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Module H4 Session 6
Economic Concepts for Statisticians
Session 6 Inflation
At the end of this session, students will have an understanding of:
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What economists mean by prices
The causes of inflation
What impact does inflation have on people and on the economy?
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Controlling inflation (monetary policy)
Should we aim for zero inflation?
Prices
In Session 1 we studied the concept of prices in relation to supply and demand in three
markets: the goods market, the money market and the foreign exchange market. In the
money market, we saw that the interest rate is the ‘price’ of money. In the foreign exchange
market, the ‘price’ is the exchange rate. In Session 7, we will look at labour markets, where
the ‘price’ of labour is the worker’s wage. For economists, these are all examples of prices.
However, unless they specify otherwise, economists – in common with ordinary people! –
normally use the term ‘prices’ when referring to the prices of goods and services. This
should be quite straightforward when studying the price of a single item. For instance, I
might say that the price of coffee is US$4 per pound. But even here, I need to be careful! Is
this the price I pay to buy coffee in my local supermarket (the consumer price), or is it the
price received by the grower (the producer price)? And when is this the price? I need to
specify the date, as prices change over time. An added complication is that sometimes the
asking price is different from the price for which the item is actually sold (for instance, this
is common with house price sales, and also among street vendors in some countries).
The Consumer Price Index
In this session, we are going to look at inflation. Inflation is defined as a sustained, general
increase in prices over time. To study inflation, economists use the Consumer Price Index
(CPI), an index which tracks changes in consumer prices over time. It is compiled using a
‘basket’ of ‘representative’ consumer goods and services, weighted to reflect how much
consumers purchase of each item. The weights are calculated from surveys. Researchers
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from the national statistical office visit retailers every month to collect data on the prices of
the items in the basket. This data is used to update the CPI.
Some countries have more than one consumer price index to calculate different measures
of inflation. For instance, the UK has a Retail Price Index (RPI) as well as a CPI; these
indices measure inflation in a slightly different way (ONS, 2004). It also has a ‘RPIX’,
which excludes interest payments on mortgages (home loans), and a ‘RPIY’, which
“excludes indirect taxes such as VAT, excise duties and other specific taxes” (ONS, 2004).
Exercise 1
Check how the CPI – or equivalent – is compiled in your country. How does this compare
with the process described in ONS (2004)? What similarities and differences can you find?
ONS (2004) is available from:
http://www.statistics.gov.uk/downloads/theme_economy/CP_Brief_Guide_2004.pdf
Then go to the ONS website at www.statistics.gov.uk and click on Inflation under key
statistics to see how the ONS shows the CPI and RPI data. How does this compare with
the information available on the national statistical office website in your country?
Causes of inflation
Demand pull and cost push inflation
‘Demand pull inflation’ is the term used to describe inflation caused by an increase in
aggregate demand in the economy so that demand for goods and services exceeds supply,
and prices are ‘pulled up’. This is easy to understand if we think about an individual
product. For instance, when demand for maize exceeds supply, there are many people
looking to buy maize, and they bid up the price. When such excess demand occurs for a
whole range of goods and services, this leads to increases in prices of many different goods
and services at once and the CPI rises, producing inflation.
Demand pull inflation may be caused by excess real demand. Alternatively, it may be caused
by excess nominal demand i.e. the amount of money in the economy rises so that people
feel they have more to spend and bid up the prices of the goods they want to buy. In this
case, the imbalance is not real – it is due to an increase in the money supply (see Box 1).
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‘Cost push inflation’ occurs when there are rises in the prices of raw materials or other
inputs into production (including the cost of labour). This in turn raises the costs of
production, which may be passed on to consumers if producers can raise prices because
they are monopolies or oligopolies (see Session 1, footnote 2) with a big market shares.
Alternatively, in a competitive market, producers may cut back supply because of increased
costs (aggregate supply falls), so again demand exceeds supply and prices rise.
Box 1 The central bank and the money supply
The central bank in each country is a bank which has been given the authority to print
money. Normally, only one bank has such authority. In ancient societies, money was in the
form of gold, silver or other precious commodities which were seen as having value, and
could be exchanged for goods and services. However, by the 13th century the Chinese had
come up with the idea of using paper money – i.e. money which only has value because the
government says it does! Economists call this ‘fiat money’.
