to the increase in its size.

There is no single true measure of inflation, because the value of inflation will depend on the weight given to each good in the index, as well as the extent of the economic region being examined.

Examples of common measures of inflation include:
The Cost of Living Index or CLI is the theoretical increase in the cost of living of an individual, which Consumer Price Indexes are supposed to approximate. Economists argue over whether a particular CPI over or under estimates the CLI. This is referred to as "bias" within the CPI. The CLI may be adjusted for "purchasing power parity" to reflect the differences in prices for land or other local commodities which differ widely from world prices.
The consumer price index (CPI) measures the price of a selection of goods purchased by a "typical consumer". In many industrial nations, annualised percentage changes in these indexes are the most commonly reported inflation figure. These measures are often used in wage and salary negotiations, since employees wish to have nominal pay raises that equal or exceed the rate of increase of the CPI. Sometimes, labor contracts include cost of living escalators, or adjustments, that imply nominal pay raises automatically occur due to CPI increases, usually at a slower rate than actual inflation (and after inflation has occurred).
The producer price index (PPIs) which measures the price received by a producer. This differs from the CPI in that price subsidation, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. Many believe that this allows a rough-and-ready prediction of CPI inflation tomorrow based on PPI inflation today, although the composition of the indexes varies; one important difference is the treatment and inclusion of services.
The wholesale price index which measures the change in price of a selection of goods at wholesale (i.e., typically prior to sales taxes). These are very similar to the PPI.
The commodity price index which measures the change in price of a selection of commodities. These commodities can be selected for their use in the economy, or their use in a particular context. Sometimes a single commodity is used, for example gold, to stand in for the entire range of commodities.
The GDP deflator which is based on calculations of the gross domestic product: it is based on the ratio of the total amount of money spent on GDP (nominal GDP) to the inflation-corrected measure of GDP (constant-price or "real" GDP). (See real vs. nominal in economics.) It is the broadest measure of the price level. Deflators are also calculated for components of GDP such as personal consumption expenditure. In the United States, the Federal Reserve has shifted over to using the personal consumption deflator and other deflators for guiding its anti-inflation policies. The personal consumption expenditures price index (PCEPI). In its semi-annually "Monetary Policy Report to the Congress" ("Humphrey-Hawkins Report") from February 17, 2000 the FOMC said it was changing its primary measure of inflation from the CPI to the "chain-type price index for personal consumption expenditures".
Changes in the price of gold bullion in a currency as a measure of inflation in that currency. Those who prefer this measure (e.g., supply-side economists) tend to do so for several reasons:
Price series over hundreds of years (where available) show that gold retains its purchasing power; in this way, gold demonstrates one of the desirable attributes of money as a store of value.
The authorities in various countries calculate their price indexes in different ways, and using different baskets of goods.
The weightings of each good in price indexes rapidly become obsolete because of technological obsolescence and changes in taste

Because each measure is based on both other measures, and a model that brings them together, economists often dispute whether there is "bias" either in measurement or in the model of inflation. For example In 1995, the Boskin Commission found the CPI produced by the US Department of Labor's Bureau of Labor Statistics (BLS) to be a biased measure, and gave a quantitative analysis of the bias, arguing that inflation was overstated because of people substituting away from expensive goods, and because of the "hedonic" improvements that technology created, these both reduced the rate of CPI-U increase. Another example from the early 1980's was the finding that the rental component of the CPI-U and CPI-W did not factor in the increase on rental units that were unoccupied, and that, when factored in, the rate of inflation was dramatically understated. This change was adopted in 1982 into the CPI calculations.

Presently there are those who argue that even more hedonic adjustment should be factored in, including the tendency of people to move to less expensive areas when more expensive ones become out of reach, while others argue that the housing part of the index is dramatically understating the impact of home values on cost of living, and dramatically under accounting for the cost of medications in the cost of living for retirees.

