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II. How Economies Function

Search F&D ! Inflation: Prices on the Rise

Inflation measures how much more expensive a set of goods and services has
become over a certain period, usually a year

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Ceyda Oner

BACK TO BASICS It may be one of the most familiar words in economics. Inflation has plunged
countries into long periods of instability. Central bankers often aspire to be known
as “inflation hawks.” Politicians have won elections with promises to combat
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inflation, only to lose power after failing to do so. Inflation was even declared
Public Enemy No. 1 in the United States—by President Gerald Ford in 1974. What,
# F&D ON FACEBOOK then, is inflation, and why is it so important?

$ SUBSCRIBE TO RSS Inflation is the rate of increase in prices over a given period of time. Inflation is
typically a broad measure, such as the overall increase in prices or the increase in
the cost of living in a country. But it can also be more narrowly calculated—for
certain goods, such as food, or for services, such as a haircut, for example.
Whatever the context, inflation represents how much more expensive the relevant
IMF Global Economy set of goods and/or services has become over a certain period, most commonly a
Forum year.

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Measuring inflation

Consumers’ cost of living depends on the prices of many goods and services and
the share of each in the household budget. To measure the average consumer’s
% Videos cost of living, government agencies conduct household surveys to identify a basket
of commonly purchased items and track over time the cost of purchasing this
basket. (Housing expenses, including rent and mortgages, constitute the largest
component of the consumer basket in the United States.) The cost of this basket at
F&D Magazine a given time expressed relative to a base year is the consumer price index (CPI),
and the percentage change in the CPI over a certain period is consumer price
About F&D " inflation, the most widely used measure of inflation. (For example, if the base year
CPI is 100 and the current CPI is 110, inflation is 10 percent over the period.)
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Core consumer inflation focuses on the underlying and persistent trends in
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inflation by excluding prices set by the government and the more volatile prices of
Copyright Information " products, such as food and energy, most affected by seasonal factors or temporary
supply conditions. Core inflation is also watched closely by policymakers.
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Calculation of an overall inflation rate—for a country, say, and not just for
consumers—requires an index with broader coverage, such as the GDP deflator.

The CPI basket is mostly kept constant over time for consistency, but is tweaked
EMAIL NOTIFICATION SIGN-UP occasionally to reflect changing consumption patterns—for example, to include
Sign up to receive free e-mail notices when new hi-tech goods and to replace items no longer widely purchased. Because it
new series and/or country items are posted shows how, on average, prices change over time for everything produced in an
on the IMF website. economy, the contents of the GDP deflator vary each year and are more current
than the mostly fixed CPI basket. On the other hand, the deflator includes
MODIFY YOUR PROFILE " nonconsumer items (such as military spending) and is therefore not a good
measure of the cost of living.

The good and the bad

To the extent that households’ nominal income, which they receive in current
money, does not increase as much as prices, they are worse off, because they can
afford to purchase less. In other words, their purchasing power or real—inflation-
adjusted—income falls. Real income is a proxy for the standard of living. When real
incomes are rising, so is the standard of living, and vice versa.

In reality, prices change at different paces. Some, such as the prices of traded
commodities, change every day; others, such as wages established by contracts,
take longer to adjust (or are “sticky,” in economic parlance). In an inflationary
environment, unevenly rising prices inevitably reduce the purchasing power of
some consumers, and this erosion of real income is the single biggest cost of
inflation.

Inflation can also distort purchasing power over time for recipients and payers of
fixed interest rates. Take pensioners who receive a fixed 5 percent yearly increase
to their pension. If inflation is higher than 5 percent, a pensioner’s purchasing
power falls. On the other hand, a borrower who pays a fixed-rate mortgage of 5
percent would benefit from 5 percent inflation, because the real interest rate (the
nominal rate minus the inflation rate) would be zero; servicing this debt would be
even easier if inflation were higher, as long as the borrower’s income keeps up with
inflation. The lender’s real income, of course, suffers. To the extent that inflation is
not factored into nominal interest rates, some gain and some lose purchasing
power.