Modern central banks issue fiat money in the form of notes and coins. This forms the base
of the money supply or ‘monetary base’ (M0), which consists of money in circulation
plus the money held by commercial banks as cash reserves at the central bank. The
commercial banks create deposits as a multiple of their reserves, and this expands the
money supply. The ‘narrow money supply’ (M1) consists of M0 plus deposits which can
be withdrawn on demand. M2 consists of M1 plus time deposits (requiring notice for
withdrawals). M3 is the broadest definition of the money supply, and may include foreign
currency deposits, repurchase agreements, money market mutual funds and debt securities.
In less developed financial systems, the central bank has considerable control of the money
supply through its control of M0. But in developed economies with complex financial
systems, M3 is a very large multiple of M0, so the central bank has less control.
The quantity theory of money
Demand pull and cost push inflation are terms which economists associate with Keynesian
economics. An alternative view, known as ‘monetarism’, was put forward in the 1960s. The
monetarist school is famous for saying that “inflation is always and everywhere a monetary
phenomenon” (Friedman and Schwartz, 1963). The monetarists argued that inflation is
caused entirely by changes in the money supply. For Keynes, this was only part of the story.
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The ‘monetarist’ school bases its argument on the Quantity Theory of Money:
MxV=PxY
Where:
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

M = quantity of money in circulation in the economy
Y = real national income
P = prices
V = velocity of circulation, the speed at which money circulates in the economy
The Quantity Theory of Money makes two assumptions: (i) that money is ‘neutral’, and (ii)
that the velocity of circulation (V) is constant for any given situation. What is meant by
money being ‘neutral’? This means that changes in the money supply do not affect output. The
monetarists argue that output is a real variable, which is driven only by real factors such as
those discussed in Session 3.
If V is constant and Y cannot be changed by an increase in M, then the only part of the
equation that can be changed by an increase in M is P. So if the Central Bank increases the
money supply leading to a rise in M, the result has to be an equivalent increase in P.
Endogenous money
Both Keynes and the monetarists accepted the Quantity Theory of Money as a useful tool
for their analyses. The main difference was that the monetarists argued that changes in M
would lead inevitably to changes in P, with no impact on output except on a very temporary
basis, while the Keynesian view predicts that changes in M will lead to changes in Y for
relatively long periods of time (see Session 5).
A contrasting view, associated with the ‘neo-Keynesian’ school of thought, is that the
money supply is endogenous. In other words, the money supply responds to the credit
needs of economy. For instance, a firm needs a loan and goes to a commercial bank, which
sees the opportunity to do more business – for which it needs more cash reserves with the
central bank. Thus, the money supply expands in response to demand from the commercial
banks, which are in turn responding to demand from borrowers, not because of decisions
by the central bank – which in fact has little control over the money supply. In this school
of thought, inflation is not caused by the central bank increasing the money supply.
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Case study: The UK under Chancellor Nigel Lawson*
An example of this was during the late 1980s with the so-called ‘Lawson Boom’. There was
a sharp rise in the demand for credit and a sharp rise in house prices. The amount of
money in circulation grew at alarming rates and caused excess demand in the economy. By
the autumn of 1990, retail price inflation had climbed to 10.9%. A recession was needed to
bring it back down again. The chart below shows that by 1988 there was a huge inflationary
gap in the economy – shown by the highly positive output gap (the difference between
actual and potential GDP). This was a symptom of an economy experiencing a very high
level of excess aggregate demand for goods and services.
* Source: www.tutor2u.net/economics/content/topics/inflation/demand_pull_inflation.htm
What does the evidence tell us?
The evidence suggests that the monetarist view may be useful for explaining inflation in
the long run – particularly in cases of very high inflation. However, it is not helpful for
explaining moderate (single digit) inflation.
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As financial systems develop and become increasingly sophisticated, there is also evidence
that the central bank becomes less powerful: its ability to control the broad money supply
(M3) becomes more limited. The theory of endogenous money becomes more relevant.
In developing countries with less sophisticated financial systems, it is generally true to say
that the central bank retains considerable power. It is also generally true in developing
countries that the Keynesian concepts of demand pull and cost push inflation are useful
for understanding the causes of inflation – particularly in the short term.
