Print More Money

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Let's Just Say It: Print More Money

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It is clear now that fiscal stimulus has not engendered a V-recovery and deflation is here in spades as money velocity and quantity plummet. Bankruptcies, defaults, and deleveraging are destroying money at an historic pace, perhaps as much as $12 trillion USD in the past 18 months, crashing prices for houses, oil, flat panel televisions, and falloff in purchases of labor, food, and clothing. Price cuts for non-commodities have been moderated as corporate managers cling to what little pricing power they have since they're unwilling to crash their wages. As our economy unwinds, we stare out the back window wondering what we can grow for food, and wonder what happened to Ben Bernanke's helicopter

When excess capacity is pandemic, and when half the planet is still living in near poverty- why isn't economy activity booming? Well, it was, but then the Fed increased interest rates 18 times. 18, stealing cash for debt service and profit coverage, like reducing the oxygen in a room full of students building a human pyramid- and when a couple of them faltered, the whole thing started coming down.

So what's the solution that will rebuild the pyramid - just tell them to get up? No. Prop a couple of them up? No. The answer should be obvious: more oxygen, in concentrated form, the sooner the better - and a promise not to cut it off again.

So, where's the money? Where's the quantitative easing? Not token hundreds of billions. Trillions. Dollars. Without sterilization. The kind of money that will create - no, force - inflation. Unfortunately, there are still too many inflation hawks and scarcity paradigm acolytes in the mix, the chicken littles of our day.

It is clear this generational crisis needs serious action. Not so much to preserve the supply and demand that are being destroyed- those can be rebuilt fairly quickly, if demand returns. Rather, the rules of capitalism- rewarding risk and competition with reward- have been broken, and if not fixed the confidence and desire to play the game will be greatly diminished. And given the massive increase in global living standards the past 30 years, this would be a bad thing for human progress.

So, print money. It's an economic tool actually bestowed by the Constitution to Congress (who's outsourced it to the Fed). Buy Treasuries and oil with newly minted dollars. Sure, the price of imported commodities will skyrocket. Exchange rates will shift (though many countries are in our same boat). Long term interest rates will increase. But aren't these all necessary? When an hour of labor in the US costs many times what it costs in the developing world, shouldn't there be a shift? And when we're drowning in debt, who needs more?

Hyperinflation, you say? The US is not Zimbabwe - we have way more productive capacity and supply potential. So oil goes back to $120 and gas $4/gallon - we can telecommute while we build out solar and the smart grid. Food climbs - the government can stop paying farmers to not grow crops. Travel to China- the Olympics were last year. Meanwhile, shifting exchange rates help exporters and employment grows. Real labor prices and home prices recover, toxic assets become less toxic, and consumers start buying again- reviving the tattered export economies of China and Japan to offset devaluation of their dollars - and they start to take advantage of the affordability of a vacation in the USA.

As prices and utilization rise, payback on investment in new capacity improves, and economies of scale, technological substitution, competition, and specialization mitigate price increases. And investors see that inflation will rob them of deals, and come off the sidelines to invest in productive ventures sooner rather than later.

And then, Congress must act to keep Fed fund rates low - for a long time. The next time GDP approaches 4%, tell anyone who uses the word "overheated" to take their Philips curve and go home and plant their garden. Encourage global development, alternative energy development, cyberspace development, to alleviate your commutes, our sickness, and our ignorance.

Once money and velocity recover, what will happen to stock prices? They'll go up, along with all other assets, in dollar terms. What will be the big winners? Probably oil, although alternative solutions will eventually force much of it to rot in the ground. Probably gold, although productive assets that once can have confidence in without an assay or forensic accountant should increase in value more. Probably copper, although aluminum wires and wireless could create a major shift in consumption. Emcore (EMKR) is positioned as the arms dealer in the solar wars, Boeing (BA) the arms dealer in the travel wars, and Microsoft (MSFT) the arms dealer in the cyberspace wars - and is there a more optimistic view of the future than clean energy powering both real and virtual exploration?

