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Definition: inflation from Philip's Encyclopedia

Continual upward movement of prices. Although normally associated with periods of prosperity, inflation may also occur during recessions. It usually occurs when there is relatively full employment. Under 'cost-push' inflation, prices rise because the producers' costs increase. Under 'demand-pull' inflation, prices increase because of excessive consumer demand for goods.

Summary Article: Inflation from The SAGE Encyclopedia of Economics and Society

Inflation is generally described as a sustained increase in the level of prices. It is challenging to identify which factors generate inflationary pressures. Interest in these factors is at the core of active policies on inflation control. These policies are not neutral with respect to the consequences that they have on the distribution of national income; since inflationary and anti-inflationary policies change the national income distribution, they may lead to conflicts between social groups and, at times, between states. A particular form of inflation is hyperinflation. Hyperinflation happens when policy makers lose control of the economy; it is a disruptive form of inflation that creates an unstable and unpredictable environment for people and firms.

Each nation has specific inflationary dynamics. This is because inflation is to a certain extent determined by the economic and monetary policies that a government puts in place. The term inflation cannot be applied if the prices of only some goods increase while the prices of other goods remain stationary or increase only slightly. The reference to “slight increases” in prices is evidence of realism in that when the general level of prices varies by 1 or 2 percent, it does not constitute inflation. Thus, the measure of inflation is in some way a conventional and subjective phenomenon, based on a societal consensus, although the effects on the economy are objective.

Causes of Inflation

Discussing the causes of inflation entails identifying the factors that lead to an acceleration of growth in general price levels. For example, in country A, the general price level has increased because the amount of money injected by the central authorities exceeds the availability of goods produced in A in the same period. In this definition, the focus turns toward the amount of money in excess or the amount of goods that are lacking to maintain prices in equilibrium. It thus becomes quite natural to think that inflation is caused by an excess of money, and in this sense, it expresses the view of the monetarist school. Milton Friedman, for example, considered inflation a purely monetary phenomenon, which can only be produced by a more rapid increase in the growth of monetary supply than in the growth of real income. However, certain situations can lead to an increase in monetary supply that exceeds that of real national income. National income is distributed differently among various social groups, sometimes leading to demand-pull inflation and other times to cost-push inflation.

Demand-Pull Inflation

Inflation induced by demand is directly linked to the quantity theory of money. This theory assumes that the price level depends on the supply of money in circulation, as well as its speed of circulation. Demand-pull inflation occurs when, in a certain period of time, there are continuous increases in aggregate demand while the supply, because of some of its rigidities, meets these increases only in part or with some delay. An increase in a country's money supply is associated with a production gap, and enterprises wait to employ the thus far unused production factors until the increase in demand has some quantitative consistency over time. At first, the increase in demand translates into an increase in prices; subsequently, when production responds to the demand stimulus, the increase in prices decelerates.

Government policy can play an important role in determining inflation, especially when it results in an increase in public spending not aimed at developing production. Another type of demand-pull inflation occurs when a country is open to international trade and a significant increase in foreign demand for goods produced in that country is suddenly manifested. Demand-pull inflation typically occurs when an economy is expanding. In terms of the effects of demand-pull inflation, this generally produces an increase in employment, although not necessarily consolidated over time.

Cost-Push Inflation

Cost-push inflation occurs when prices are pushed upward by an increase in the costs of some or even all production factors. One of the most significant forms of this type of inflation occurs in the “price-wage spiral.” A significant historical experience of this occurred in the world, and particularly in Europe, in 1973 and 1974. These inflationary dynamics were set in motion by the Organisation of Petroleum Exporting Countries with an autonomous increase in the price of oil in two different time phases. Oil is an intermediate good that has many applications in the production activities of advanced economies. At the time when the Organisation of Petroleum Exporting Countries sharply increased the price of oil, simultaneously setting production quotas, these countries were well aware that the global demand for oil in the short and even medium terms was rigid and that economically advanced countries could not reduce their demand for oil.

The higher oil prices resulted in higher costs in those processes where oil was a key intermediate good. This factor triggered a cost-push inflation that was reabsorbed over time, but only after a sharp rise in unemployment in industrialized countries; indeed, a reduction in employment is generally a consequence of cost inflation. The second phase consisted of the attempt by the unions of industrialized countries to recover at least part of the portion of income “consumed” by the oil inflation. This resulted in a further increase in production costs, this time due to the realignment of salary levels. In turn, this realignment resulted in a further upward revision of the prices of goods produced in industrialized countries. In sum, a classic price-wage spiral was manifested. In the 1980s, the inflation rate reached or exceeded 15 percent per year in some European countries.