The role of inflation in the economy

One effect of small steady inflation is that it is difficult to renegotiate some prices, and particularly wages and contracts, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are "sticky downward" and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Thus, some business executives see mild inflation as "greasing the wheels of commerce". Efforts to attain complete price stability can also lead to deflation (steadily falling prices), which can be very destructive, encouraging bankruptcy and recession (or even depression).

Many in the financial community regard the "hidden risk" of inflation as an essential incentive to invest, rather than simply save, accumulated Wealth. Inflation, from this perspective, is seen as the market expression of what the time value of money is. That is, if a dollar today is worth more to someone than a dollar a year from now, then there should be a discount in the economy as a whole for dollars in the future. From this perspective, inflation represents the uncertainty about the value of future dollars.

Inflation, however, above relatively low levels is generally considered as having increasingly negative effects on the economy. These negative effects are the result of "discounting" previous economic activity. Since inflation is often the result of government policies to increase the money supply, the government contribution to an inflationary environment is a tax on holding currency. As inflation increases, it increases the tax on holding currency, and therefore encourages spending and borrowing, which increase the velocity of money, and therefore reinforce the inflationary environment, a "vicious circle". To extremes this can become hyperinflation.
Increasing uncertainty may discourage investment and saving.
Redistribution
It will redistribute income from those on fixed incomes, such as pensioners, and shift it to those who draw a more flexible income, for example from profits and most wages which may keep pace with inflation.
Similarly it will redistribute Wealth from those who lend a fixed amount of money to those who borrow (if the lenders are caught by surprise or cannot adjust to inflation). For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as the "inflation tax".
International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade.
Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.)
Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
Hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply. For example, the confusion resulting from not knowing whether prices went up because all prices are going up, or because the consumable resource is just more scarce can result in a less efficient use of the resource by the society.

In an economy where some sectors are "indexed" to inflation, while others are not, inflation acts as a redistribution towards the indexed sectors away from the unindexed sectors. Again, in small amounts this is a policy choice, acting as a tax on "liquidity preference" and hoarding, rather than saving. However, beyond this amount, the effect becomes distorting, as individuals begin "investing in inflation", which, again, encourages inflationary expectations.

Because of the above reasons for discouraging inflation above the small amounts needed to discount previous actions and discourage hoarding of currency, most central banks define price stability as a central goal, with a perceptible, but low, rate of inflation as the target.

Misery index

In the 1970s a “misery index” was proposed which equated economic unhappiness as a weighted sum of inflation and unemployment. This formula: misery = inflation % + unemployment % implied that the general population would be as unhappy about a 1% rise in monetary inflation as they would by a 1% increase in unemployment. However, modern economists have struggled to deduce such a drastically negative level of “misery” from inflation using the mechanisms of inflation’s negative impact described above. In fact, many economists believe that the prejudice against moderate inflation in the public is an association effect, in which the public simply remember that difficult economic conditions are correlated with periods of high inflation. In this view, a moderate level of inflation is a relatively insignificant economic problem, which has been blown out of proportion by the fight against stagflation (possibly encouraged by monetarist ideology).
Many economists have advocated higher rates of inflation (especially for Japan) as a solution to recession.
Surveys on inflation consistently show a divergence of opinion between mainstream economists and the public on the damage caused by moderate inflation: While the public continue to treat the harm as severe, most monetary economists tend to see it as slight, with many saying it does no harm at all.

In opposition to the deadweight loss argument against the redistributive nature of inflation it has been argued that, in economies where the rate of capital gains tax is low or nil, inflation acts as an important “Wealth tax”, and that low inflation societies will tend to see Wealth condensation.

Causes of inflation

There are different schools of thought as to what causes inflation. The two most prevalent theories are the neo-classical theory that inflation is driven by increases in the money supply, often used to finance government spending and the neo-Keynesian view that inflation is the result of diminishing returns of productivity.

