Inflation is an increase in the price of goods or services that is not offset by an increase in quality. If investors expect higher rates of inflation, they will demand higher market interest rates so that a real return remains after inflation.
Types of Inflation
Inflation may be associated with a change in costs or a change in the money supply, or because of speculation or so-called administrative pressures.
Price Changes Initiated by a Change in Costs
The price level can sometimes increase without the original impulse coming from either the money supply or its velocity. If costs rise faster than productivity increases, as when wages go up, businesses with some control over prices will try to raise them to cover the higher costs. Such increases are likely to be effective when the demand for goods is strong compared to the supply.
The need for more funds to meet production and distribution at higher prices usually causes the money supply and velocity to increase. This type of inflation is called cost-push inflation, as this rise in prices comes from the cost side, not from increases in the money supply.
Prices may not go up, however, if the monetary authorities restrict credit expansion. In that case, only the most efficient businesses will have enough demand to operate profitably. As a result, some resources will be unemployed.
Cost-push inflation can occur only in industries in which labor negotiations are carried out industry-wide, and in which management has the ability to increase prices. Cost-push inflation is different from inflation caused by an increase in the money supply.
Price Changes Initiated by a Change in the Money Supply
Demand-pull inflation occurs when an excessive demand for goods and services is created during periods of economic expansion as a result of large increases in the money supply. While changes in the velocity, or turnover, of money can also impact price changes, we focus our discussion on changes in the supply of money.
An increase in the money supply occurs when the Fed purchases government securities through its open-market operations. If this happens when people and resources are not fully employed, the volume of trade goes up; prices are only slightly affected at first. As unused resources are brought into use, however, prices will go up.
When resources, such as metals, become scarce, their prices rise. As any resource begins to be used up, the expectation of future price rises will itself force prices up, because attempts to buy before such price rises will increase demand above current needs. Since some costs will lag—such as interest costs and wages set by contract—profits will rise, increasing the demand for capital goods.
Once resources are fully employed, the full effect of the increased money supply will be felt on prices. Prices may rise out of proportion for a time as expectations of higher prices lead to faster spending and so raise the velocity of money.
The expansion will continue until trade and prices are in balance at the new levels of the money supply. Velocity will probably drop somewhat from those levels during the period of rising prices, since the desire to buy goods before the price goes up has disappeared.
Even if the supply of money is increased when people and resources are fully employed, prices may not go up proportionately. Higher prices increase profits for a time, and so lead to a demand for more capital and labor. Thus, previously unemployed spouses, retired workers, and similar groups begin to enter the labor force. Businesses may use capital more fully by having two or three shifts use the same machines.
Demand-pull inflation traditionally exists during periods of economic expansion when the demand for goods and services exceeds the available supply of such goods and services. Demand-pull inflation may also be caused by changes in demand in particular industries.
The demand for oil and natural gas, for example, may be greater than demand in general, so that prices rise in this industry before they rise generally. The first rise is likely to be in the price of basic materials themselves, leading to increased profits in the industries that produce them.
Labor will press for wage increases to get its share of the total value of output, and thus labor costs also rise. Price increases in basic industries lead to price increases in the industries that use their products.
Wage increases in one major industry are also likely to lead to demands for similar increases in other industries and among the nonorganized workers in such industries. The process, once set into motion, can lead to general changes in prices, provided the monetary authorities do not restrict credit so as to prevent it.
Inflation associated with increases in the money supply also can occur because of the monetization of the U.S. government debt. The Treasury finances government deficits by selling U.S. government securities to the public, financial institutions, foreign and international investors, and the Federal Reserve.
When the Federal Reserve purchases U.S. government securities, reserves must be created to pay for the purchases. This, in turn, may lead to higher inflation because of an increase in money supply and bank reserves.
Speculation and Administrative Inflation
When an increased money supply causes inflation, it can lead to the additional price pressure called speculative inflation.
Since prices have risen for some time, people believe that they will keep on rising. Inflation becomes self-generating for a time because, instead of higher prices resulting in lower demand, people may buy more to get goods before their prices go still higher, as happened in the late 1970s.
This effect may be confined to certain areas, as it was to land prices in the 1920s Florida land boom, or to security prices in the 1928–1929 stock market boom. Such a price rise leads to an increase in velocity as speculators try to turn over their funds as rapidly as possible, and many others try to buy ahead of needs before there are further price rises.
For three decades, until the early 1980s, price pressures and inflation were continual despite occasional policies of strict credit restraint. During this long period, in fact, prices continued upward in recession periods, though at a slower rate than in prosperity periods.
The need to restrain price rises hampered the Fed’s ability to promote growth and fight recessions. Prices and other economic developments during this period led many to feel that the economy had developed a long-run inflationary bias. However, the continued low inflation rates from the early 1990s to the present seem to have curtailed these beliefs.