Impact of inflation
We might wonder why inflation should be a problem: if consumer prices double, and so do
wages and other incomes, this should not be a problem for consumers! But there are
several reasons why inflation is a problem for people and for the economy:
1. Wages and pensions often rise by less than the CPI, and/or lag behind inflation,
so that real incomes (nominal incomes minus inflation) fall.
2. Income tax: many countries operate income tax systems which include a ‘personal
allowance’, i.e. an amount of money which the individual can earn before being
subject to income tax. This allowance is unlikely to rise in line with inflation, so its
value to the tax payer will become less and less.
3. Interest on bank savings. Savers put their money in banks because of attractive
interest rates. The are interested in the real interest rate, net of tax. The real interest
rate is the nominal interest rate minus inflation. Table 1 shows what happens to real
interest net of tax as inflation rises, using an example where savings are taxed at
20%. This hits people with savings, like the elderly, and therefore has social costs.
4. The ‘inflation tax’. People have to hold a certain amount of cash (notes and coins)
at home – or in a current account where it earns little or no interest – in order to
meet day-to-day needs. Inflation erodes the value of this money, and this is seen as
a ‘tax’ because the central bank makes a profit from printing money (known as
seignorage) equivalent to the amount that the individual or household loses.
5. Uncertainty. Inflation makes it harder for businesses and individuals to plan,
particularly at high inflation levels, because price changes are unpredictable.
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6. ‘Shoe leather’ and ‘menu’ costs. These are the terms used for the nuisance costs
of inflation – people having to spend more time on financial management including
frequent visits to the bank (wasting shoe leather!) and companies having extra costs
of repeatedly printing new menus, price labels, etc.
Despite these costs, inflation is not usually bad for economic growth at low-to-moderate
inflation levels. There are winners as well as losers: borrowers win because the real cost of
their loan repayments tends to fall; and businesses win because they do not pay tax on the
money they earn until several months or even years after they earned it, by which point the
real value of the nominal amount of tax due has fallen. However, at high inflation levels
(over 15%), the evidence indicates that inflation undermines economic growth.
Table 1: Returns on savings at 20% rate of tax
Nominal interest rate
(%)
Inflation rate
(%)
Real interest rate (%)
= nominal interest rate
minus inflation
After tax returns (%)
= 80% of nominal
interest rate minus
inflation
5
2
3
2
7
4
3
1.6
10
7
3
1
15
12
3
0
20
17
3
-1
25
22
3
-2
Controlling inflation: monetary policy
In most countries, the central bank is entrusted with controlling inflation through monetary
policy. There are three main approaches, known as intermediate targets:
1. Money supply targeting,
2. Exchange rate targeting, and
3. Inflation targeting.
Some central banks use a combination of methods – for instance the European Central
Bank combines money supply targeting with inflation targeting. The US Federal Reserve is
an exception, as it does not use any specific intermediate targets.
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The first method, money supply targeting, is based on the Quantity Theory of Money,
which implies that the central bank can set the rate of growth of the money supply to
achieve a particular level of inflation. This was popular in the 1980s, but it was found to
have a number of problems – partly because the assumptions of the theory about constant
velocity of circulation and neutrality of money do not necessarily hold in practice; partly
because inflation may have causes other than money supply growth, as Keynes argued; and
partly because central banks’ control of the money supply was weakening (as explained by
endogenous money theory). It also proved problematic to decide which measure of the
money supply should be targeted – M1 or M3 – as they do not always move in the same
direction!
The second method, exchange rate targeting, involves either fixing or managing the
exchange rate. This was popular in the 1990s. For instance, in Argentina from April 1991
to January 2002, the peso was tied to the US dollar at one-to-one parity and the central
bank lost control of monetary policy because it could not print pesos unless they were
backed by US dollars. This was a deliberate policy to prevent the central bank from
expanding the money supply too fast and causing inflation. In such cases, inflation tends
towards the same level as inflation in the currency to which the local currency is tied (e.g.
US dollar inflation). In Argentina, this policy was highly successful in controlling inflation,
but it brought the economy to its knees in 2001 and the central bank had to abandon it.
Similar problems were experienced by the UK and Italy when they operated inside the
European Exchange Rate Mechanism (ERM) in the early 1990s.
Inflation targeting is now the most popular approach in developed countries. This
involves (a) setting an explicit inflation target for a point in the future, and (b) adjusting
interest rates if the forecast rate of inflation is above or below target. In order to decide
whether inflation is going to be higher or lower than the target level, the central bank must
look at large range of variables. It has discretion to decide how important each of these are,
although it normally publishes its reasoning to ensure transparency.