Monetary Theory

One of the most widespread theories of inflation is also the most straightforward: inflation is an increase in the supply of money at a rate greater than the expansion in the size of the economy. This is practically measured by comparing the GDP deflator to the rate of increase of the money supply, and setting the interest rate through the central bank to maintain a constant quantity of money. This view differs from the Austrian school below in that it focuses on a "quantity of money" theory, rather than the "quality of money" theory. In the monetarist framework, it is the aggregate money supply which is important.

The Quantity Theory of Money, simply stated, is that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:

P is the general price level of consumers' goods, DC is the aggregate demand for consumers' goods and SC is the aggregate supply of consumers' goods. The idea behind this formula is that the general price level of consumers' goods will rise only if the aggregate supply of consumers' goods goes down relative to the aggregate demand for consumers' goods, or if the aggregate demand increases relative to the aggregate supply of consumers' goods. Based on the idea that total spending is based primarily on the total amount of money in existence, the economists calculate aggregate demand for consumers' goods based on the total quantity of money. Therefore, they posit that as the quantity of money increases, total spending increases and the aggregate demand for consumers' goods increases as well. For this reason the economists who believe in the Quantity Theory of Money also believe that the only cause for rising prices in a growing economy (ie an economy in which aggregate supply is increasing), is an increase of the total quantity of money in existence, which is caused by monetary policies of central banks.

From this perspective, the root cause of inflation is an increase in money supply over demand for money, and therefore "inflation is always and everywhere a monetary phenomenon", as Friedman puts it. This means that controlling inflation rests on monetary and fiscal restraint: the government must neither make it too easy to borrow, nor must it borrow excessively itself. This view focuses on the importance of controlling central government budget deficits and interest rates, as well as the productivity of the economy, which is, in effect, "cost pull" inflation.

More broadly neo-classical theory asserts that government contribution to aggregate demand by borrowing is the main culprit in the central bank taking an accommodative stance, because governments have the ability to borrow even when ordinary borrowers would retrench from rising interest rates. In this model, the fiscal authority spends, and the monetary authority, which may or may not be nominally independent, accommodates this spending by increasing the money supply to allow it. In its most direct form, the government simply writes checks backed without assets and uses them to pay for government spending. Hence reducing budget deficits and constraining budget spending is a key part of neo-classical theory and fighting inflation.

Neo-Keynesian Theory

According to Neo-Keynesian economic theory there are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model": Demand pull inflation - inflation due to high demand for GDP and low unemployment, also known as Phillips Curve inflation. Cost push inflation - nowadays termed "supply shock inflation", due to an event such as a sudden increase in the price of oil. Built-in inflation - induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle". Built-in inflation reflects events in the past, and so might be seen as hangover inflation. It is also known as "inertial" inflation, "inflationary momentum", and even "structural inflation".

These three types of inflation can be added up at any time to get an explanation of the current inflation rate. However, over time, the first two (and the actual inflation rate) affect the amount of built-in inflation: persistently high (or low) actual inflation leads to higher (lower) built-in inflation.

Within the context of the triangle model, there are two main elements: movements along the Phillips Curve, for example as unemployment rates fall, encouraging greater inflation, and shifts of that curve, as when inflation rises or falls at a given unemployment rate.

Phillips Curve or Demand inflation

A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This has been seen most graphically when governments have financed spending in a crisis by increasing the amount of currency in circulation to avoid the results of economic collapse, sometimes during wartime conditions. This has lead to hyperinflation where prices rise at extremely high rates in short periods of time in extreme cases.

A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. In classical Keynesian economics this model suggested that price stability was a trade off against employment. Therefore some level of inflation could be considered desirable in order to minimize unemployment. The Philips curve model described the US experience well in the 1960s, but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s. The modern use of the Phillips curve relates payroll growth to the general inflation rate, rather than relating the unemployment rate to the inflation rate, and suggests that trade offs between inflation and employment are based on the change in the rate of inflation, rather than the inflation rate itself.

In this model, increases in aggregate demand drive prices upwards, as suppliers are aware that they have pricing power, which leads to more people working, which leads to increased aggregate demand.

Shifts of the Phillips Curve

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) due to such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.