Without having to pick the winners, if the government (and European Central Banks in the same predicament) just fuels the economy with enough money, equilibrium can be reached by the market without massive government intervention, and further damage to the rules of the game. And once we recover, more and more people are poised to enter the game, which is good for everyone.

So, Mr. Bernanke, please take off, and drop the cash as you've promised. Trillions, sir, trillions.

Why Not Just Print More Money?

http://economics.about.com/cs/money/a/print_money.htm

If we print more money, prices will rise such that we're no better off than we were before. To see why, we'll suppose this isn't true, and that prices will not increase much when we drastically increase the money supply. Consider the case of the United States. Let's suppose the United States decides to increase the money supply by mailing every man, woman, and child an envelope full of money. What would people do with that money? Some of that money will be saved, some might go toward paying off debt like mortgages and credit cards, but most of it will be spent. I know the first thing I'd do is go down to Walmart and buy an Xbox or PlayStation 2 (if you have an opinion of which I should buy e-mail me by using the feedback form).

I'm not going to be the only one who runs out to buy an Xbox. This presents a problem for Walmart. Do they keep their prices the same and not have enough Xboxes to sell to everyone who wants one, or do they raise their prices? The obvious decision would be to raise their prices. If Walmart (along with everyone else) decides to raise their prices right away, we would have massive inflation, and our money is now devalued. Since we're trying to argue this won't happen, we'll suppose that Walmart and the other retailers don't increase the price of Xboxes. For the price of Xboxes to hold steady, the supply of Xboxes will have to meet this added demand. If there are shortages, certainly the price will rise, as consumers who are denied an Xbox will offer to pay a price well in excess of what Walmart was formerly charging.

For the retail price of the Xbox not to rise, we will need the producer of the Xbox, Microsoft, to increase production to satisfy this increased demand. Certainly this will not be technically possible in some industries, as there are capacity constraints (machinery, factory space) that limit how much production can be increased in a short period of time. We also need Microsoft not to charge retailers more per system, as this would cause Walmart to increase the price they charged to consumers, as we're trying to create a scenario where the price of the Xbox won't rise. By this logic we also need the per-unit costs of producing the Xbox not to rise. This is going to be difficult as the companies that Microsoft buys parts from are going to have the same pressures and incentives to raise prices that Walmart and Microsoft do. If Microsoft is going to produce more Xboxes, they're going to need more man hours of labor and obtaining these hours cannot add too much (if anything) to their per-unit costs, or else they will be forced to raise the price they charge retailers.

Wages are essentially prices; an hourly wage is the price a person charges for an hour of labor. It will be impossible for hourly wages to stay at their current levels. Some of the added labor may come through employees working overtime. This clearly has added costs, and workers are not likely to be as productive (per hour) if they're working 12 hours a day than if they're working 8. Many companies will need to hire extra labor. This demand for extra labor will cause wages to rise, as companies bid up wage rates in order to induce workers to work for their company. They'll also have to induce their current workers not to retire. If you were given an envelope full of cash, do you think you'd put in more hours at work, or less? Labor market pressures require wages to increase, so product costs must increase as well.

In short prices will go up after a drastic increase in the money supply because:

1. If people have more money, they'll divert some of that money to spending. Retailers will be forced to raise prices, or run out of product.

2. Retailers who run out of product will try to replenish it. Producers face the same dilemma of retailers that they will either have to raise prices, or face shortages because they do not have the capacity to create extra product and they cannot find labor at rates which are low enough to justify the extra production.

In articles such as "Why Does Money Have Value?", "The Demand For Money", and "Prices and Recessions" we've seen that inflation is caused by a combination of four factors. Those factors are:

* The supply of money goes up.

* The supply of goods goes down.

* Demand for money goes down.

* Demand for goods goes up.

We've seen why an increase in the supply of money causes prices to rise. If the supply of goods increased enough, factor 1 and 2 could balance each other out and we could avoid inflation. Suppliers would produce more goods if wage rates and the price of their inputs wouldn't increase. However, we've seen they will increase. In fact, it's likely that they'll increase to such a level where it will be optimal for the firm to produce the amount they would have if the money supply had not increased.