Administrative inflation is the tendency of prices, aided by union-corporation contracts, to rise during economic expansion and to resist declines during recessions. Prices and wages tend to rise during periods of the boom in a competitive economy.
This tendency is reinforced by wage contracts that provide escalator clauses to keep wages in line with prices, and by wage increases that are sometimes greater than increases in productivity. Second, during recessions, prices tend to remain stable rather than decrease.
This is because major unions have long-run contracts calling for annual wage increases no matter what economic conditions are at the time.
The tendency of large corporations to rely on nonprice competition (advertising, and style, and color changes) and to reduce output rather than cut prices also keeps prices stable.
Furthermore, if prices do decline drastically in a field, the government is likely to step in with programs to help take excess supplies off the market. There is little doubt that prices would decline in a severe and prolonged depression.
Government takes action to counter resulting unemployment, however, before the economy reaches such a level. Thus, we no longer experience the downward price pressure of a depression.
Administrative inflation differs from demand-pull inflation which happens when demand exceeds the available supply of goods, either because demand is increasing faster than supply in the early stages of a recovery period or because demand from monetary expansion by the banking system or the government exceeds the available supply.
Traditional monetary policy is not wholly effective against administrative inflation. If money supplies are restricted enough, prices can be kept in line; this will lead to long-term unemployment and slow growth.
It is also difficult for new firms and small, growing firms to get credit since lending policies are likely to be conservative. If administrative inflation resurfaces, new tools may need to be developed to effectively deal with it.
Historical International Price Movements
Changes in the money supply or in the amount of metal in the money unit have influenced prices since the earliest records of civilization. The money standard in ancient Babylon was in terms of silver and barley.
The earliest available price records show that one shekel of silver was equal to 240 measures of grain. At the time of Hammurabi (about 1750 B.C.), a shekel in silver was worth between 150 and 180 measures of grain, while in the following century it declined to 90 measures. After Persia conquered Babylonia in 539 B.C., the value of the silver shekel was recorded as between 15 and 40 measures of grain.
Alexander the Great probably caused the greatest inflationary period in ancient history when he captured the large gold hoards of Persia and took them to Greece. Inflation was high for some years, but 20 years after Alexander’s death, a period of deflation began that lasted for over 50 years.
The first recorded cases of deliberate currency debasement (lowering the value) occurred in the Greek city-states. The government would debase the currency by calling in all coins and issuing new ones containing less of the precious metals. This must have been a convenient form of inflation, for there are many such cases in the records of Greek city-states.
During the Punic Wars, devaluation led to inflation as the heavy bronze coin was reduced in stages from one pound to one ounce. Similar inflation occurred in Roman history. Augustus brought so much precious metal from Egypt that prices rose and interest rates fell. From the time of Nero, debasements were frequent.
The weight of gold coins was gradually reduced, and silver coins had baser metals added to them so that they were finally only 2 percent silver.
Few attempts were made to arrest or reverse this process of debasement of coins as the populace adjusted to the process. When Aurelian tried to improve the coinage by adding to its precious metal content, he was resisted so strongly that armed rebellion broke out.
The Middle Ages Through Modern Times
During the Middle Ages, princes and kings debased the coinage to get more revenue. The rulers of France used this ploy more than others, and records show that profit from debasement was sometimes greater than the total of all other revenues.
An important example of inflation followed the arrival of Europeans in America. Gold and silver poured into Spain from Mexico and Peru.
Since the riches were used to buy goods from other countries, they were distributed over the continent and to England. Prices rose in Spain and in most of Europe but not in proportion to the increase in gold and silver stocks. This was because trade increased and because many people hoarded precious metals.
Paper money was not used generally until the end of the seventeenth century. The first outstanding example of inflation due to the issuing of an excessive amount of paper money was in France.
In 1719, the government gave Scottish banker John Law a charter for a bank that could issue paper money. The note circulation of his bank amounted to almost 2,700 million livres (the monetary unit in use at that time in France), against which he had coins of only 21 million livres and bullion of 27 million livres. Prices went up rapidly, but they fell just as fast when Law’s bank failed. Afterward, the money supply was again restricted.
The next outstanding periods of inflation were during the American Revolution (1775–83) and French Revolution (1789–99). For example, France’s revolutionary government-issued paper currency in huge quantities.
This currency, called assignats, declined to 0.5 percent of its face value. Spectacular inflation also took place in Germany in 1923, when prices soared to astronomical heights. During World War II, runaway inflation took place in China and Hungary, as well as in other countries.
Inflation in the United States
Monetary factors have often affected price levels in the United States, especially during major wars.
The war that brought the United States into being was financed mainly by inflation. The Second Continental Congress had no real authority to levy taxes and, thus, found it difficult to raise money. As a result, Congress decided to issue notes for $2 million.
It issued more and more notes until the total rose to over $240 million. The individual states issued $200 million more. Since the notes were crudely engraved, counterfeiting was common, adding to the total of circulating currency. Continental currency depreciated in value so rapidly that the expression “not worth a continental” became a part of the American language.
