Simply said, inflation is the rate at which prices increase across the economy.
For a long time, Central banks thought that they could keep the economy stable by keeping inflation balanced. But, from the last decade and on, inflation hasn’t just played by the rules.
For instance, despite having a high rate of employment in countries like the United States that normally causes inflation to rise, it’s somehow mysteriously been low across developed countries around the globe. Therefore, central banks haven’t succeeded in increasing it when they want, so this somehow breaks with the classical notion that central banks can manage inflation without hesitation.
In classical economics, price inflation is attributed to excessive growth of the money in circulation, called the ‘quantity theory of money’ even though it is a theory of inflation and not really a theory of money.
In other words, according to his theory, inflation is caused by banks issuing an excessive supply of money. Moreover, banks can only control the terms and rate of interest on loans made.
Following this reasoning, and considering demand and offer, the theory explains that the aggregate price level is determined through the interaction between money supply and money demand. For this reason, and because inflation is an important aspect that affects widely the economy but at the same time can be found back to the basic forces of supply and demand, this theory can qualify as a microfounded model of macroeconomics.
Inflation helps explain why a hamburger costed much less years ago. This can be defined in the following definition of Demand-Pull Inflation:
“too many dollars chasing too few goods”.
According to this, if central banks print too much money or make it very easy to borrow money by keeping interest rates low then prices will rise, because by increasing the purchasing power of people, more goods will be demanded and sold and markets will respond with higher prices if more people can buy them.
If inflation is stable then it doesn’t hurt much of the economy but when it’s high and volatile, in times of uncertainty can damage the economy.
For business, it can make difficult planning, it can make borrowing money and lending money also more difficult because of the interest rates. In countries of higher inflation, for instance, long-term borrowing is more difficult.
To avoid economic difficulties, most central banks keep inflation at 2%.
To stop inflation, central banks tend to increase interest rates. This in turn, makes it more expensive to borrow money and has the effect of slowing economic growth and lower inflation.
A.W. Phillips observed that wages in Britain rose faster when employment was high. He plotted the named “Phillips Curve” with the relationship between salary rates-of-change and unemployment levels:
The Phillips Curve was a curve that central banks used to predict inflation.
In times when more people were employed, wages were rising and people increased its purchasing power and this tended to lead to price increases.
That is, if unemployment is low and wages are therefore rising faster, firms naturally will increase prices because apparently the economy is apparently doing well.
On the other hand, if the economy is weak and unemployment is high, wages stop rising and if firms raise prices further, then they will start losing further customers.
Back in the 1970s there was a spike of oil price and overspending to fund the Vietnam war meant that inflation was increasingly at speed in America. At this time, Paul Volcker, head of the Federal Reserve raised interest rates to a record 20%, a hike in interest known as the “Volcker Shock”. This turn caused inflation to go down by the 1980s.
But, these actions to inflation hit credit loans and created mass unemployment in the U.S.
However, this idea that unemployment matches inflation somehow isn’t working in our modern economic system. When recession came to the U.S., in the global financial crisis of 2007-2009, there was mass unemployment in America but oddly inflation didn’t go down.
Some economists theorise the Phillips curve is dead or at least hibernating.
One explanation is that central banks kept inflation low for so long that people no longer expect inflation to rise even when employment is high. In this scenario, firms are more reluctant to raise their prices or wages if they don’t expect others to do the same.
Another theory is that globalisation has kept prices low by the supply of cheap imports. If for instance, there comes cheap manufacturing from emerging economies, central banks can’t allow other prices to rise.
It’s important to say that central banks have kept interest rates low since the global financial crisis.
Other economists argue that during the financial crisis, firms didn’t cut wages to protect their employees. But also, didn’t raise wages very much during the recovery. These actions of firms, slowed down inflation.
Eventually, salaries and inflation would rise but would take time to do it.
This leads us to our modern world, where before there was a correction of inflation, the pandemic hit, disrupting the economy.
This disruption might help raise inflation to get it back on track.
The pandemic has caused interest rates to go down to almost 0, and a need for greater cooperation between central banks and governments.
Governments of some countries have offered several fierce stimulus packages to cope with the pandemic and ensure spending.
This cooperation could help raise inflation and economic growth and repair the global economy.
Ireland, P. (2014, November). The classical theory of inflation and its uses today. In Shadow Open Market Committee Meeting. New York: Economic Policies for the 21st Century.