Friday, February 3, 2012

Let's talk about inflation, baby

Inflation is a concept that many people seem to struggle with. A brief overview may be helpful.

What is inflation? Inflation is any rise in the general level of prices. What, then, is the price level? It is the average price of goods and services produced by the economy. Suppose, for example, that the price of everything doubles over the course of a year. In that case, the average price of goods and services--that is, the price level--doubles, too. The rate of inflation, in turn, averages 100% per year.

What determines the rate of inflation? The price level is determined by the intersection of the aggregate demand (AD) schedule and the aggregate supply (AS) schedule. Thus, the rate of inflation is determined by the rates of change of AD and AS.

The value of money is determined by the intersection of the money demand schedule and the money supply schedule. The prices of goods and services are quoted in units of money. As a result, it makes sense to think of the price level as the money-price of goods and services, and the value of money as the goods-and-services-price of money. These variables are two sides of the same coin. A higher price level means that one needs more money to buy the same goods and services, implying a lesser value for money. A lower price level means that one needs less money to buy the same goods and services, implying a greater value for money. The price level is thus simultaneously determined by the intersection of the money demand schedule and money supply schedule. Consequently, the rate of inflation is simultaneously determined by the rates of change of money demand and money supply.

The economic function of inflation is to concurrently equilibrate the market for goods and services (AD and AS) and the market for money (money demand and money supply). Suppose, for illustration, that the government creates some extra money, with which it buys things. This expands the money supply, putting downward pressure on the value of money, which in turn puts upward pressure on the price level. The result, in equilibrium, is inflation. Another way of seeing this play out is as follows: when the government buys these things, it puts extra money in the hands of people who were previously satisfied with their money balances. Not needing to add to their money balances, they spend the money instead, expanding AD, putting upward pressure on the price level. Again, the equilibrium result is inflation. The reverse experiment, contracting the money supply, puts downward pressure on the price level, the equilibrium effect of which is deflation (the opposite of inflation).

Why does the rate of inflation matter? First, in the short run, prices are sticky. The higher the rate of inflation, the faster each price must adjust in order for relative prices to remain the same. Price stickiness means that some prices may not keep up with the rest, altering relative prices, causing resources to be misallocated.

Second, inflation instability undermines intertemporal transactions. Suppose I lend you $100, to be paid back in one year at a 10% per year interest rate. A year from now, you will pay me back $110. If, in the interim, the rate of inflation averages 20% per year, then $110 in next year's dollars is equivalent to $91.67 in this year's dollars. You'll pay me back less, in real terms, than I intended. If instead I charge you a 32% per year interest rate, then a year from now you'll pay me back $132, which is equivalent to $110 in this year's dollars. By modifying the interest rate that I charge, I may nullify the effects of inflation. I can only do this, however, if the rate of inflation is predictable. If it isn't, then I do not know how much I will be paid back, regardless of the interest rate I charge; hence, I will be discouraged from entering into this transaction in the first place.

Third, there is a short-run tradeoff between inflation and unemployment. More AD/money supply, in the face of sticky prices, boosts employment at the expense of higher inflation, while less AD/money supply contains inflation at the expense of lower employment.

Ergo, the dual mandate of macroeconomic policymaking: maximum employment (enough AD/money supply to fully employ the labor force) and stable prices (not so much AD/money supply as to produce high and/or unstable inflation). The question, then, is which regime is most conducive to fulfilling this dual mandate. I believe the answer is NGDP targeting, but either way the above is most everything you need to know about inflation. In my next post, I'll try to put to rest some misconceptions about inflation. (E.g., inflation is bad for savers, inflation raises people's cost of living, the gold standard is the best policy for managing inflation, etc.)


  1. Thanks for this explanation of inflation. I'm enjoying it.

    Is it possible to denominate the value of money? In what terms?

  2. Depends on which units you wish to denominate it in. For example, if the money-price of apples is $2 per apple, then the apple-price of money (the value of money denominated in apples) is 0.5 apples per dollar. Typically, we don't want to think about the value of money in terms of apples--we want to think about it in terms of goods and services, since that's what money is good for (buying goods and services). Trouble is, there's no good unit for "goods and services", which is why there are so many price indices. (Consumer Price Index, Personal Consumption Expenditure Price Index, GDP Deflator, the "core" versions of each of these, etc.) Given a particular price index, if inflation occurs at rate r%, then the value of money deteriorates by 100r/(100+r)%. To see this, note that if the price of apples rises to $4 per apple, then the apple-price of money falls to 0.25 per apple. Apple inflation averages 100%, and the value of money deteriorates by 100*100/(100+100)% = 50%. Keep in mind, though, that while the value of money deteriorates at that rate, the value of your savings does not, unless you have all your savings in cash. The yields on your various investments will have taken that into account, so that it makes no difference how fast it is deteriorating, as long as it is doing so at a relatively constant rate.