What is inflation?

Note: Other posts in this discussion are available under the tag “inflation debate“.

Thank you for all the insightful and intelligent comments (and posts on other blog) on the Re-thinking monetary policy post. Now that you guys have put down the important issues that we have to look at with monetary policy all I need to do is discuss them with my own opinions 😉

However, even with all your help we can’t just jump straight in to saying whether policy should change or stay the same. First we have to define what the hell we are talking about! This involves starting with the question, what is inflation? Once we know what inflation is, we can figure out what the costs of inflation are. From there we can work out what trade-off exists when dealing with inflation, and then we can sort out whether current monetary policy is dealing with this trade-off appropriately.

There is a simple answer to what is inflation, but it isn’t particularly useful. The simple definition is that inflation is “the rate of change” in the general price level (*). To really understand what inflation is though, we have to understand what causes growth in the general level of prices.

Here I will go over some points that build off each other (the fundamental points are in italics, the bold bits are just titles 🙂 ). If you disagree with a specific point, raise your criticisms and we will discuss it and try to figure out where to go from there. Hopefully painting it out this way will make the final description transparent.

Point 1: Price changes and inflation

As Peter said here (*) it is important not to confuse inflation with relative price movements. The whole purpose of prices is to indicate the value of goods relative to other goods. When these relative prices change it is efficient to let them change, instead of using artificial tools to try and stop them changing.

In this sense the increase in the price of food and oil is not “inflation” – it is a relative price movement that is sadly making people poorer at the moment (although in the case of food it could well be making us wealthier).

The inflation we are concerned about is when the price of all goods consistently (ht Paul Walker) increase for no “real” (as in a change in underlying economic circumstances) reason.

Point 2: Inflation in this sense stems from

Most simply this type of inflation stems directly from the growth in “money” in the economy above growth in the quantity of real products – where the quantity of “money” in a given time period simply equals the money stock times a “velocity” measure, that tells us how quickly this money stock moves around the economy. (Quantity theory).

If there is a greater growth in the amount of “money” (in this sense) then there is real products then the nominal price level of goods will be bid up (more dollars chasing fewer products).

The fundamental problem with this definition is the circularity implicit in velocity. How quickly the money stock is moved around the economy depends partially on the current level of prices while the current level of prices will depend on the velocity with which money moves around the economy. (For people that know about the quantity theory, I’m saying that velocity is not a constant – an increasingly mainstream view among economists).

As a result, peoples expectations of the price level will play a role in determining inflation, even if the money stock was fixed!

Point 3: Drivers of “money” growth

Like all economics the study of monetary aggregates enjoys a relationship with supply and demand. The supply relationship enjoyed alot of attention for a long time, with the idea of targeting a fixed quantity of money supply growth providing a popular pastime for many central banks.

However, this view of money supply is a bit misleading when we view “money” in the way we are here. The money supply in this case is truly the money stock – it tells us the quantity that is currently derived, it doesn’t tell us anything about the supply and demand relationship that is causing it.

Currently the Reserve Bank sets an “interest rate” by choosing their official cash rate. As an interest rate defines the price of money (as a higher interest rate increases the opportunity cost of holding money), by setting the interest rate the Bank can move up and down the “money demand” curve. Money demand is the constraint that the Bank pins itself to when setting interest rates – not the stock of money. As a result, as long as the quantity of money demanded falls as the interest rate rises, and as long as the Bank has an ability to decrease and increase interest rates, then inflation can be controlled by the Bank’s choice of interest rates. (Note: Printing money would only work if there is sufficient demand – which requires lower interest rates!)

Source: University of Rhode Island (*)

Now it is all well and good to say that the money stock is rising in NZ, as it is. However, it is the relationship with money demand that is the essential component behind this money growth. If people are not willing to borrow the money at that given interest rate then all this “credit creation” does not matter.

