What is Inflation?

Welcome back everyone.  Happy New Year!  I hope your Christmas and New Year was not too perilous.  Back to Work…

In this blog I am only considering inflationary pressures that arise from nominal demand (spending) growth outstripping the real capacity of the economy to react to it with output responses. In other words, I am excluding inflation that may arise from supply shocks – such as a rise in an imported raw material (for example, oil). That is another issue altogether.

The reason I am excluding supply-driven inflationary impulses is because the mainstream attack on the current use fiscal policy (and monetary policy) is really about demand pressures. We are continually reading crude statements such as there is “too much money” in the system.

Further, the mechanisms through which the supply shocks manifest are different and this deserves a separate analysis, which will come in a subsequent blog.

However, the solution to both sources of inflation is not that dissimilar although additional measures might be brought to bear to handle the case of a price hike in an imported raw material.

First we should make sure what we are talking about. Many conservative commentators think that when workers get a pay rise it is inflation. It is not. Those on the left think that when the corporate sector increase the price of a good or service it is inflation. It is not.

It is also not inflation when the exchange rate falls pushing the price of imports up a step. So a depreciation in the currency does not constitute inflation. It might stimulate inflation but is not in itself inflation.

It is also not inflation when the government increases a particular tax (say the VAT or GST) by x per cent to some new level.

So while a price rise is a necessary condition for inflation it is not a sufficient condition. Observing a price rise alone will not be sufficient to categorise the phenomena that you are observing as being an inflationary episode.

Inflation is the continuous rise in the price level. That is, the price level has to be rising each period that you observe it. So if the price level or a wage level rises by 10 per cent every month, then you have an inflationary episode. In this case, the inflation rate would be considered stable – a constant rise per period.

If the price level was rising by 10 per cent in month one, then 11 per cent in month two, then 12 per cent in month three and so on, then you have accelerating inflation. Alternatively, if the price level was rising by 10 per cent in month one, 9 per cent in month two etc then you have falling or decelerating inflation.

If the price level starts to continuously fall then we call that a deflationary episode.

Hyper-inflation is just inflation big-time!

So a price rise can become inflation but is not necessarily inflation. Many commentators and economists get this basic understanding wrong – often and continually.

Second, it also follows that cyclical adjustments in price levels by firms from what they are currently offering at depressed levels of activity to what the price levels that are defined at their normal operating capacity levels are not inflation. When the economy is in poor shape, firms cut prices in an attempt to increase capacity utilisation by temporarily suppressing their profit margins and hence maintain market share. As demand conditions become more favourable the firms start increasing the prices they offer until they get back to those levels that offer them the desired rate of return at normal capacity utilisation.

Firms are basically quantity adjusters if they have spare capacity. They will seek to maintain market share when nominal demand grows by increasing output where possible. Should nominal demand growth (supported in part by net public spending) outstrip this capacity then firms will become price adjusters, because they can no longer expand real output.

Bottlenecks in some sub-markets may occur before other sectors are at full capacity and so price pressures might emerge just before overall full capacity is reached. So, in reality, the aggregate supply response (which tells you how much real output will be forthcoming at each price level) may not be strictly reverse-L shaped (where price is on the vertical axis and output on the horizontal axis). The extent to which the reverse-L becomes a curve at at a point approaching full capacity is an empirical matter.

Inflation occurs when there is chronic excess demand relative to the real capacity of the economy to produce.

In the next few posts we’ll deal with some myths surrounding inflation hysteria.  We will also deal with some of the more advanced concepts of Modern Money Mechanics so put your thinking cap on.

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3 Responses to What is Inflation?

  1. Hi Senexx. Came here from Heteconomist. Nice, “clean” looking blog.

    I like the “quantity adjusters” versus “price adjusters” explanation. Never saw that before. But… you write:
    Inflation occurs when there is chronic excess demand relative to the real capacity of the economy to produce.
    That is only demand-pull inflation. I know you said so above, but your statement does not feel limited by that constraint. And you write:
    Bottlenecks in some sub-markets may occur before other sectors are at full capacity and so price pressures might emerge just before overall full capacity is reached.
    (Again, I am aware that I am ignoring your constraint.)
    We seem to be having a resurgence of inflation at present. But surely we are not “just before” the point at which full capacity is reached.

    The view that there is a gap between “enough growth to cause inflation” and “enough lethargy to cause unemployment” is a view that should have died forever with the rise of stagflation in the 1970s.

    If economics is to serve any purpose, it must explain the disappearance of that gap. But to the present day, I do not find people who even acknowledge the disappearance of that gap.

    Art S.


  2. senexx says:

    Hi Art,

    The news about the prospect of global inflation has only just reached me. I haven’t looked into it deeply yet.

    I suspect that is inflation expectations on a supply side shock with all the disruptions in Africa-Middle East. Warren Mosler has a couple quick and good posts on the issue. Mainly he notes that Saudi Arabia sets the price on oil & to keep things restrained they’re going to produce more oil.



  3. Karl says:

    Don’t you think that the real cause of inflation is the exessive interest expense paid by the producers in the real economy?

    In a sound economy supply should create its own demand. A baker may supply bread to buy wheat, a rice producer supplies rice to buy some other commodity. One can only demand something by supplying something in return. How can demand then exceed supply when the source of demand is supply? This is why one will never experience inflation in a barter economy.

    I believe that the root cause of inflation in our current monetary system is that we expect money to be a store of value and not just a medium of exchange. The store of value leads to people with money earning more money for simply hoarding the medium of exchange. This leads to low velocity of circulation. Money is the only factor of production that earns a return when it is idle. Our education has taught us the complete opposite. Interest rates do not compensate us for inflation but are the chief cause of rising prices. It is the compound interest that leads to higher prices because the interest expenses invariably grows at a rate higher than the gdp growth rate.


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