Inflation and Its Effects

Devaluation of Currency: Understanding Inflation, Causes, and Historical Instances

• Inflation is the increase in the general price level of goods and services in an economy, which reduces the purchasing power of money.

• Inflation rate is the annualized percentage change in a general price index, and the consumer price index (CPI) is often used to measure it.

• The causes of inflation are attributed to fluctuations in real demand for goods and services or changes in available supplies.

• Low and steady inflation is favored by most economists as it reduces the probability of economic recessions and allows the central bank greater freedom in carrying out monetary policy.

• Inflation is related to the value of currency itself, and when currency was linked with gold, if new gold deposits were found, the price of gold and the value of currency would fall, and consequently, prices of all other goods would become higher.

• Historically, periods of inflation and deflation would alternate depending on the condition of the economy, but the adoption of fiat currency by many countries made much larger variations in the supply of money possible.

• Rapid increases in the money supply have taken place a number of times in countries experiencing political crises, producing hyperinflations, which are episodes of extreme inflation rates much higher than those observed in earlier periods of commodity money.

• The hyperinflation in Venezuela is currently the highest in the world, with an annual inflation rate of 833,997% as of October 2018.

• Other economic concepts related to inflation include deflation, disinflation, hyperinflation, stagflation, reflation, and asset price inflation.

• The inflation rate is most widely calculated by determining the movement or change in a price index, typically the CPI, and the inflation rate is the percentage change of a price index over time.

• The Retail Prices Index (RPI) is also a measure of inflation that is commonly used in the United Kingdom, which is broader than the CPI and contains a larger basket of goods and services.

• Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or location.Understanding Inflation: Causes, Measurements, and Effects

• Inflation is the rate at which the general level of prices for goods and services is rising, resulting in a decrease in purchasing power.

• Inflation is measured by calculating the price change of a large "basket" of representative goods and services, with weighted pricing necessary to measure the effect of individual unit price changes on the economy's overall inflation.

• The Consumer Price Index (CPI) uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services.

• Inflation measures are often modified over time, either for the relative weight of goods in the basket or in the way goods and services from the present are compared with goods and services from the past.

• Different segments of the population may naturally consume different "baskets" of goods and services and may even experience different inflation rates.

• Inflation numbers are often seasonally adjusted to differentiate expected cyclical cost shifts and may be averaged or otherwise subjected to statistical techniques to remove statistical noise and volatility of individual prices.

• Inflation expectations are the rate of inflation that is anticipated for some time in the foreseeable future, and there are two major approaches to modeling the formation of inflation expectations.

• Inflation expectations affect the economy by being built into nominal interest rates and the rate of wage increases.

• Historically, there were different schools of thought as to the causes of inflation; most historical theories can be divided into two broad areas: quality theories of inflation and quantity theories of inflation.

• In the long run, the inflation rate depends on the growth rate of the money supply relative to the growth of real income.

• In the short and medium term, inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices, and interest rates.

• The unemployment rate generally only affects inflation in the short-term but not the long-term, and the velocity of money is far more predictive of inflation than low unemployment in the long term.

• Monetarists believe the most significant factor influencing inflation or deflation is how fast the money supply grows or shrinks, and they consider fiscal policy as ineffective in controlling inflation.Summary Title: Theories and Effects of Inflation

• Monetarists assume that changes in the quantity of money drive changes in the general price level, with velocity of money assumed to be unaffected by monetary policy in the long run.

• Rational expectations theory asserts that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures.

• The Austrian School stresses that inflation is not uniform over all assets, goods, and services, and that price inflation will necessarily follow an increase in the quantity of money not offset by a corresponding increase in the need for money.

• The real bills doctrine asserts that banks should issue their money in exchange for short-term real bills of adequate value to maintain their assets, while the quantity theory of money claims that inflation results when money outruns the economy's production of goods.

• Inflation decreases the purchasing power of a currency, affecting different sectors of the economy differently, with some benefitting and others being adversely affected.

• High or unpredictable inflation rates add inefficiencies in the market, make it difficult for companies to budget or plan long-term, and discourage investment and saving.

• Inflation can also impose hidden tax increases and redistribute purchasing power from those on fixed nominal incomes to those with variable incomes.

• Cost-of-living adjustments adjust salaries based on changes in a cost-of-living index to keep their real values constant.

• Monetary policy is the policy enacted by the monetary authorities to control the interest rate or money supply so as to control inflation and ensure price stability.

• Fixed exchange rates stabilize the value of a currency but prevent a government from using domestic monetary policy to achieve macroeconomic stability.

• The gold standard is a monetary system in which a region's common medium of exchange is paper notes convertible into fixed quantities of gold, but it has been largely abandoned in favor of fiat money.

• Central banks target a low inflation rate because high inflation is economically costly, while low inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn.Methods to Control Inflation

• The gold standard determines the rate of inflation by the growth rate of the supply of gold relative to total output.

• Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining.

• Wage and price controls or incomes policies are another method attempted in the past to control inflation.

• Temporary price controls may be used as a complement to other policies to fight inflation.

• Economists generally advise against the imposition of price controls.

• Wage and price controls in combination with rationing have been used successfully in wartime environments.

• Their use in other contexts is far more mixed.

• Wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation.

• They often have perverse effects due to the distorted signals they send to the market.

• Artificially low prices often cause rationing and shortages and discourage future investment.

• The usual economic analysis is that any product or service that is under-priced is overconsumed.

• If the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.