Inflation and Unemployment: The Phillips Curve

Demand-pull inflation shows that an increase in liquidity corresponds to an increase in inflation. If the increase in the price level acts as a stimulus on the economy, then an increase in the level of employment may ensue. In fact, it can be assumed that there is a trade-off between inflation and unemployment whereby a rise in the level of inflation is associated with a decrease in unemployment. Bill Phillips empirically verified this trade-off, which is represented with the Phillips curve. In 1958, Phillips demonstrated the existence of a statistical relationship between wage inflation and unemployment in the United Kingdom between 1861 and 1951. Policy makers in Western countries saw the existence of a relationship between inflation and unemployment as a justification for expansionary demand-side policies based on an increase in public debt. However, subsequent analyses conducted in the 1960s showed that such a relationship does not necessarily exist, or rather, it can exist but only in the short term.

In a longer-term perspective, an important role is assumed by the expectations of both workers and firms, not least because inflation expectations affect the short-run trade-off between inflation and unemployment. Suppose that economic agents are rational and that they are capable of accurately predicting the future using the economic data available to them, including those relating to the policies pursued by the monetary authorities. In turn, monetary and fiscal policies exert an influence on inflation, so it can be assumed that inflation expectations are affected by the policies put in place by public authorities. Therefore, if these authorities change the monetary policy and/or fiscal policy, economic agents change their inflationary expectations. This assumption is based on the hypothesis of a target inflation rate whereby the evolutionary process should lead to the long-run equilibrium between the level of inflation and the unemployment rate. The theory of rational expectations and the long-term ineffectiveness of monetary policy form the basis of the theoretical assumptions of the Chicago School.

Income Policy

The price-wage spiral indicates the interdependence between the increase in the general price level and that of wage levels. However, the increase in wage levels does not necessarily take place in the same way for all categories of workers. There will be workers who enjoy strong bargaining power (especially those operating in protected sectors) and others who have weak bargaining power. Thus, while workers with strong bargaining power can impose nominal wage adjustments that go beyond the increases in their labor productivity, this could imply the closure of businesses and the loss of jobs in less protected sectors. Thus, especially in a situation of cost-push inflation, an increase in prices can be accompanied by the loss of jobs. This is particularly true if the economy of a country hit by inflation is sufficiently open to international trade. An increase in the level of prices in such a country worsens the competitiveness of its enterprises operating in foreign markets.

The labor market of a modern country is strongly dualistic, and especially in current times, the differences are exacerbated between social groups that receive very high incomes and those that do not have the power to secure a stable share of the national income, especially in times of inflation. Inflation seriously harms low-income earners and, even more, those with zero income. In this perspective, inflation can also be seen as the consequence of bad income distribution among social groups in a country. After the end of World War II, a school of thought developed in western Europe that sought to address the dual problem of inflation and unemployment, which are interrelated. According to the Keynesian perspective, the income-policy methodological apparatus is intended to use budgetary and fiscal policies to distribute national income according to a principle of optimality.

The state must ensure that national income is attributed to its recipients based on the actual contribution of each social group to the national income. If the productivity of a social group or economic sector is too low, active policies should be put in place that alter the economic structure of that country. An important instrument of income policy is therefore public spending, which should aim to encourage investments rather than favoring current expenditure. Income policy cannot be confused with inflation targeting. According to Ben Bernanke and his colleagues (1999),

inflation targeting is a framework for monetary policy characterized by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit acknowledgment that low, stable inflation is monetary policy's primary long-run goal.

(Global Talent Management)

See also Abundance and Scarcity; Discounting; Fair Trade Movement; Full Employment; Price Gouging

Further Readings
  • Bernanke, Ben; Homas Laubach; Frederic Mishkin; Adam Posen. Inflation Targeting. Princeton University Press Princeton NJ, 1999.
  • Cencini, Alvaro; Mauro Baranzini, eds. Inflation and Unemployment. Routledge London, 1996.
  • Heymann, Daniel; Axel Leijonhufvud. High Inflation. Clarendon Press Oxford, 2002.
  • Kandir, Antonio. Dynamics of Inflation. University of Notre Dame Press London, 1991.
  • Mankiw, Gregory; Mark Taylor. Macroeconomics. Worth Publishers New York, 2008.
  • Maurizio Mistri
    Copyright © 2015 by SAGE Publications, Inc.

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