This gets us to why drastically increasing the money supply on the surface seems like a good idea. When we say we'd like more money, what we're really saying is we'd like more wealth. The problem is if we all have more money, collectively we're not going to be any more wealthy. Increasing the amount of money does nothing to increasing the amount of wealth or more plainly the amount of stuff in the world. Since the same number of people are chasing the same amount of stuff, we cannot on average be wealthier than we were before.

The Effects of Inflation

Even moderate inflation can cause problems because it lessens the practical advantages of using money instead of having to trade. This can be better understood if you look at the four functions that economists generally attribute to money and the way that inflation affects them:

* Money is a storage of value. If you were to sell a horse for 10 gold coins, you should be able to go back and change that money in for another horse tomorrow or the next week or the next month. When money holds its value, you feel safe saving it, and instead of selling a horse, you might be in situation in which you sell real estate or any other asset.

* Inflation weakens the function of money as a storage of value, because each unit of money is worth less with the passing of time.

* Money is a standard unit of account. If you are interested in buying a sheep, you will probably not want to take the sheep as a loan with the commitment of paying off two sheep the next year. Most likely you will get a loan and pay it in monetary terms. In other words, get a loan of one gold coin to buy your sheep, with the commitment of paying two gold coins next year.

* The progressive loss of the value of money during a period of inflation makes the borrowers to be less willing to use the money as standard differed payments. Suppose that a friend asks you to loan him $100, and commits to paying you $120 within a year. This seems like a good deal - after all this is an interest weigh of twenty percent. But if the prices are increasing rapidly and the value of money is decreasing, how much will you be able to buy with those $120?

* Inflation makes people be less willing to loan out money. They fear that once the loans are paid off, the money they receive will not have the same buying value then the money loaned. This uncertainty can cause a devastating effect over the development of new businesses, that to finance their businesses are based a good amount on loans.

* Money is a means of exchange. Money is a means of exchange between buyers and sellers because it can be directly changed for anything else, which makes buying and selling a lot easier. In an economy of trade, an apple producer that wants to buy chocolate might see himself first forced to buy oranges and then exchange the oranges for the chocolate, because it is possible that the chocolate salesperson only wants oranges. Money however, eliminates this type of problem.

* But if inflation is high enough, money is no longer an effective means of exchange. During hyperinflations, frequently the economies go back to trading and this way, the buyers and sellers do not have to worry for the loss of the value of money. For example, in a healthy economy the apples sales man can sell them for money and then change this money in for chocolate. But during hyperinflation, while he is selling the apples for money and buys the chocolate, the price of the chocolate could have increased so much that he is not longer able to buy chocolate. During a hyperinflation, the economies have to go to tricky trades.

Another result of inflation is that it produces a similar effect to a significant increase of taxes. This may seem strange, because we normally consider the government charge taxes taking part of the people's money from them, no by printing more money. But a tax is basically anything that transfers private property to the government. The alternation of the money or printing of more money can have this effect.

Suppose that the government wants to buy a new van that is going to cost $20,000 for the national library. The right way to do this would be to use $20,000 from the income taxes to buy it. A sneaky way of doing it would be to print up the $20,000 of new money. By printing and spending new money, the government has turned $20,000 of private property, which in this case is the van, into public property. So this means that printing new money works exactly like a tax. Since printing new money generates inflation, this type of tax is generally known as an inflationary tax.

