Inflation

Inflation popularly means rising general prices, most frequently calculated by the CONSUMER PRICE INDEX (CPI) - a measure of the cost of a basket of commodities purchased by a typical family. The rate of inflation refers to the percentage increase in the price level and is usually expressed at an annual rate; if the CPI rose from 100 to 132 over 2 years, then the price level rose by 32%; that is, the rate of inflation was about 16% annually. Most of the sharp inflation of the 19th and 20th centuries has been associated with major wars, and since WWII prices have generally risen.

The average annual rate of inflation in consumer prices from 1970 to 1975 was 6.5% in the US, 7% in Canada, 6% in West Germany, 12% in the UK, 18% in Yugoslavia, 50% in Argentina and 112% in Chile. In 1981 Canadian inflation reached an annual rate of 12.5%; by 1986 this figure stood at 4.1% and by 1994 it had fallen to 1.7%. In the US, the average annual CPI rose only 1.1% in 1986, the lowest gain in 25 years. By 1994 the rate of inflation in the US stood at 3%.

In an inflationary period, distinctions must be made between money income (measured in dollars) and real income (measured in purchasing power). If money income rises by the same percentage as prices of goods, then real income is unchanged. For real income to increase, money income must rise more than prices. Inflation does not necessarily harm everyone; its main consequence is the redistribution of real income. If prices are stable (the rate of inflation is zero) and A borrows $100 from B at a 2% interest rate, in 1 year B expects to receive $102 in real income. However, if prices rise by 5%, then $102 will not buy what $100 would have bought a year ago; B's real income will be reduced and A's real income will be higher. Unexpected inflation therefore redistributes real income from lenders to borrowers. Pensioners who contributed to PENSION funds when inflation rates were low and are repaid with dollars that are worth much less than anticipated are among those harmed by inflation.

The relationship among prices, employment, wages and profits is complex. Inflation can be halted by decreasing aggregate demand (total spending), achieved with FISCAL POLICY by reducing government expenditure or raising taxes, and with monetary policy by restricting the growth in the supply of money in the economy, thereby raising interest rates and reducing credit. However, much of the initial impact of the reduced aggregate demand is reflected in lower output and employment rather than in prices (even in the 19th century, falling prices were generally associated with fairly high levels of unemployment), so governments have chosen alternatives such as wage and price controls, although these alone will not lastingly affect inflation. However, if controls are used in conjunction with appropriate monetary and fiscal policies, they may help reduce inflation, with fewer harmful side effects.

Economists generally agree that inflation will not continue unless the money supply is allowed to increase; monetarists tend to emphasize control of the money supply, while Keynesians favour other tools such as wage and price controls. See also STAGFLATION.