Tools of monetary policy
Whether the declared target for controlling inflation is the money supply, the exchange rate
or inflation itself, the most common operational instrument or tool used by central banks to
achieve their goals is interest rates. Central banks can control interest rates because they
are the only supplier of cash to the financial system (M0). By increasing the supply of
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reserves to the commercial banks they can bring down interest rates, or by draining
reserves from the banking system they can push up interest rates1.
How does changing interest rates affect inflation?

An decrease in interest rates will tend to stimulate consumption and investment (see
Session 5) and therefore aggregate demand in the economy rises. An increase in
aggregate demand means that demand of goods and services exceeds aggregate supply
and prices will eventually rise (this is an example of demand-pull inflation).

An increase in interest rates will tend to reduce consumption and investment (see
Session 5) and therefore aggregate demand in the economy. A reduction in demand to
below aggregate supply of goods and services means that prices will eventually fall.
It is important to remember that there will be time lag between the change in interest rates
and the impact on inflation. The length of the lag and size of the impact on inflation
depends on the structure of the economy. So central banks need to have a forward-looking
approach to monetary policy, and they need reliable CPI data and related information.
1
This is done by buying and selling securities (open market operations) or by lending funds
directly to the banks (discount window lending). A third approach is to declare a change in
the level of reserves which banks are obliged to hold with the central bank (an increase or
decrease in the ‘minimum reserve requirement’) – although this tool is used infrequently.
For details, see Federal Reserve Board (2005) at www.federalreserve.gov/pf/pdf/pf_3.pdf
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Exercise 2
Students should divide into two (or more) groups. The first group should study the
information available at www.bankofengland.co.uk/monetarypolicy/index.htm under the
sections entitled “Monetary Policy Framework”, “Monetary Policy Committee” and “How
Monetary Policy Works” and prepare a 10-minute presentation on how monetary policy is
conducted in the UK. The second group should do the same for monetary policy in the
US, using the website http://www.federalreserve.gov/fomc/ as a starting point and
following the links to Section 2 of The Structure of the Federal Reserve System and
Chapter 2 of the book ‘Purposes and Functions’ (12 pages).
Is zero inflation a good thing?
Most central banks in developed countries aim for inflation of around 2%. They do not
want zero inflation because zero inflation means a risk of deflation (i.e. falling prices), and
deflation is bad for economies. Why? Because if prices fall, nominal interest rates also have
to fall to avoid high real interest rates. But nominal interest rates cannot be reduced to zero
(nobody would keep their money in a bank account), which means that real interest rates
remain relatively high when prices are falling. This discourages new investment and is bad
for growth. At the same time, high real interest rates are bad for existing borrowers and
lead to an increase in the number of companies and individuals defaulting on debt.
Together, these developments are likely to push the economy into recession, and the
central bank will be helpless to solve the problem because its main policy tool (the interest
rate) is useless!
The case of Japan in recent years has reinforced the fear of deflation. According to Miles
and Scott (2005):
“The Japanese economy remained in recession for most of the 1990s even though the
Bank of Japan reduced interest rates to virtually zero… between 2000 and 2003, even
though the level of interest rates set by the Japanese central bank was zero, the output
gap rose, confidence fell, and land and share prices fell. Inflation remained negative
so that even though nominal interest rates were zero, real rates were positive… low
interest rates should stimulate output growth, but this did not happen in Japan”.
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References
Federal Reserve Board (2005) The Federal Reserve System: Purposes and Functions, 9th edn, Board
of Governors of the Federal Reserve System, Washington D.C. Available at:
http://www.federalreserve.gov/pf/pdf/pf_complete.pdf
Friedman, M. and Schwartz, A. (1963) A Monetary History of the United States 1867-1960,
Princeton University Press, Princeton, New Jersey.
Miles, D. and Scott, A. (2005) Macroeconomics – Understanding the Wealth of Nations, 2nd edn.
John Wiley & Sons, Chichester, West Sussex.
Office for National Statistics, ONS (2004) Consumer Price Indices – A brief guide. Available at
http://www.statistics.gov.uk/downloads/theme_economy/CP_Brief_Guide_2004.pdf
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