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Causes and cost of inflation
David Ranson, The Zimbabwe Independent
May 18, 2007

http://www.encyclopedia.com/doc/1Y1-106518887.html

INFLATION is the loss in purchasing power of a currency unit, usually expressed as a general rise in the prices of goods and services.

A classic example is the Great Inflation of the Roman Empire. Successive emperors replaced a steadily increasing fraction of the silver in their ancient currency, the denarius, with base metals like bronze or copper. As a result prices rose inexorably despite repeated attempts to restrain them through legislation. Diocletian, rather than taking responsibility for the debasement, attributed the rapid inflation of his day to the avarice of his subjects.

His famous edict of AD 301 threatened with death any vendor who charged prices exceeding official limits. But inflation ran along unhindered for another century until an alternative currency, an undepreciated gold coin known to Shakespeare as the bezant, became the customary unit of account, spreading throughout Europe and lasting well into the Middle Ages.

In modern times inflation continues to be blamed on private greed, and governments still seek to restrain it by decree, sometimes even devaluing their currencies as they do so.

We have many measures of inflation, but none provides a truly reliable gauge of inflation at any specific time. The most widely watched measure is the consumer price index (CPI), published monthly in most countries.

The problem with the CPI is that the weight attached to each class of goods and services is held constant for years at a time. Therefore, when consumers lower their cost of living by buying more items whose relative price has fallen and fewer items whose relative price has risen, the CPI will not show a decline in the cost of living.

Moreover, the difficult problem of allowing for changing quality has never been solved. Nor can the government inspectors who collect the data from retailers track down all the sales and discounts of which consumers are so keenly aware. As a result of these and other factors, the consumer price index reflects inflation trends only with a long delay and portrays an artificially smooth path for the inflation rate.

Other indicators of inflation include producer prices and unit-value indexes for imports and exports. As we move back through the distribution chain from the consumer toward the supplier of raw materials, a more jumpy picture of inflation is revealed at each step.

In the news media, discussion of inflation often takes a "bottom up" view. Each month's change in the CPI can be, and is, split up into dozens of components, such as food, energy and housing. It is tempting to see the sectors where prices rose the most as causes of the observed inflation. This way of looking at inflation is mistaken. The prices of some items always are rising or falling relative to others. Surely inflation is not simply the sum total of a collection of independent price changes, as the arithmetic of the CPI implies. It is the degree to which all of the prices move in concert.

What does inflation cost? Economists who view inflation as a very serious problem point to what they call the "inflation tax". By this they mean the reduction in the purchasing power of the cash balances held by the private sector - like a wealth tax. This tax is a drag on the economy - an "efficiency loss" - because it induces people and businesses to economise on cash balances, making it more difficult to participate in the money economy.

Economic losses associated with the inflation tax and other distortions are known as the "welfare cost of inflation." At one extreme of the debate, Harvard economist Martin Feldstein has claimed that the present value of the losses that result from unending inflation may be infinite! His argument is that each year the cost to the economy grows in proportion to society's money balances. Because the rate of growth of money balances exceeds the interest rate he uses to calculate the present value, the present value is unbounded.

The increase in government spending could be claimed as either a cost or a benefit to the economy, depending on whether one wants more or less government spending. But there is a real cost that is not ambiguous. High tax rates on employment, on business investment, and on the accumulation of capital deter all these activities in favor of untaxed uses of the economy's resources and, therefore, impede output and growth.

Still more difficult than measuring inflation is the problem of identifying its root causes. In spite of its long and rich history, few subjects in the field of economics are more confused. Professional economists have still not reached broad agreement as to the origins of the inflation process.

Two camps dominate the debate. Some see inflation as a malady of the currency (as was surely the case in the Roman Empire). In the words of Milton Friedman: "Inflation is always and everywhere a monetary problem." Others see nonmonetary forces at work, such as monopolies, union demands for higher wages, oil politics, or the "wage-price spiral".

Some nonmonetary ideas are illogical. The existence of monopoly power or union power might be argued to raise prices generally relative to what they otherwise would be. But a continuing price rise year-in year-out requires a continuing increase in the degree of monopoly or union power in the economy. This is neither plausible over long periods of time, nor consistent with evidence from recent decades for the United States.

Nonmonetary theories of inflation traditionally separate "demand-pull" sources from "cost-push" factors like oil, monopoly power, or wages. A surge in the demand for goods and services in general ("aggregate demand") is thought to "pull" prices up across the board, especially when "aggregate supply" is held back by inertia or capacity limitations. Sceptics rightly question how demand could constantly outstrip supply. Surely, demand must originate from purchasing power, purchasing power from wealth, wealth from income, and income from the ability to produce (and hence supply) goods and services.

Other logical objections to the idea of demand-pull inflation center on the importance of money. How could prices rise without a commensurate increase in the quantity of money in private hands? If such a thing happened, the purchasing power of the quantity of money would have declined involuntarily, and that would not be consistent with market equilibrium. Economists of the "monetarist" school emphasize the power and discretion of government to vary the money supply, causing private markets to bring the economy's price structure into conformity.

Among those who attribute inflation to monetary causes, at least two quite different views exist. The monetarist view is that increases in the quantity of money cause inflation. Critics of this view point out that the quantity of money is difficult to define, especially when funds can be transferred electronically and credit cards can substitute for cash balances. It can also be argued that people have freedom to choose the quantity of money they want to hold rather than merely accept the quantity the government wishes to impose upon them.

The other monetary view, held historically by opponents of fiat (ie, government) paper money, and by advocates today of restoring the gold standard, is that the quantity of money can take care of itself. What really is needed, according to this view, is a mechanism for keeping the price of the currency stable, for providing an anchor, so to speak.

Governments have been slow to accept the recommendations of either of these camps. That probably is because either a strict monetary rule or strict adherence to a gold standard or other price rule would place strict limits on discretionary government management of the economy.

* David Ranson is president of HC Wainwright and Company, Economics, an investment research firm in Boston. He was formerly an assistant to the secretary of the Treasury in Washington.

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