Now that we have seen how inflation is measured, let's turn to analyzing the different types of inflation. Inflation can be classified by how rapidly average prices rise, or by whether people expect it. Other distinctions pinpoint its causes. This section addresses all three approaches.
Figure 2 Inflation Since 1860
Source: Bureau of Labor Statistics, 1994.
Creeping or Galloping Inflation vs. Hyperinflation
The price level may rise for a number of reasons and at different rates over time.
Creeping inflation occurs when average prices rise at fairly low rates.
Inflation has persisted at creeping rates for decades in the United States, but it "galloped" briefly in the 1970s.
Galloping inflation occurs if average prices rise at double-digit annual rates.
People in other countries have been even less fortunate. Most economists accept the definition of hyperinflation offered by Philip Cagan, a specialist in this area.
Hyperinflation occurs when average prices rise more than 50 percent per month.
Hyperinflations have occurred at rates that can only be described as astronomical. A kilogram of bread cost less than 1 German mark in 1919, and 9 marks would buy an American dollar. Between the onset of World War I and 1923, average prices in Germany rose 1,422,900 million percent. By the end of 1923, $1 exchanged for an incredible 4.2 trillion German marks, and a one-inch stack of 5 million mark notes would buy one egg. But even more remarkable inflations have occurred. Hungary experienced inflation of 828 octillion (828 followed by 24 zeros!) percent between 1945 and 1946. Today, The former Yugoslavia is fighting the second most severe hyperinflation in historyTheir 600 trillion percent inflation in 1993 was brought on by economic disintegration and UN sanctions for its role in the Bosnian conflict. Figure 3 illustrates these three twentieth-century hyperinflations.
Figure 3 Selected Episodes of Hyperinflation: China, Germany, and Yugoslavia
Sources: For China: Shun-Hsin Chou, The Chinese Inflation: 1936--1949 (New York: Columbia University Press, 1973), p. 261. For Germany: Fritz K. Ringer, The German Inflation of 1923 (New York: Oxford University Press, 1969), p. 69. For Hungary: B. Nogaro, "Hungary's Monetary Crisis," American Economic Review, XXXVIII (1948), pp. 526--542.
Interestingly, studies by Philip Cagan indicate that a monetary system can still function as long as inflation stays below 50 percent monthly. Any time inflation looms on the horizon, however, bond markets become shaky, interest rates rise, and investment falters. Creeping inflation clearly poses fewer problems than hyperinflation for consumers, investors, and for macroeconomic policymakers. During episodes of hyperinflation, money becomes a "hot potato" that people spend as fast as they can in attempts to beat expected price hikes. But they quickly lose faith in money. When this happens, transaction costs skyrocket---barter takes over and goods and resources are traded directly for other goods or resources, without money as an economic lubricant.
Very rapid inflation usually signals an economy experiencing severe trauma. Wars, coups, or natural disasters may set the stage for galloping inflation or hyperinflation. Excessive inflation is also the norm for economies in transition.
Anticipated vs. Unexpected Inflation
A second way to categorize inflation or deflation is by how accurately people anticipate changes in the price level. When inflation is expected, people can try to hedge.
Attempts to avoid possible losses from foreseeable possibilities are hedges.
For example, if you became convinced that virtually all prices will soon rise, you might hedge by buying a new car immediately, or by making guaranteed reservations a year in advance for a resort vacation. Even stocks of canned food can be used to hedge against severe inflation.
Speculation based on inflationary expectations can be profitable, but also extremely risky. Buying real estate on credit before an inflationary boom, for example, can yield handsome real rates of return. (Are you familiar with the rule, "Buy low and sell high"?) But overly generous forecasts can be as damaging as projections that underanticipate changes in the price level. For example, investors who speculated that California real estate prices would continue on an upward trend that had lasted from 1946 into the 1980s were often bankrupted when housing prices plummeted in the early 1990s.
The lesson here is that the rate of inflation may be less harmful than its volatility. Price-level stability is desirable because consumers and investors can avoid unnecessary costs associated with hedging and speculating. A stable price level allows consumers to focus on buying the most satisfying goods, and investors to concentrate on capital expenditures that will help firms best serve the needs of consumers, instead of strategies to avoid inflation or to profit from it.
We can use the Aggregate Demand/Aggregate Supply model introduced in Chapter 5 to help identify different sources and types of inflation. When a given price rises, then either: (a) demand increased, or (b) supply decreased, or (c) some combination of a and b occurred. This pattern offers parallels for the economy as a whole.
Demand-pull (demand-side) inflation occurs when average prices rise because Aggregate Demand grows excessively relative to Aggregate Supply.