Point 4: Drivers of money demand growth

There are a large number of factors that drive money demand growth, many of which are mentioned at about.com (*). We’ve already mentioned interest rates (as the effective “price”), but there are some other factors that “shift” the money demand curve (we are focusing on “real” money demand – as a result, inflation is not listed below. However, actual inflation will increase “nominal” money demand). Factors that will increase money demand are:

  1. Greater demand for goods and services,
  2. Lower levels of liquidity/precautionary motives,
  3. Higher inflation expectations,
  4. An increase in foreign demand for domestic goods/assets,
  5. An increase in foreign demand for domestic currency holdings

Now in fact, we are only interested in factors that increase money growth that in turn is used to bid up the price of goods and services (All the way back from point 2). If the Reserve Bank works to keep the interest rate constant, factors 2 and 5 do not do this, as neither of these factors are used for goods and services.

Factor 1 is inflationary if this increase in consumer spending is in excess of what is justifiable given productive growth in the economy. Here the increased demand for money will gradually bid prices up.

Factor 3 is also inflationary. If people increase their demand for money given that they expect prices to increase then prices in the economy will be bid up, causing the inflation that was feared. The clearest (and most consistent) example of this is a wage-price spiral whereby inflation expectations lead to larger wage demands, which increase firm costs, which lead to larger price increases.

Factor 4 would not be inflationary if the increase in exports was met with a corresponding increase in imports. However, if the increase in imports is sufficiently small, then the additional income stemming from higher export values will lead to an increase in inflationary pressures similar to factor 1.

Now in terms of thinking about inflation, factor 1 and 4 are not sustainable – demand is unlikely to remain above economic fundamentals extended periods of time (unless we have an asset bubble which drives up households perceived wealth levels, eg housing). As a result, the fundamental issue at hand is factor 3 (which can be driven by factors 1 and 4). Keeping inflation expectations down will keep inflation down!


As a result, the way I see it, inflation stems directly from the bidding up of prices in the economy which in turn leads to greater money demand. I feel that this overall way of viewing inflation is consistent with both monetarist and Keynesian explanations for what drives inflation – however, the assumptions made within the general framework are different.

However, I am more than willing to accept that I could well be wrong in large sections of the above post – which is why I would appreciate another set of intelligent comments on the “what is inflation” issue. After all, once we have sorted out what inflation is we will have a solid base with which to discuss New Zealand’s monetary policy framework.

When critiquing what I have written I would appreciate it if you attack my points in order (starting with the earliest ones you wish to criticise) and clearly indicate which point you are discussing at all times. Also, if you want to talk about the current monetary policy framework and not discuss this actual post you should head over to the previous post on that issue, which is found here (*).

Thanks in advance 🙂

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13 replies
  1. Paul Walker
    Paul Walker says:

    Point 1: Price changes and inflation. Here I would say that inflation is best thought of as “a sustained rise in the general level of prices”. Both parts of this definition are important. First, as you say, we are not worried about relative price changes. The issue is what happens to the average level of prices. If all prices went up by 10% we would have 10% inflation as the general level of prices would have increased but if the price of bread goes up by 10% we have no inflation as only a relative price has changed. Second, the sustained bit. The increase in the price level must be sustained. If the price level went up for a week and then dropped back to its old level it won’t be inflation. Changes in GST would be a good example. When GST increases the price level jumps up by the amount of the increase but we don’t get any inflation. The jump is instantaneous, not sustained.

  2. Matt Nolan
    Matt Nolan says:

    “Here I would say that inflation is best thought of as “a sustained rise in the general level of prices”.”

    Exactly right – my definition was not appropriate in that sense as it seemed to include one-off price level adjustments.

    In that sense I should have been clearer that I was discussing a “rate of change” in the price level, rather than a shift. Thanks 🙂

  3. Mike Sproul
    Mike Sproul says:

    The article states the quantity theory of money as if no other theory were worth considering. A better theory of inflation is the real bills doctrine, which says that inflation is caused when the quantity of money outruns the assets of the bank that issued it.

  4. Matt Nolan
    Matt Nolan says:

    Hi Mike,

    Thanks for the comment on the real bills doctrine. My feeling was that the real bills doctrine is merely another way of fixing the money supply – and as a result is completely consistent with the general view of the quantity theory of money.