Another Keynesian concept is the potential output (sometimes called the "natural gross domestic product"), a level of GDP where the economy is at its optimal level of production, given institutional and natural constraints. This level of output corresponds to the NAIRU or the "natural" rate of unemployment or the full-employment unemployment rate. In this framework, the built-in inflation rate is determined endogenously (by the normal workings of the economy): if GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that, all else equal, inflation will accelerate as suppliers increase their prices and built-in inflation worsens. This causes the Phillips curve to shift in the stagflationary direction, toward greater inflation and greater unemployment. This kind of "inflationary acceleration" may have been seen in the late 1960s in the U.S., when Vietnam war spending (counteracted only by small tax hikes) kept unemployment below 4 percent for several years.
If GDP falls below its potential level (and unemployment is above the NAIRU), all else equal inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation: there is disinflation. This causes the Phillips curve to shift in the desired direction, toward less inflation and less unemployment. This disinflation may have been seen in the early 1980s, when Fed chief Paul Volcker's anti-inflation campaign kept unemployment high for several years and at almost 10 percent for two years.
If GDP is equal to potential (and the unemployment rate equals the NAIRU), the inflation rate will not change, as long as there are no supply shocks. In the "long run," most neo-Keynesian macroeconomists see the Phillips Curve as vertical. That is, the unemployment rate is given and equal to the NAIRU, while there are a large number of possible inflation rates that can prevail at that unemployment rate.

However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change due to policy: for example, high unemployment under Prime Minister Margaret Thatcher in the U.K. may have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed, unable to find jobs that fit their skills in the British economy. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.

Most non-Keynesian theories of inflation can be understood within the neo-Keynesian perspective as assuming that the NAIRU and potential output are both unique and are attained relatively quickly. With the "supply side" at a fixed level, the amount of inflation is then determined by aggregate demand. The fixed supply side also implies that government and private-sector spending are always in conflict, so that government deficit spending leads to crowding out of the private sector and has no effect on the level of employment. Thus, it is only the money supply and monetary policy that determine the inflation rate.

Productivity

For these reasons neo-Keynesian theory focuses on productivty, because it is falling productivity which signals diminishing returns of production, and therefore inflationary pressures from overheating and output above "potential". From the neo-Keynesian perspective budget balancing and restraints on spending do not control inflation, and persistent budget deficits do not cause inflation. What causes inflation is an increase in the velocity of money, and the reduction in efficiency caused by excessive present consumption versus investment. That is, a savings rate that is too low to fund the improvements in production required to keep pace with increases in aggregate demand. Consequently neo-Keynesians such as Franco Modigliani warned that it is an insufficient savings rate which is the better predictor of future inflation.

Indexing and inertial inflation

In the 1980s several industrialized nations experienced persistent inflation, and attempted to address it by cutting budgets and engaging in IMF backed austerity plans. These plans had the paradoxical effect of causing people to flee the main currency, and pushing up the inflation rate. The next round of programs were targeted at reducing budget deficits, but they focused on ending wage indexing and on cutting government subsidies for commodities, instead of simply reducing government spending in the aggregate. Neo-Keynesians argue that the experience of Israel, Argentina, Bolivia and Brazil in dealing with inflation and hyperinflation shows that government budget deficits are exogenous to money supply growth, and that therefore central banks which are accommodating them may not have the autonomy to constrict the money supply. Thus it is fiscal, not monetary policy, which is the main agent for driving inflation where governments use seigniorage as an active source of revenue where the market for money clears.

Other theories of inflation

Austrian economics focuses on a theory related to the "quality of money", or the expectation by holders of debt and currency that the purchasing power of their holdings will remain stable. This view is related to the ideas of "business confidence" which are still widely held, and to arguments in favor of a gold standard, as well as arguments that the credibility of a central bank is important for fighting inflation. In the Austrian view, however, this concept is far more rigorously defined, as holding the notes or other instruments of a government is regarded as less preferable to holding the original commodity which is the store of value. Since at its base Austrian economics asserts that there is no such thing as "money" but merely a set of inter-related commodities, some of which have greater stability of purchasing power than others, the Austrian view of inflation is that notes are a substitute, and only a substitute, for some commodity of value, or are backed only by the force of the government issuing them.