An inflationary tax is not only sneaky, but also unjustly affects the poor because they spend almost all of their income on goods and services that go up considerable during inflation. In comparison, since the rich are able to save a high proportion of their income instead of spending almost everything they receive, an inflationary tax affects them proportionately less. The rich can protect themselves from a great part of the damage caused by inflation by inverting their savings into assets, such as root property, whose prices increase during inflation.
tory 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 seigniorage.[11] 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 decrease, 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.[12]

By the nineteenth century, economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the value or resource costs of the good, a change in the price of money which then was usually a fluctuation in metallic content in the currency, and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. Following the proliferation of private bank note currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable bank notes outstripped the quantity of metal available for their redemption. The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods.[13]

This relationship between the over-supply of bank notes and a resulting depreciation in their value was noted by earlier classical economists such as David Hume and David Ricardo, who would go on to examine and debate to what effect a currency devaluation (later termed monetary inflation) has on the price of goods (later termed price inflation, and eventually just inflation).[14]

Related definitions

The term "inflation" usually refers to a measured rise in a broad price index that represents the overall level of prices in goods and services in the economy. The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some examples of broad price indices. The term inflation may also be used to describe the rising level of prices in a narrow set of assets, goods or services within the economy, such as commodities (which include food, fuel, metals), financial assets (such as stocks, bonds and real estate), and services (such as entertainment and health care). The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Asset price inflation is a rise in the price of assets, as opposed to goods and services. Core inflation is a measure of price fluctuations in a sub-set of the broad price index which excludes food and energy prices. The Federal Reserve Board uses the core inflation rate to measure overall inflation, eliminating food and energy prices to mitigate against short term price fluctuations that could distort estimates of future long term inflation trends in the general economy.[15]

Other related economic concepts include: deflation - a fall in the general price level; disinflation - a decrease in the rate of inflation; hyperinflation - an out-of-control inflationary spiral; stagflation - a combination of inflation, slow economic growth and high unemployment; and reflation - an attempt to raise the general level of prices to counteract deflationary pressures.

Measures

Annual inflation rates in the United States from 1666 to 2004.

Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price Index.[16] The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer".[17] The inflation rate is the percentage rate of change of a price index over time.

For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007.[18]

Other widely used price indices for calculating price inflation include the following:

* Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes.

* Producer price indices (PPIs) which measures average changes in prices received by domestic producers for their output. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any eventual increase in the CPI. Producer price index measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index.

* Commodity price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee.

* Core price indices: because food and oil prices can change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when those prices are included. Therefore most statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a broad price index like the CPI. Because core inflation is less affected by short run supply and demand conditions in specific markets, central banks rely on it to better measure the inflationary impact of current monetary policy.

Other common measures of inflation are:

* GDP deflator is a measure of the price of all the goods and services included in Gross Domestic Product (GDP). The US Commerce Department publishes a deflator series for US GDP, defined as its nominal GDP measure divided by its real GDP measure.

* Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US.

* Historical inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation s. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology.

* Asset price inflation is an undue increase in the prices of real or financial assets, such as stock (equity) and real estate. While there is no widely-accepted index of this type, some central bankers have suggested that it would be better to aim at stabilizing a wider general price level inflation measure that includes some asset prices, instead of stabilizing CPI or core inflation only. The reason is that by raising interest rates when stock prices or real estate prices rise, and lowering them when these asset prices fall, central banks might be more successful in avoiding bubbles and crashes in asset prices.[dubious - discuss]

Issues in measuring

Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. For example, if the price of a 10oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price difference represents inflation. This single price change would not, however, represent general inflation in an overall economy. To measure overall inflation, the price change of a large "basket" of representative goods and services is measured. This is the purpose of a price index, which is the combined price of a "basket" of many goods and services. The combined price is the sum of the weighted average prices of items in the "basket". A weighted price is calculated by multiplying the unit price of an item to the number of those items the average consumer purchases. Weighted pricing is a necessary means to measuring the impact of individual unit price changes on the economy's overall inflation. The Consumer Price Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price.[10]

Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Over time adjustments are made to the type of goods and services selected in order to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time in order to keep pace with the changing marketplace.

Inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost shifts. For example, home heating costs are expected to rise in colder months, and seasonal adjustments are often used when measuring for inflation to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices.

When looking at inflation economic institutions may focus only on certain kinds of prices, or special indices, such as the core inflation index which is used by central banks to formulate monetary policy.