Indeed, many countries have grappled with high inflation—and in some cases
hyperinflation, 1,000 percent or more a year. In 2008, Zimbabwe experienced one
of the worst cases of hyperinflation ever, with estimated annual inflation at one
point of 500 billion percent. Such high levels of inflation have been disastrous, and
countries have had to take difficult and painful policy measures to bring inflation
back to reasonable levels, sometimes by giving up their national currency, as
Zimbabwe has.

Although high inflation hurts an economy, deflation, or falling prices, is not

desirable either. When prices are falling, consumers delay making purchases if they
can, anticipating lower prices in the future. For the economy this means less
economic activity, less income generated by producers, and lower economic
growth. Japan is one country with a long period of nearly no economic growth,
largely because of deflation. Preventing deflation during the global financial crisis
that began in 2007 was one of the reasons the US Federal Reserve and other
central banks around the world kept interest rates low for a prolonged period and
have instituted other monetary policies to ensure financial systems have plenty of
liquidity.

Most economists now believe that low, stable, and—most important—predictable

inflation is good for an economy. If inflation is low and predictable, it is easier to
capture it in price-adjustment contracts and interest rates, reducing its
distortionary impact. Moreover, knowing that prices will be slightly higher in the
future gives consumers an incentive to make purchases sooner, which boosts
economic activity. Many central bankers have made their primary policy objective
maintaining low and stable inflation, a policy called inflation targeting.

What creates inflation?

Long-lasting episodes of high inflation are often the result of lax monetary policy. If
the money supply grows too big relative to the size of an economy, the unit value
of the currency diminishes; in other words, its purchasing power falls and prices
rise. This relationship between the money supply and the size of the economy is
called the quantity theory of money and is one of the oldest hypotheses in
economics.

Pressures on the supply or demand side of the economy can also be inflationary.
Supply shocks that disrupt production, such as natural disasters, or raise
production costs, such as high oil prices, can reduce overall supply and lead to
“cost-push” inflation, in which the impetus for price increases comes from a
disruption to supply. The food and fuel inflation of 2008 was such a case for the
global economy—sharply rising food and fuel prices were transmitted from country
to country by trade. Conversely, demand shocks, such as a stock market rally, or
expansionary policies, such as when a central bank lowers interest rates or a
government raises spending, can temporarily boost overall demand and economic
growth. If, however, this increase in demand exceeds an economy’s production
capacity, the resulting strain on resources is reflected in “demand-pull” inflation.
Policymakers must find the right balance between boosting demand and growth
when needed without overstimulating the economy and causing inflation.

Expectations also play a key role in determining inflation. If people or firms

anticipate higher prices, they build these expectations into wage negotiations and
contractual price adjustments (such as automatic rent increases). This behavior
partly determines the next period’s inflation; once the contracts are exercised and
wages or prices rise as agreed, expectations become self-fulfilling. And to the
extent that people base their expectations on the recent past, inflation would
follow similar patterns over time, resulting in inflation inertia.

How policymakers deal with inflation

The right set of disinflationary policies, those aimed at reducing inflation, depends
on the causes of inflation. If the economy has overheated, central banks—if they
are committed to ensuring price stability—can implement contractionary policies
that rein in aggregate demand, usually by raising interest rates. Some central
bankers have chosen, with varying degrees of success, to impose monetary
discipline by fixing the exchange rate—tying the value of its currency to that of
another currency, and thereby its monetary policy to that of another country.
However, when inflation is driven by global rather than domestic developments,
such policies may not help. In 2008, when inflation rose across the globe on the
back of high food and fuel prices, many countries allowed the high global prices to
pass through to the domestic economy. In some cases the government may
directly set prices (as some did in 2008 to prevent high food and fuel prices from
passing through). Such administrative price-setting measures usually result in the
government’s accrual of large subsidy bills to compensate producers for lost
income.

Central bankers are increasingly relying on their ability to influence inflation

expectations as an inflation-reduction tool. Policymakers announce their intention
to keep economic activity low temporarily to bring down inflation, hoping to
influence expectations and contracts’ built-in inflation component. The more
credibility central banks have, the greater the influence of their pronouncements
on inflation expectations.

CEYDA ONER is a deputy division chief in the IMF’s Finance Department.

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