In this view, actions which undermine the linkage between the original commodity and the notes undermine the quality of the currency, and by Gresham's Law individuals will preferentially spend those notes whose future buying power is less certain, in preference to others where the value is more certain. That is, "bad money will drive out good." Actions taken by governments which undermine property rights are seen as contributing to inflation. Austrian economics also argues for very strong forms of hedonic adjustment, in that falls or rises in price level which are related to improvements in technology should not be considered to be "inflation". Hence the key policies for inflation fighting in an Austrian framework are incentives for investment and entrepreneurship - which improve productivity, and protection of property rights, which maintain confidence in the linkage between currency and the underlying commodities which store value.

While this view is unorthodox in neo-classical economics, it is not without its analogs in other forms of economic theory, which accept the idea that contagion can destabilize currencies, and a lack of transparency can diminish confidence in an economy or currency. It also relates to the neo-Keynesian view that it is productivity which is the key lens for predicting inflation. In an Austrian framework improved productivity does not produce deflation, even if prices are falling.
Supply-side economics asserts that inflation is always caused by either an increase in the supply of base money or a decrease in the demand for base money (or both). The value of money is seen as being purely subject to these two factors. Thus the inflation experienced during the Black Plague in medieval Europe is seen as being caused by a decrease in the demand for money as the volume of production and trade fell, while the inflation of the 1970s is regarded as been initially caused by an increased supply of money that occurred following the US exit from the Bretton Woods gold standard. Supply-side economics asserts that the money supply can grow without causing inflation as long as the demand for money also grows at the same rate.

One of the factors that supply side economists say was instrumental in ending the US experience of high inflation was the economic expansion of the 1980s ushered in by lower taxes. The argument is that an expanding economy creates an increased demand for base money and in so doing it counteracts inflationary forces. An expanding economy can be seen as frequently leading to an increased demand for money, and, all else being equal, an increase in the value of money. In international currency markets this principle is mostly undisputed, however, supply side economists argue that economic expansion increases the domestic valuation of money and not just the international valuation.
Welfare economics takes the concept that the real purchasing power of an individual is measured in the basket of commodities that they can command. Therefore, it measures standard of living differently from GDP and price level, and instead uses the concept of "welfare" or happiness grounded in other measures. Neoclassical economics defines utility as being related to price, and therefore does not need to look at separate components of general welfare individually, only their aggregate price. This view is used by Marxian economists to argue that production and not consumption should be central to the definition of inflation.

This view stands outside that of mainstream economic thought, but is influential in political economy. Measures of well being are used by NGOs in arguing for greater aid, and Nepal has adopted a happiness, rather than product based measure of standard of living.

Stopping inflation

There are a number of methods which have been suggested to stop inflation.

Monetary policy

Central banks such as the U.S. Federal Reserve System can affect inflation to a significant extent through setting interest rates and through other operations (i.e., using monetary policy). High interest rates (and slow growth of the money supply) are the traditional way that central banks fight inflation, using unemployment and the decline of production to prevent price increases.

However, Central Banks view the means of controlling the inflation differently. For instance, some follow a symmetrical inflation target while others only control inflation when it gets too high. The European Central Bank has come under some criticism for following the latter practice, especially in the face of high unemployment.
Monetarists emphasize increasing interest rates by reducing the money supply through monetary policy to fight inflation.
Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand. They also note the role of monetary policy, particularly for inflation in basic commodities from the work of Robert Solow.
Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some stable reference currency such as gold, or by reducing marginal tax rates in a floating currency regime to encourage capital formation.

All of these policies are achieved in practice through a process of open market operations.

Price controls

Another method attempted is simply instituting wage and price controls (see "incomes policies"). They are related to Price supports, which set minimum prices to prevent deflation, or to maintain a particular good or service in production.

