Inflation
Whether you have taken a course in economics at college or you just regularly pay attention to the economical affairs, you were told that inflation is the rising level of prices of goods and services in an economy. This is the modern definition of inflation, which was introduced and is still defended by the two mainstream schools of economic thought: Keynesianism, named after the British economist John Maynard Keynes; and Monetarism of the Chicago school, whose leading figure was the American Nobel prize winner Milton Friedman. Since then there have appeared other schools of thought which are simply mutations of those two schools—check history of money and economy to find more. However, the keynesians and the monetarists disagree on the causes of "inflation".
For keynesians
Cost-Push Inflation
Cost-push inflation occurs when prices increase due to increases in production costs, such as raw materials and wages. The demand for goods is unchanged while the supply of goods declines due to the higher costs of production. As a result, the added costs of production are passed onto consumers in the form of higher prices for the finished goods.
One of the signs of possible cost-push inflation can be seen in rising commodity prices such as oil and metals, since they're major production inputs. For example, if the price of copper rises, companies that use copper to make their products might increase the prices of their goods. If the demand for the product is independent of the demand for copper, the business will pass on the higher costs of raw materials to consumers. The result is higher prices for consumers without any change in demand for the products their consuming.
Wages also affect the cost of production and are typically the single biggest expense for businesses. When the economy is performing well, and the unemployment rate is low, shortages in labor or workers can occur. Companies, in turn, increase wages to attract qualified candidates, causing production costs to rise for the company. If the company raises prices due to the rise in employee wages, cost-push inflation occurs.
Demand-Pull Inflation
Demand-pull inflation can be caused by strong consumer demand for a product or service. When there's a surge in demand for goods across an economy, prices increase, and the result is demand-pull inflation. Consumer confidence tends to be high when unemployment is low, and wages are rising — leading to more spending. An economic expansion has a direct impact on the level of consumer spending in an economy, which can lead to a high demand for products and services.
As demand for a particular good or service increases, the available supply decreases. When fewer items are available, consumers are willing to pay more to obtain the item — following the principle of supply and demand. The result is higher prices.
Companies also play a role in inflation, especially if they manufacture popular products. A company can raise prices simply because consumers are willing to pay the increased amount. Corporations also raise prices freely when the item for sale is something consumers need for everyday existence, such as oil and gas. However, it's the demand from consumers that makes the corporations to raise prices.
The housing market, for example, has seen its ups and downs over the years. If homes are in demand because the economy is experiencing an expansion, home prices will rise, considering that supply doesn't catch up. The demand also impacts ancillary products and services that support the housing industry. Construction products such as lumber and steel, as well as the nails and rivets used in homes, might all see increases in demand resulting from higher demand for homes.
Expansionary fiscal policy by governments can increase the amount of discretionary income for both businesses and consumers. If a government cuts taxes, businesses may spend it on capital improvements, employee compensation, or new hiring. Consumers may purchase more goods as well. The government could also stimulate the economy by increasing spending on infrastructure projects. The result could be an increase in demand for goods and services, leading to price increases.
Moreover, central banks like the Federal Reserve can lower the cost for banks to lend — interest rate — which allows banks to lend more money to businesses and consumers. The increase in the money supply leads to more spending and demand for goods and services.
For monetarists
Inflation can happen if the money supply grows faster than the economic output, under otherwise normal economic circumstances. Inflation, can also be affected by factors beyond money supply.
The theory most discussed when looking at the link between inflation and money supply is the quantity theory of money (QTM).
Quantity Theory
The quantity theory of money proposes that the exchange value of money is determined like any other good, with supply and demand. The basic equation for the quantity theory is called The Fisher Equation because it was developed by American economist Irving Fisher. In it's simplest form, it looks like this:
MV=PT,
where: M=Money Supply; V=Velocity of circulation (the number of times money changes hands); P=Average price level; T=Volume of transactions of goods and services.
Some variants of the quantity theory propose that inflation and deflation occur proportionately to increases or decreases in the supply of money. A more nuanced version of the quantity theory adds two caveats:
In a nutshell, prices tend to be higher if more currency is circulating and involved in economic transactions. As Milton Friedman put it in his influential work A Monetary History of the United States, 1867–1960, "inflation is always and everywhere a monetary phenomenon".
Measuring "Inflation"
There are a few metrics that are used to measure the "inflation" rate. One of the most popular is the Consumer Price Index (CPI), which measures prices for a basket of goods and services in the economy, including food, cars, education, and recreation.
Another measure of inflation is the Producer Price Index (PPI), which reports the price changes that affect domestic producers. The PPI measures prices for fuel, farm products (meats and grains), chemical products, and metals. If the price increases that cause the PPI to spike get passed onto consumers, it will be reflected in the Consumer Price Index.
