At its most basic level, inflation is a general increase in prices across the economy and is well-known to all of us. After all, who among us has not reminisced about cheap rents of the past or how little lunch used to cost? And who has not noticed prices on everything from milk to movie tickets creeping upward? In this article, we explore the major types of inflation and touch upon the competing explanations offered by different economic schools.
Stagflation and Hyperinflation: Two Extremes
Although as consumers we may hate rising prices, many economists believe a moderate degree of inflation is healthy for a nation’s economy. Typically, central banks aim to maintain inflation around 2% to 3%. Increases in inflation significantly beyond this range can lead to fears of possible hyperinflation, a devastating scenario in which inflation rises rapidly out of control.
There have been several notable instances of hyperinflation throughout history. The most famous example is Germany during the early 1920s, when inflation reached 30,000% per month. Zimbabwe offers an even more extreme example. According to research by Steve H. Hanke and Alex K. F. Kwok, monthly price increases in Zimbabwe reached an estimated 79,600,000,000% in November 2008.
Stagflation (a time of economic stagnation combined with inflation) can also wreak havoc. This type of inflation is a witch’s brew of economic adversity, combining poor economic growth, high unemployment and severe inflation all in one. Although recorded instances of stagflation are rare, the phenomenon occurred as recently as the 1970s, when it gripped the United States and the United Kingdom—much to the dismay of both nations’ central banks. (For related reading, see: Stagflation, 1970s Style.)
Stagflation poses a particularly daunting challenge to central banks, because it increases the risks associated with fiscal and monetary policy responses. Whereas central banks can usually raise interest rates to combat high inflation, doing so in a period of stagflation could risk further increasing unemployment. Conversely, central banks are limited in their ability to decrease interest rates in times of stagflation because doing so could cause inflation to rise even further. As such, stagflation acts as a kind of check-mate against central banks, leaving them with no moves left to make. Stagflation is arguably the most difficult type of inflation to manage.
Also known as deflation, negative inflation occurs when prices drop for various reasons. Having a smaller money supply increases the value of money, which in turn decreases prices. A reduction in demand either because there is too large of a supply or a reduction in consumer spending can also cause negative inflation. Deflation may seem like a good thing because it reduces the prices of goods and services, thus making them more affordable, but it can negatively affect the economy in the long run. When businesses make less money on their products, they are forced to cut costs, which often means laying off or terminating employees, thereby increasing unemployment. (For related reading, see: Do Deflationary Shocks Help or Hurt the Economy?)
What Causes Inflation?
We can define inflation with relative ease, but the question of what causes inflation is significantly more complex. Although numerous theories exist, arguably the two most influential schools of thought on inflation are those of Keynesian and monetarist economics.
The Keynesian school of thought derived its name and intellectual foundation from British economist John Maynard Keynes (1883–1946). Although its modern interpretation continues to evolve, Keynesian economics is broadly characterized by its emphasis on aggregate demand as the prime mover of economic development. As such, adherents of this tradition advocate government intervention through fiscal and monetary policy as a means of achieving desired economic outcomes, such as increasing employment or dampening the volatility of the business cycle. The Keynesian school believes inflation results from economic pressures such as rising costs of production or increases in aggregate demand. Specifically, they distinguish between two broad types of inflation: cost-push inflation and demand-pull inflation. (For related reading, see: Cost-Push Inflation Versus Demand-Pull Inflation.)
- Cost-push inflation results from general increases in the costs of the factors of production. These factors—which include capital, land, labor and entrepreneurship—are the necessary inputs required to produce goods and services. When the cost of these factors rise, producers wishing to retain their profit margins must increase the price of their goods and services. When these production costs rise on an economy-wide level, it can lead to increased consumer prices throughout the whole economy, as producers pass on their increased costs to consumers. Consumer prices, in effect, are thus pushed up by production costs.
- Demand-pull inflation results from an excess of aggregate demand relative to aggregate supply. For example, consider a popular product where demand for the product outstrips supply. The price of the product would increase. The theory in demand-pull inflation is if aggregate demand exceeds aggregate supply, prices will increase economy-wide.
Monetarism is not explicitly linked to a particular founding figure, but is closely associated with the American economist, Milton Friedman (1912–2006). As its name suggests, monetarism is concerned principally with the role of money in influencing economic developments. Specifically, it is concerned with the economic effects of changes to the money supply.
Adherents of the monetarist school are more skeptical than their Keynesian counterparts regarding the effectiveness of government intervention in the economy. Monetarists caution such interventions risk doing more harm than good. Perhaps the most famous such criticism was made by Friedman himself in his influential publication (co-written with Anna J. Schwartz), A Monetary History of the United States, 1867-1960, in which Friedman and Schwartz argued that policy decisions of the Federal Reserve inadvertently deepened the severity of the Great Depression. Based on this skepticism, Friedman suggested central banks should concern themselves with maintaining a stable rate of growth for the nation’s money supply in line with gross domestic product (GDP).
Monetarists: It's All About the Money
Monetarists have historically explained inflation as a consequence of an expanding money supply. The monetarist view is perfectly encapsulated by Friedman’s remark that “inflation is always and everywhere a monetary phenomenon.” According to this view, the principal factor underlying inflation has little to do with things like labor, materials costs or consumer demand. Instead, it is all about the supply of money. (For related reading, see: Monetarism: Printing Money to Curb Inflation.)
At the heart of this perspective is the quantity theory of money, which posits the relationship between the money supply and inflation is governed by the relationship M x V = P x T. Here, M equals the money supply, V equals the velocity of money, P represents the average price level and T represents the volume of transactions occurring in the economy.
Implicit in this equation is the belief that if the velocity of money and the volume of transactions is constant, an increase (or decrease) in the supply of money will cause a corresponding increase (or decrease) in the average price level.
Given that the velocity of money and the volume of transactions are in reality never constant, it follows that this relationship is not as straightforward as it may initially seem. Nevertheless, this equation serves as an effective model of the monetarists’ belief that expansion of the money supply is the principal cause of inflation.
The Bottom Line
Inflation comes in many forms, from historically extreme cases of hyperinflation and stagflation to the five-cent and 10-cent increases we hardly notice. Economists from the Keynesian and monetarist schools disagree on the root causes of inflation, underscoring the fact that inflation is a far more complex phenomenon than one might initially assume.
(For related reading, see: How to Profit From Inflation.)