Price controls as not new

In AD 301, The Roman Emperor Diocletian attempted to curb the rampant inflation of the 3rd century, and issued his Edict on Maximum Prices. This Edict fixed prices for over a thousand goods, fixed wages, and threatened the death penalty to merchants who overcharged. It was unable to stop the inflation and was eventually ignored.

Laws controlling price were common through out the middle ages and well into the 18th century in Europe, with standard goods being given a fixed price in silver. However, the evidence indicates that what changed was the weight and quality of the goods in question. This pattern, noted by early economists, was the basis for the argument that price should be allowed to float, with buyers deciding how much they could afford. It also lead to a movement to establish standard weights and measures (See Metric system) so that buyers would be able to compare price and quantity accurately.

In the modern era, regulation has generally focused on requiring a specific quality of a particular good or service, because that is information that the buyer cannot easily obtain, where as price information can be obtained through relatively direct examination.

Price controls and their aftermath

In general, most economists regard price controls as counterproductive in that they tend to distort the functioning of the economy because they encourage shortages, decreases in the quality of products or the use of "black market" exchanges. The only exception is during war time, when shortages are expected, and the purpose is to allow the government to borrow money at a lower rate of interest than could be obtained normally, as well as prevent war profiteering of various kinds. The price controls used during World War II in the United States were effective not only at controlling inflation during the war, but after the war as well.

Another criticism of price controls is that they work only so long as they are in force, removal tends to produce more inflation than would have been obtained without them. War time price controls are criticized because they are often maintained long after the war has ended, because they act as a transfer of Wealth from some producers to others, and to consumers who then overconsume the price controlled commodity. Controls on rent, for example, often remain in force for decades, because it allows property owners to limit the rate of new building, making it possible to maintain capital parity more easily, and renters to stay in one place for a long period of time with a net reduction in the cost of rent, since inflation reduces the burden of a fixed rental price.

Controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high.

Inflation and Money Supply

Money supply may increase without inflation to occur. One example is the U.S. money supply, which has been increasing at a much faster rate than inflation itself. This phenomenon occurs because there has been a trend of rising global demand for the U.S. dollar, which has become a global currency for the exchange of goods. More goods are available to be purchased by the dollar, if there were no expansion in the supply of the dollar, the price of goods would drop. However, the expansionary policy of the FED (the "printing of more money out of the thin air" through the Open Market Operations) has not only stopped deflation, it also has created slight inflation. It must be noted though that if there has been no increase in the demand for the dollar (from the Chinese and the Indian workers who will work cheaply to earn the dollar), the increase in the supply of money would surely meant hyperinflation as seen in the 1970's and 1980's.

Wealth redistribution effect of increased money supply

If the total money supply has increased, even if there were no inflation (similar to the low inflation environment in the US. in the early 2000's), what would be the Wealth redistribution effect if any? The assets and commodities that would go up in value are those whose supply are finite or non-renewable (such as fossile fuel and real estate near areas of centers of trades). The assets and commodities whose supply are increasing would see its value to fall (including money). How can the value of money to fall when there is no inflation? This is because inflation has a very narrow definition. Inflation does not take into account the rise in price of essential commodities(such as energy) and the price of essential assets (such as real estate). These essential commodities and assets can become more expensive when the money supply increases but they are not measured by the standard measures of inflation. In scenarios like this, increased money supply redistributes Wealth from the holders of money to the holders of finite assets and commodity regardless of inflation.

References

Barro, Robert J. Macroeconomics
Brown, A. World Inflation Since 1950
Case, Karl E. and Fair, Ray C. Principles of Macroeconomics
Bureau of Labor Statistics
Kieler, Mads The ECB's Inflation Objective
George Reisman, Capitalism: A Treatise on Economics (Ottawa : Jameson Books, 1990), 503-506 & Chapter 19 ISBN 0915463733
Murray N. Rothbard, What has government done to our money? ISBN 0945466102. Good introduction to Austrian school's view on money, inflation etc.

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