When Aggregate Demand expands from AD0 to AD1 in Figure 4, the price level rises from P0 to P1. Inflation is sustained only if Aggregate Demand continues to rise.
Economists are nearly unanimous in believing that inflation occurs when our demands for goods grow faster than our capacity to produce them. Indeed, a substantial minority of economists insist that this is the only realistic explanation for sustained inflation. Excessive demands ripple through a fully employed economy when the money supply grows too rapidly or government spends far more than it collects in taxes.
Creeping inflations in many industrialized economies during the 1960s and 1970s at least partially originated from shocks on the supply side.
Supply-side inflation results when Aggregate Supply shrinks (e.g., because of rising resource prices or technological reversals), causing the price level to rise and aggregate output to fall.
Figure 5 illustrates a supply-side "shock" as a shift in Aggregate Supply from AS0 to AS1. Runaway energy costs, worldwide drought, monopolistic greed, and disputes between labor unions and management are only a few of the culprits that some people identify as causal factors. OPEC oil price hikes during the 1970s were clearly severe shocks to the supply side. Supply-side shocks can be grouped into the broad categories of cost-push and administered-price explanations for inflation.
FIGURE 5 MISSING
Exorbitant union wage hikes are often fingered as inflationary. This is one example of a cost-push theory of inflation. Powerful unions presumably demand wage hikes not warranted by increased worker productivity. Rising labor costs are then passed forward to consumers as "pushed up" prices. This explanation pinpoints unions as the villains causing inflation. Blaming unions is especially popular among some politicians and business leaders. Other cost-push theories point to rising oil prices or to increases in the prices of imported goods or raw materials.
Some economists turn the mechanics of the union-based, cost-push inflation explanation upside down. According to the administered-price theory, firms with market power may be reluctant to raise prices because they fear adverse publicity, antitrust actions, or similar threats to their dominance in a market. They use hikes in wages or other resource costs as excuses to raise prices, generally by more than their higher costs would justify. Huge firms' failures to resist excessive wage demands, it is argued, tend to reinforce the momentum of inflation.
Mixed Theories of Inflation
Disputes about whether inflation is caused only by rising Aggregate Demand or only by shrinking Aggregate Supply parallel debates about whether the top or bottom blade of a pair of scissors cuts a piece of paper. An accurate portrait of any episode of inflation usually requires considering influences from both sides. Composition-shift and expectational theories blend demand-side and supply-side pressures.
The foundation of composition-shift inflation theory is the assumption that prices rise more easily than they fall. Thus, if demand rises in one sector of the economy, prices rise. But if there are offsetting declines in demands in other sectors, prices do not fall, at least in the short run. Instead, as sales shrink, firms reduce output and lay off workers. Thus, inflationary pressures emerge as the composition of demands and supplies changes. Growing sectors will typically experience increases in prices, while declining sectors suffer from stagnation and unemployment rather than long-term price cuts.
Inflationary expectations may cause expectational inflation because prevalent forecasts are at least partially self-fulfilling---we create our own future realities by what we anticipate. Thus, producers who expect inflation build inventories by boosting output while cutting back on current sales. Why sell now when prices will soon be higher? Current sales are reduced by immediate price hikes and temporary decreases in supplies.
If, at the same time, buyers expect inflation, they will try hedge by accumulating their own inventories of durable goods. This bolsters their current demands, as they attempt to beat the higher prices expected later. Thus, inflationary expectations quickly cause price hikes because they reduce supplies and increase demands. Inflationary expectations are important in explaining why inflation is so difficult to suppress. You may have heard people refer to the "wage-price inflationary spiral" or to the "vicious circle of inflation." Inflation causes expectations of inflation, which stimulates more inflation, and so forth.
The preceding theories of inflation are not mutually exclusive; many inflations emerge from combinations of forces. For example, all European hyperinflations following World Wars I and II were triggered by political turmoil and supply-side disturbances followed by incredibly rapid growth in these countries' money supplies. Bolivian inflation in the 1980s was caused by a government policy that financed 15 percent of its spending by taxation and printed money to cover the other 85 percent. Aggregate Demand grows excessively if the money supply grows faster than real output. When we explore these sources of inflation in detail later in this book, you will learn why inflation cannot be sustained for long without growth of the money supply.
Composition-shift, expectational, or other mixed theories of inflation entail combinations of declines in supply and expansion of demand. Thus, Aggregate Supply curves shift leftward, while Aggregate Demand curves shift to the right, as illustrated in Figure 6. You now have some ideas about how indices are calculated, various types of inflation, and how the forces at work in an inflationary process shift Aggregate Demands and Aggregate Supplies. We need to examine the effect of inflation on social welfare.