The real inflation
The original definition of inflation is simply the expansion of the monetary supply. This version is the one that the Austrian school accepts and teaches. The austrians concur with the monetarists in the assessment that inflation is a monetary phenomenum. Be that as it may, while the latter claim that the increase in the money supply leads to the rise of the price "level" ("inflation") — as you'll see, the term "level" is misleading --, the former take the view that inflation is the expansion of the money supply, which could result in higher prices.
For keynesians
Cost-Push Inflation
Cost-push inflation occurs when prices increase due to increases in production costs, such as raw materials and wages. The demand for goods is unchanged while the supply of goods declines due to the higher costs of production. As a result, the added costs of production are passed onto consumers in the form of higher prices for the finished goods.
One of the signs of possible cost-push inflation can be seen in rising commodity prices such as oil and metals, since they're major production inputs. For example, if the price of copper rises, companies that use copper to make their products might increase the prices of their goods. If the demand for the product is independent of the demand for copper, the business will pass on the higher costs of raw materials to consumers. The result is higher prices for consumers without any change in demand for the products their consuming.
Wages also affect the cost of production and are typically the single biggest expense for businesses. When the economy is performing well, and the unemployment rate is low, shortages in labor or workers can occur. Companies, in turn, increase wages to attract qualified candidates, causing production costs to rise for the company. If the company raises prices due to the rise in employee wages, cost-push inflation occurs.
Demand-Pull Inflation
Demand-pull inflation can be caused by strong consumer demand for a product or service. When there's a surge in demand for goods across an economy, prices increase, and the result is demand-pull inflation. Consumer confidence tends to be high when unemployment is low, and wages are rising — leading to more spending. An economic expansion has a direct impact on the level of consumer spending in an economy, which can lead to a high demand for products and services.
As demand for a particular good or service increases, the available supply decreases. When fewer items are available, consumers are willing to pay more to obtain the item — following the principle of supply and demand. The result is higher prices.
Companies also play a role in inflation, especially if they manufacture popular products. A company can raise prices simply because consumers are willing to pay the increased amount. Corporations also raise prices freely when the item for sale is something consumers need for everyday existence, such as oil and gas. However, it's the demand from consumers that makes the corporations to raise prices.
The housing market, for example, has seen its ups and downs over the years. If homes are in demand because the economy is experiencing an expansion, home prices will rise, considering that supply doesn't catch up. The demand also impacts ancillary products and services that support the housing industry. Construction products such as lumber and steel, as well as the nails and rivets used in homes, might all see increases in demand resulting from higher demand for homes.
Expansionary fiscal policy by governments can increase the amount of discretionary income for both businesses and consumers. If a government cuts taxes, businesses may spend it on capital improvements, employee compensation, or new hiring. Consumers may purchase more goods as well. The government could also stimulate the economy by increasing spending on infrastructure projects. The result could be an increase in demand for goods and services, leading to price increases.
Moreover, central banks like the Federal Reserve can lower the cost for banks to lend — interest rate — which allows banks to lend more money to businesses and consumers. The increase in the money supply leads to more spending and demand for goods and services.
For monetarists
Inflation can happen if the money supply grows faster than the economic output, under otherwise normal economic circumstances. Inflation, can also be affected by factors beyond money supply.
The theory most discussed when looking at the link between inflation and money supply is the quantity theory of money (QTM).
Quantity Theory
The quantity theory of money proposes that the exchange value of money is determined like any other good, with supply and demand. The basic equation for the quantity theory is called The Fisher Equation because it was developed by American economist Irving Fisher. In it's simplest form, it looks like this:
MV=PT,
where: M=Money Supply; V=Velocity of circulation (the number of times money changes hands); P=Average price level; T=Volume of transactions of goods and services.
Some variants of the quantity theory propose that inflation and deflation occur proportionately to increases or decreases in the supply of money. A more nuanced version of the quantity theory adds two caveats:
- New money has to actually circulate in the economy to cause inflation.
- Inflation is relative — not absolute.
In a nutshell, prices tend to be higher if more currency is circulating and involved in economic transactions. As Milton Friedman put it in his influential work A Monetary History of the United States, 1867–1960, "inflation is always and everywhere a monetary phenomenon".
Measuring "Inflation"
There are a few metrics that are used to measure the "inflation" rate. One of the most popular is the Consumer Price Index (CPI), which measures prices for a basket of goods and services in the economy, including food, cars, education, and recreation.
Another measure of inflation is the Producer Price Index (PPI), which reports the price changes that affect domestic producers. The PPI measures prices for fuel, farm products (meats and grains), chemical products, and metals. If the price increases that cause the PPI to spike get passed onto consumers, it will be reflected in the Consumer Price Index.
The real inflation
The original definition of inflation is simply the expansion of the monetary supply. This version is the one that the Austrian school accepts and teaches. The austrians concur with the monetarists in the assessment that inflation is a monetary phenomenum. Be that as it may, while the latter claim that the increase in the money supply leads to the rise of the price "level" ("inflation") — as you'll see, the term "level" is misleading --, the former take the view that inflation is the expansion of the money supply, which could result in higher prices.