Most inflation indices are calculated from weighted averages of selected price changes. This necessarily introduces distortion, and can lead to legitimate disputes about what the true inflation rate is. This problem can be overcome by including all available price changes in the calculation, and then choosing the median value. This measure is known as "median inflation".

Effects
General

An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services.[19] The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money. For example, with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments.[10]

Increases in the price level (inflation) erodes the real value of money (the functional currency) and other items with an underlying monetary nature (e.g. loans and bonds). However, inflation has no effect on the real value of non-monetary items, (e.g. goods and commodities, gold, real estate).[20]

Negative

High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation.[10] Uncertainty about the future purchasing power of money discourages investment and saving.[21] And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates.

With high inflation, purchasing power is redistributed from those on fixed incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation.[10] This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.

Cost-push inflation

Rising inflation can prompt employees to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral.[22] In a sense, inflation begets further inflationary expectations.

Hoarding

People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.

Hyperinflation

If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.

Allocative efficiency

A change in the supply or demand for a good will normally cause its price to change, signalling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, genuine price signals get lost in the noise, so agents are slow to respond to them. The result is a loss of allocative efficiency.

Shoe leather cost

High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.

Menu costs

With high inflation, firms must change their prices often in order to keep up with economy wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly.

Business cycles

According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.[23]

Positive

Labor-market adjustments

Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster.

Debt relief

Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The “real” interest on a loan is the nominal rate minus the inflation rate.[dubious - discuss] (R=n-i) For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate.

Room to maneuver

The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.

Tobin effect

The Nobel prize winning economist James Tobin at one point had argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects. See Tobin monetary model[24]

Causes

The Bank of England, central bank of the United Kingdom, monitors causes and attempts to control inflation.

Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the quantity equation of money, that relates the money supply, its velocity, and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.[citation needed]

Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.[25] The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.

Keynesian view

Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices. The supply of money is a major, but not the only, cause of inflation.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":[26]

* Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.

* Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.

* Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Demand-pull theory states that the rate of inflation accelerates whenever aggregate demand is increased beyond the ability of the economy to produce (its potential output). Hence, any factor that increases aggregate demand can cause inflation. However, in the long run, aggregate demand can be held above productive capacity only by increasing the quantity of money in circulation faster than the real growth rate of the economy. Another (although much less common) cause can be a rapid decline in the demand for money, as happened in Europe during the Black Death, or in the Japanese occupied territories just before the defeat of Japan in 1945.

The effect of money on inflation is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively. This sometimes leads to hyperinflation, a condition where prices can double in a month or less. Money supply is also thought to play a major role in determining moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economists, by contrast, typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians, the money supply is only one determinant of aggregate demand.

Some Keynesian economists also disagree with the notion that central banks fully control the money supply, arguing that central banks have little control, since the money supply adapts to the demand for bank credit issued by commercial banks. This is known as the theory of endogenous money, and has been advocated strongly by post-Keynesians as far back as the 1960s. It has today become a central focus of Taylor rule advocates. This position is not universally accepted - banks create money by making loans, but the aggregate volume of these loans diminishes as real interest rates increase. Thus, central banks can influence the money supply by making money cheaper or more expensive, thus increasing or decreasing its production.

A fundamental concept in inflation analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment. The Phillips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s.

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.

Another concept of note is the potential output (sometimes called the "natural gross domestic product"), a level of GDP, where the economy is at its optimal level of production given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.

However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under British Prime Minister Margaret Thatcher might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed (also see unemployment), unable to find jobs that fit their skills. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.

Monetarist view

Monetarists believe the most significant factor influencing inflation or deflation is the management of money supply through the easing or tightening of credit. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation.[27] According to the famous monetarist economist Milton Friedman, "Inflation is always and everywhere a monetary phenomenon."[28]

Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. This theory begins with the identity:

M \cdot V = P \cdot Q

where

M is the quantity of money.