War of 1812
During the War of 1812, the government tried to avoid repeating the inflationary measures of the Revolutionary War. However, since the war was not popular in New England, it was impossible to finance it by taxation and borrowing.
Paper currency was issued in a somewhat disguised form: bonds of small denomination bearing no interest and having no maturity date. The wholesale price index, based on 100 as the 1910–1914 average prices, rose from 131 in 1812 to 182 in 1814. Prices declined to about the prewar level by 1816 and continued downward as depression hit the economy.
The Mexican War (1846–1848) did not involve the total economy to any extent and led to no inflationary price movements. The Civil War (1861–1865), however, was financed partly by issuing paper money. In the war’s early stages, the U.S. Congress could not raise enough money by taxes and borrowing to finance all expenditures; therefore, it resorted to inflation by issuing U.S. notes with no backing, known as greenbacks.
In all, $450 million was authorized. Even though this was but a fraction of the cost of the war, prices went up substantially. Wholesale prices on a base of 100 increased from 93 in 1860 to 185 in 1865. Attempts to retire the greenbacks at the end of the war led to deflation and depression in 1866. As a result, the law withdrawing greenbacks was repealed.
World War I
Although the U.S.government did not print money to finance World War I, it did practice other inflationary policies. About one-third of the cost of the war was raised by taxes and two-thirds of the cost by borrowing.
The banking system provided much of this credit, which added to the money supply. People were even persuaded to use Liberty Bonds as collateral for bank loans to buy other bonds. The wholesale price index rose from 99 in 1914 to 226 in 1920. Then, as credit expansion was finally restricted in 1921, it dropped to 141 in 1922.
World War II and the Postwar Period
The government used fewer inflationary policies to finance World War II. Nevertheless, the banking system still took up large sums of bonds. By the end of the war, the debt of the federal government had increased by $207 billion.
Bank holdings of government bonds had increased by almost $60 billion. Prices went up by only about one-third during the war because they were held in check after the first year by price and wage controls. They then rose rapidly when the controls were lifted after the war. In 1948, wholesale prices had risen to 236 from a level of 110 in 1939.
Wholesale prices increased during the Korean War and again during the 1955–1957 expansion in economic activity as the economy recovered from the 1954 recession. Consumer goods prices continued to move upward during practically the entire postwar period, increasing gradually even in those years in which wholesale prices hardly changed.
Wholesale consumer goods prices increased substantially when the Vietnam War escalated after mid-1965. Prices continued upward after American participation in the Vietnam War was reduced in the early 1970s.
After American participation in the war ended in 1974, prices rose at the most rapid levels since World War I. Inflation was worldwide in the middle 1970s; its effects were much worse in many other industrial countries than in the United States.
As the 1970s ended, economists realized the full impact of a philosophy based on a high inflation rate.
Many economists thought high inflation could keep unemployment down permanently, even though history shows that it does not. The government’s efforts to control interest rates by increasing the money supply created doubts that such policies would reduce inflation and high-interest rates.
By October 1979, the Federal Reserve System abandoned this failed approach to interest rate control and adopted a policy of monetary growth control. The result was twofold. First, there was far greater volatility in interest rates as the Federal Reserve concentrated on monetary factors. Second, during the first three quarters of 1980, some monetary restraint was exercised.
This monetary restraint depressed production and employment. The Federal Reserve System quickly backed off from this position of restraint, and by the end of 1980, a far greater level of monetary stimulus had driven interest rates to new peaks.
By this time, the prime rate had risen to 21.5 percent and three-month Treasury bills had doubled in yield from their midyear lows. These high-interest rates had a profound negative effect on such interest-sensitive industries as housing and automobiles.
The Fed reversed the rapid growth of the money supply throughout 1981 and until late in 1982. Unemployment climbed as the effects of monetary restraint were imposed on the economy, but the back of inflation was broken. By the end of 1982, economic recovery was in place, along with an easing of monetary restraint.
Inflation stayed at moderate levels beginning in 1983 and continuing through most of the remainder of the 1980s until near the end of the decade. After peaking in 1990 above a 6 percent annual rate, changes in the CPI stayed at about 3 percent until 1997, when the inflation rate dropped even further.
In early 1994, the Fed moved toward a tighter monetary policy in an effort to keep inflation from rising. As the country finished the 1990s and moved into the early twenty-first century, inflation rates remained at relatively low levels.
For 2007, the rate of inflation using changes in the CPI for all items was 4.1 percent, reflect- ing record-high oil prices. Using the alternative CPI measure, adjusted to exclude food and energy, the rate of inflation was 2.4 percent for 2007.
Since then, changes in the all-items CPI have generally been under 2 percent (except for 2009 and 2011) and were less than 1 percent in 2014 and 2015. Changes in the CPI measure that exclude food and energy have averaged 2 percent or less in recent years.