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INFLATION
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by Valentino Piana (2001) |
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Significance If inflation is not
compensated by nominal increases of income, people become poorer. High and variable
inflation makes economic price forecasting more difficult
and decision-making processes may be negatively affected. Extremely high inflation attracts too much daily attention from households and decision-makers, distracting them from more important tasks. Economists attempted to distinguish inflation as a continuous systematic process of general price increase from two other situations: 1.
an abrupt once-and-for-all overall price increase; From an empirical point of view, this distinction is unpractical and not used: central statistical offices measure inflation in reference to some average of prices growth, irrespective of the abovementioned distinction. Incomes, wages and asset prices (like share quotations) are not included in the averaged "prices", thus inflation has important real effects (i.e. on quantities), to the extent it is not perfectly matched by soaring income and asset prices.
There is no strictly binding definition of ranges of intensity in price increase. Still, some indications can be given as it follows. Hyperinflation
is the most extreme inflation phenomenon, with yearly price increases
of three-digits percentage points and an explosive acceleration. Extremely high
inflation could range anywhere between 50% and 100%. High
inflation is a situation of price increase of, say, 30%-50% a year.
Both kinds can be stable or dangerously accelerate to enter in an hyperinflation
condition. Moderate inflation
can be differently defined around the world, given the different inflation
histories. As an indication only, one could consider an inflation as moderate
when it ranges from 5% to 25-30%. For some countries, the higher part
of this range is already "high inflation". Low inflation can be characterized from 1-2% to 5%. Around zero there is no inflation (price stability). Below zero, a country faces deflation. A
transversal classification distiguish inflations, basing on their broadly-defined
origins: 1.
domestic demand; A
systematic institutional difference is between countries having or not
having (partial or total) indexation of wages (and other income
sources). Indexation makes inflation much less painful, but normally keeps it at a higher level and increases the risk of a continous acceleration. Determinants These decisions may
result from coordination and monopoly/oligopoly
dynamics, as well as from the attempt to increase margins and profits.
But there is no need
for formal coordination: a favourable demand situation, with higher
income and booming propensity to consumption,
makes price increase easier. A generalized cost
increase, as with wages, energy
prices (especially oil prices), devaluation,
and certain taxes, is clearly conducive to inflation.
A mediation is given by productivity improvements,
which reduce unitary costs of production. Large increases
in money quantity, especially if clearly exceeding
nominal GDP growth, risk to accelerate current inflation. In other words,
if present inflation plus real GDP growth is (much) less than money-quantity
rate of growth, there is a consistent risk of acceleration, unless other
factors push in the opposite direction. A pro-inflation pressure
may come also from fiscal deficit, with different dynamics depending
on ways of financing it (bonds sold to the market or to the central bank,
i.e. with a sharp increase of money quantity). An important determinant
of inflation is given by expectations on future rate of inflation,
to the extent they are widely accepted and exert influence on decision-making
processes, as with long and medium-term wage contracts. Oil price fluctuations exert a distictive important influence on inflation throughout the world. The increase abroad of prices for products that our country purchase, if not counteracted by a re-valuation of the currency, exerts a pressure on the price level, possibly inducing "imported inflation". Inflation in the country's trade partners then spread out and can feedback there. Uncompensated inflation
reduces incomes, thus consumption and savings.
Through a Keynesian multiplier, income and consumption
will cumulatively fall further. If inflation is mainy
demand-pulled, it vanishes the increases in nominal effective demand and
it frustrates consumption expectations. By contrast, if inflation
is mainly due to efforts of increasing margins and profits,
it is possible a rise in consumption in high-income groups. Investment
should be discouraged by uncertainty about future engendered by inflation
and its wide fluctuation. Still, to the extent
that benefits of inflation are mainly reaped by domestic firms, the
real interest rate for investment fall inversely with mounting inflation.
Thus, a low or moderate inflation may help investments, at least to the
extent they are actually influenced by real interest rates and until a
central bank intervention. In fact, central
banks can try to control inflation through a sharp increase in real
interest rates, more than proportionally reflected in nominal interest
rates. This move usually
provokes a fall in investment and a revaluation
of currency. The
first effect brakes domestic demand, the second the foreign one. Summarizing some of
these arguments, higher inflation leads to higher nominal
interest rates. In a first phase, the latter may not keep pace with
inflation, thus real interest rates may fall. But afterwards, if the central
bank does not accomodate inflation, the real interest rates are kept much
higher than before. Still, too many elements
are intertwinned, so that these relationships should be treated with great
caution. In absence of central
bank reaction, it is for example common that inflation tends to provoke
currency devaluation, opening a vicious
circle. This is certainly the case with hyperinflation. In fact, in this case, central banks often choose to fix a certain exchange rate target as a nominal anchor in the battle against inflation: with fixed exchange rates, inflation makes import cheaper in comparison to domestic products, so that domestic firms face more intense competition, which should brake inflation. Until the fall in
inflation does not takes place, domestic goods become more expensive in
a international comparison, typically with a fall in exports
and a rise of imports, heavily deteriorationg
the trade balance. At the same time,
if indexed, local wages and incomes will improve
their international purchasing power, thanks to fixed nominal exchange
rate. On financial markets
of fixed-interest bonds, an increase of inflation will reduce the burden
of debt and interest payments. In the case of large public debt, inflation is an important relief for the State (also through larger tax revenues and lower personnel costs), menacing to engender a political tolerance toward inflation. World-wide inflation
has peaked in the '70s, because of two oil crises. Afterwards, inflation
has become a major target of public powers and it has been decelerating
in most countries. Nonetheless, significant episodes of hyperinflation are still common and many stagnating economies can't take off both because of inflation and anti-inflationary policies. Business
cycle behaviour External inflationary
impulse can begin virtually at any point of domestic business cycle. Imported inflation, if strong enough, is heavily anti-cyclical, since it engenders a fall in output growth. In fact, not only it reduces consumption as every generalized uncompensated price increase, but also it usually prompts requests for compensating higher wages, giving rise to self-propelling cost inflation. These requests are usually only partially accomodated, leaving real incomes lower. Central bank restrictive policies do the rest. Data Inflation
rates for 192 countries (1969-2009) Comparable wages for 162 jobs in 132 countries Exchange
rates for 200 currencies, spanning across more than 20 years Formal
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