V is the velocity of money in final expenditures;

P is the general price level;

Q is an index of the real value of final expenditures;

In this formula, the general price level is affected by the level of economic activity (Q), the quantity of money (M) and the velocity of money (V). The formula is an identity because the velocity of money (V) is defined to be the ratio of final expenditure ( P \cdot Q ) to the quantity of money (M).

Velocity of money is often assumed to be constant, and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With constant velocity, the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not constant, and can only be measured indirectly and so the formula does not necessarily imply a stable relationship between money supply and nominal output. However, in the long run, changes in money supply and level of economic activity usually dwarf changes in velocity. If velocity is relatively constant, the long run rate of increase in prices (inflation) is equal to the difference between the long run growth rate of money supply and the long run growth rate of real output.[7]

Rational expectations theory

Main article: Rational expectations theory

Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.

A core assertion of rational expectations theory is that actors will seek to "head off" central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession.

Austrian theory

The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation.[29] Austrian economists believe there is no material difference between the concepts of monetary inflation and general price inflation. Austrian economists measure monetary inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time.[30][31][32] This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply.[33] In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.[34]

Austrians argue that the state uses inflation as one of the three means by which it can fund its activities (inflation tax), the other two being taxation and borrowing.[35] Various forms of military spending is often cited as a reason for resorting to inflation and borrowing, as this can be a short term way of acquiring marketable resources and is often favored by desperate, indebted governments.[36]

In other cases, Austrians argue that the government actually creates economic recessions and depressions, by creating artificial booms that distort the structure of production. The central bank may try to avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions or depressions by artificially trying to "stimulate" the economy through "encouraging" money supply growth and further borrowing via artificially low interest rates.[37] Accordingly, many Austrian economists support the abolition of the central banks and the fractional-reserve banking system, and advocate returning to a 100 percent gold standard, or less frequently, free banking.[38][39] They argue this would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth (and inflation) would never spiral out of control.[40][41]

Real bills doctrine

Main article: Real bills doctrine

Within the context of a fixed specie basis for money, one important controversy was between the quantity theory of money and the real bills doctrine (RBD). Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. Currency and banking schools of economics argue the RBD, that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the 19th century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as currency boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of the Federal Reserve going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with libertarian principles of laissez-faire, even though almost all libertarian economists are opposed to the RBD.

The debate between currency, or quantity theory, and banking schools in Britain during the 19th century pres current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.

Anti-classical or backing theory

Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory". The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency.[42] Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions. There are very few backing theorists, making quantity theory the dominant theory explaining inflation.[citation needed]

Today the primary tool for controlling inflation is monetary policy. 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.

There are a number of methods that have been suggested to control inflation. 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. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.

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).

Fixed exchange rates

Main article: Fixed exchange rate

Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

Under the Bretton Woods agreement, most countries around the world had currencies that were fixed to the US dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attacks. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e.g. Argentina (1991-2002), Bolivia, Brazil, and Chile).

The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver.

Gold was a common form of representative money due to its rarity, durability, divisibility, fungibility, and ease of identification.[43] Representative money and the gold standard were used to protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression. However, they were not without their problems and critics, and so were partially abandoned via the international adoption of the Bretton Woods System. Under this system all other major currencies were tied at fixed rates to the dollar, which itself was tied to gold at the rate of $35 per ounce. The Bretton Woods system broke down in 1971, causing most countries to switch to fiat money - money backed only by the laws of the country. Austrian economists strongly favor a return to a 100 percent gold standard.

Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output.[44] Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining,[45][46] which some believe contributed to the Great Depression.[46][47][48]

Wage and price controls

Main article: Incomes policies

Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands.

In general wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.

Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed (see creative destruction).

Cost-of-living allowance

For more details on this topic, see Cost of living.

The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as social security) are tied to a cost-of-living index, typically to the consumer price index.[49] A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually.[49] They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.

Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally-determined indexes. Many economists and compensation analysts consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized world, average wages have increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity and worker bargaining power rather than simply living costs, and (2) most cost-of-living indexes are not forward-looking, but instead compare current or historical data

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