Price Stability Term Paper

Inflation and Deflation: The Issue of Price Stability

Maintaining relatively stable prices is one of the major concerns in all capitalist economies. History shows us that left to its own devices; the capitalist economies undergo frequent "business cycles" that typically consist of a period of surging economic growth, interrupted by economic crises -- often accompanied by the collapse of the monetary system. Alternate bouts of inflation or deflation can also occur if the money supply in an economy is not controlled. Most advanced countries in the world take measures to keep the price stable. In the United States, the Federal Reserve Bank (known as Fed for short) was created in 1913 to avoid such undesirable movements in the economy. This paper examines the causes and consequences of inflation and deflation and the role of the Federal Reserve Bank in the prevention of inflation and deflation and maintaining price stability. It will also look at the limitations of the Federal Reserve in this regard.

Inflation Defined and its Measures

Inflation can be defined as the sustained and continuous rise in the general price levels or a sustained and continuous fall in the value or purchasing power of money. (Makinen, p. 1) It is important to note that inflation refers to general price levels rather than specific price(s) and the rise in price levels must be significant and continue over a longer period to qualify as inflation. There is no single measure or index for measuring inflation but various measures such as the consumer price index, wholesale price index, or the commodity price index are commonly used.

Types of Inflation

Demand pull inflation refers to increase in prices which is the result of excess demand over supply or when too much money is chasing too few goods. Cost push inflation, on the other hand, is the persistent rise in general price levels due to rising input costs.

Causes of Inflation

There are several theories about the causes of inflation but the exact reasons for the phenomenon is still hotlt debated by the economists belonging to different schools of thought. The Monetarists believe that changes in price levels reflect fluctuating volumes of money available. They emphasize the importance of the money supply as the major cause behind inflation. Critics of this theory claim that changes in the money supply are a response to, rather than the cause of, price-level adjustments. (Makinen, p.5)

Keynesian economists emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. They believe that there is an inverse relationship between inflation and unemployment (as explained by the Philips curve

) and that price stability was a trade-off against employment. Keynesian theorists have also advanced the concept of natural Gross Domestic Product (a level of GDP where the economy is at its optimal level of production). According to this concept, if GDP exceeds its natural level, inflation will rise as suppliers increase their prices. On the other hand, if GDP falls below its natural level, inflation will decrease as suppliers attempt to fill excess capacity. (Ibid.)

The third theory about the cause of inflation emphasizes the importance of "supply-side" elements that lower productivity and fuel inflation. These include the changing pace of capital investment and major technological development -- sudden bursts of increased capital investment would fuel inflation; increased government regulations; scarcity of certain raw materials; major social and political developments; and significant economic shocks such as large oil price increases and worldwide crop disasters. (Wilson, pp. 28-29)

In general inflation is caused by an increase in the quantity of money in circulation. Its most dramatic example is the "hyperinflation" caused by excessive printing of money by governments in times of crises, as happened in Germany in the 1920s when the rate of inflation at one stage was 3.25 million % per month!

Deflation: Definition and Measures

Deflation is defined as the sustained and continuous fall in the general price levels of current goods and services or when an economy exhibits a persistently negative rate of inflation. (Buiter, p.3) It is, therefore, the opposite of inflation. It is measured by the same indices that are used to measure inflation.

Causes of Deflation

There are four basic causes of deflation, namely:

1. Decreasing Money Supply

2. Increasing Supply of Goods

3. Decreasing Demand for Goods

4. Increasing Demand for Money

In the real world, deflation generally occurs when the supply of goods increases faster than the supply of money. This may happen when cheap raw material is available due to substantial fall in prices (e.g. lower oil prices); when manufactured goods are available at significantly lower prices due to rapid advances in technology (e.g., the fall in prices of computers the supply of computers to increase at a much faster rate than demand) or the cheap availability of labor (e.g. The emergence of China and India as major global trading forces and integration of the former Communist countries in the world economy). An overvalued currency that lowers the cost of imported goods can be another cause of deflation. Deflation may also be caused by gloomy prospects -- the absence of a "feel good" factor, and lower consumer confidence, i.e., when consumers think that the future may be worse than the present. It can also be triggered in times when people are afraid of losing their jobs and save more than usual. An aging poulation that tends to spend less may also be another important cause of deflation.

How Inflation or Deflation May Damage Economic Stability

Not all inflation or deflation is bad. A certain amount of inflation, in fact, is considered as desirable by most economists to ward off unemployment. Similarly, deflation that is caused by an increased supply of goods may have a beneficial effect on the economy. Deflation caused by the dramatically increased productivity during the industrial revolution in the late 1800s is an example of such "good deflation. Inflation and deflation of a sufficiently high level, especially if sustained for long periods, however, is bad for the economy. The seriousness of persistent inflation, in particular, can be judged by the fact that at least two American Presidents (Ford and Carter) termed it as "public enemy number one." (quoted by Wilson, p. 1)

Let us see how inflation and deflation affect the stability of the economy. Initially, inflation results in some temporary benefits as it tends to increase business profits as wages and other costs lag behind price increases and increases government as well as individual spending because of the "spend now, it will cost more later" attitude. These benefits are only temporary and, in the long run, persistent inflation is invariably disruptive for the economy as well the majority of individuals.

The macroeconomic repercussions of inflation include:

1. Inflation promotes uncertainty since inflation rates often fluctuate. This results in shortsightedness and discourages new productive investment as it becomes a risky proposition.

2. Persistent inflation causes distortions in resource allocation away from long-term productive investments toward unproductive assets such as housing, inventories, real estate, gold, rare paintings etc. Savings are, therefore, channeled in areas that inhibit future growth.

3. High interest rates during periods increases business costs, discourages consumer spending, and depresses the value of stocks and bonds. Higher mortgage interest rates and rapidly escalating prices for homes discourage housing construction.

4. Exports in an economy where there is high inflation decrease and imports increase as the relative prices of domestic goods exceed those of foreign goods. This situation worsens the balance of trade and puts downward pressure on the currency. In the short run, unemployment also rises.

5. After the initial temporary period of high business profits, profits as well as overall economic activity declines due to rising wages, operating and raw material costs.

6. On the individual level, inflation erodes the real purchasing power of current incomes and accumulated financial assets, resulting in reduced consumption, particularly if consumers are unable, or unwilling, to draw on their savings and increase personal debts. Inflation hits those individuals with a fixed income the hardest. In addition, and those with weak bargaining power, the poor, unskilled, and casual workers are the biggest sufferers in times of high inflation. (Wilson, pp. 118-120; Christiano and Fitzgerald, pp. 22-24; Skene pp. 95-99)

Deflation is generally considered to be even more damaging for the stability of the economy. This is because deflation signals "a declining spiral" for the economy -- businesses make less profits and cut back on employment; people spend less money that further impacts the profits of businesses and the vicious circle continues. Deflation also has a psychological aspect to it, as amidst falling prices people lose their desire to buy (believing that prices would fall further) and causes people to hold on to cash rather than to invest the money. The psychological impact is hard to cure. (Moffat, para on "Why is Deflation Bad?")

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