History of inflation

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In the 1980s President Reagan, Mrs Thatcher, Chancellor Kohl, and many other national leaders named inflation as public enemy number one. In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Persistent inflation over many years is in fact quite a recent phenomenon. Before 1950, prices tended to rise in some years but fall in other years. In the UK the price level – the average price of goods as a whole – was no higher in 1950 than it had been in 1920. The UK price level fell quite sharply during some of the interwar years when inflation was negative. Yet since 1945 there has not been a single year in which the price level fell. Since 1950 the price level has increased by a factor of ten, more than its increase over the previous three centuries. This broad picture applies not only in the UK but also in most of the advanced economies.

To understand the costs of inflation we need to understand the effects of inflation. Monetarists say that inflation is caused by too much money chasing too few goods. They attribute this excess demand for goods to an increase in the nominal money supply. The real money supply M/P is the nominal money supply M divided by the price level P. People demand money because of its purchasing power in terms of goods.

When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation is also a decline in the real value of money – a loss of purchasing power in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate – the percentage change in a general price index (normally the Consumer Price Index) over time.

Inflation can have positive and negative effects on an economy. Negative effects of inflation include: uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include debt relief by reducing the real level of debt.

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.

Today, most mainstream economists favor a low steady rate of inflation. Low inflation (as opposed to zero or negative) may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.

Inflation originally referred to the debasement of the currency. When gold was used as currency, gold coins could be collected by the government, melted down, mixed with other metals such as silver, copper or lead, and reissued at the same nominal value. By diluting the gold with other metals, the government could increase the total number of coins issued without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in seignior age (the net revenue derived from the issuing of currency). This practice would increase the money supply but at the same time lower the relative value of each coin. As the relative value of the coins decreases, consumers would need more coins to exchange for the same goods and services. These goods and services would experience a price increase as the value of each coin is reduced.

Today the primary tool for controlling inflation is monetary policy. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum. A low positive inflation is usually targeted, as deflationary conditions are seen as dangerous for the health of the economy.

Monetarists emphasize keeping the growth rate of money steady, and using monetary policy to control inflation (increasing interest rates, slowing the rise in the money supply). Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy (increased taxation or reduced government spending to reduce demand).

Match a line in A with a line in B (as in the text).

A	B
1. labour 2. average 3. advanced 4. market 5. cash 6. relative 7. credit 8. currency 9. controlled 10. reserve	a) price b) inflation c) operations d) depreciation e) efficiency f) account g) economies h) requirements i) payments j) value

Match up the words with a close meaning.

1. average 2. shortage 3. size 4. consensus 5. target 6. persistent 7. evaluate 8. wealthy 9. recession 10. sustain 11. deflate

a) agreement b) steady, stable c) rich d) dimension e) deficit, scarcity, lack f) downturn, deflation, decrease g) aim, purpose, goal h) decrease i) appreciate, assess j) standard, medium k) continuous

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