You are here

Inflation and the economy

4 May, 2015 - 11:18

There are two types of inflation that are closely tied to each other. Monetary inflation is an increase in the money supply. Price inflation is a sustained increase in the general level of prices, which is equivalent to a decline in the value or purchasing power of money. If the supply of money and credit increases too rapidly over many months (monetary inflation), the result will usually be price inflation. Price inflation does not always increase in direct proportion to monetary inflation; it is also affected by the velocity of money and other factors. With price inflation, a dollar buys less and less over time.

The second way that inflation can occur and the more frequent way is by an increase in the velocity of money. This has only been measured since the mid 50's. A healthy economy usually has a velocity of 1.8 to 2.3. If the velocity is too high, then this means that people are not holding on to their money and spending it as fast as they get it. Inflation happens when too many dollars are chasing too few goods. If people are spending as soon as they get it, then there are more "active" dollars in the marketplace, as opposed to sitting in a bank account. This will also cause a price increase 1.

The effects of monetary and price inflation include 2:

  • Price inflation makes workers worse off if their incomes don't rise as rapidly as prices.
  • Pensioners living on a fixed income are worse off if their savings do not increase more rapidly than prices.
  • Lenders lose because they will be repaid with dollars that aren't worth as much.
  • Savers lose because the dollar they save today will not buy as much when they are ready to spend it.
  • Debtors win because the dollar they borrow today will be repaid with dollars that aren't worth as much.
  • Businesses and people will find it harder to plan and therefore may decrease investment in future projects.
  • Owners of financial assets suffer.
  • Interest rate-sensitive industries, like mortgage companies, suffer as monetary inflation drives up long-term interest rates and Federal Reserve tightening raises short-term rates.
  • Developed-market currencies become weaker against emerging markets 3.

In his 1995 book The Case Against the Fed, economist Murray N. Rothbard argues that price inflation is caused only by an increase in the money supply, and only banks increase the money supply, then banks, including the Federal Reserve, are the only source of inflation.

Adherents of the Austrian School of economic theory blame the economic crisis in the late 2000s 4 on the Federal Reserve's policy, particularly under the leadership of Alan Greenspan, of credit expansion through historically low interest rates starting in 2001, which they claim enabled the United States housing bubble.

Most mainstream economists favor a low, steady rate of inflation 5. Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy 6. The task of keeping the rate of inflation low and stable is usually given to monetary authorities.