    The only problem with fixing the money supply so directly is it ignores the demand side of the issue – a large increase in the national production will require a greater supply of money to keep the general price level unchanged. As fixing the money supply does not respond to this you end up with a leap in the interest rate and deflation.

  5. Paul
    Paul says:

    What is inflation? My understanding of inflation and the monetary policy that is used to control it seems way different from that outlined here. Probably because I have not studied economics for long enough.

    So this is what I understand:
    The I in CPI stands for ‘index’, not ‘inflation’. The CPI is an index that tells us how much prices have changed across a standardised basket of products that are purchased by consumers. Hence: consumer price index.

    Changes in the CPI are used as shorthand for the amount of inflation because when there is x% inflation there is expected to be an equal x% general increase in prices. This doesn’t say what inflation is. I will come to that.

    But the problem with that index is that it is a standardised basket of products. It assumes the mix of products stays relatively constant. To be a useful comparison over time it needs to keep a pretty constant mix. The problem is that the weighting of products in the economy is constantly changing, not least because of relative price changes. For example, the amount of petrol purchased is changing as the price rises relative to everything else.

    I think you rightly say that the amount of money in the economy, adjusted for velocity, is a measure of money supply.

    And I think you are right to say that if money supply increases, prices can be expected to increase, all other factors being equal. My understanding is that inflation is a measure of the increase in the money supply, and rising general price levels is the result of inflation.

    My understanding of monetary policy as a way to keep prices under control, is that it works as follows: increasing money supply leads to rising prices, so to prevent rising prices we take money out of the hands of those who spend it, namely consumers. To take money out of the hands of consumers we raise interest rates, which reduces the amount of money consumers have available for discretionary spend. This works really well if everyone in the economy is exposed to variable interest rates, which was the mostly case when monetary policy was first used to control inflation. The speed at which a change in interest rates can drive a change in spending is influenced by how quickly that change in rates sucks money out of the hands of consumers and businesses.

    (And as an aside, the cost of controlling prices is borne by that portion of society for whom changes in interest rates causes immediate change in the amount of money they have available to spend. And to avoid that cost most of those who can have switched their borrowing to fixed interest rates over longer periods of time. And the result is that for interest rate changes to impact on prices it now takes a greater amount of change in rates, and a longer time, to suck the requisite amount of money out of the economy, and the cost is felt by a smaller group).

    Now along comes an increase in the world price of oil. Prices of oil rise at the pumps. Everyone is exposed to the price of oil, and more money is spent on that oil. What happens to the supply of money in our economy? It gets reduced because the money is sent overseas to buy the oil. So a rise in the price of oil has the same inpact on money supply as a rise in the interest rate.

    So by my definition of inflation, a rise in the world price of oil is deflationary in New Zealand because it reduces money supply.

    Of course, it makes the CPI rise by the weighted average of the price change for petrol times the proportion that petrol makes up of the basket of goods.

    Similarly rises in the price of imported food and other products does the same thing. But only to the extent that it is driven by remittances that reduct the money supply in the hands of NZ consumers.

    Offsetting this to some extent is the world price of milk and other agricultural produce that we export. That brings more money into the NZ money supply, but the impact of that (both the size and how long it takes) is impacted by what the people who receive that extra money decide to do with it. What are the farmers doing with their windfall gains? Are they spending up large providing additonal employment within NZ, or are they socking the money away in the bank, paying off debt, etc? My guess is it is a bit of both, but with a slowing economy and falling confidence, these naturally conservative people will be salting a good proportion away for the rainy (or very dry) days ahead. So rising agricultural export prices and rising fuel and food import prices will not have an equal and offsetting impact on the economy.

    So the upshot of all this? Rising import prices are probably having a greater deflationary effect than rising export prices are offsetting, in terms of the money supply. But a high indicator of inflation, CPI, suggests (incorrectly) that interest rates should be high. High interest rates are the wrong answer.

    Of course, it is not all that simple. If we lower interest rates our exchange rate will probably fall, and those imports will become even more expensive in local terms. So someone needs to do the sums to work out the magnitude of that change. Lower exchange rates would help exporters to get busier, putting more money into the the hands of consumers. Not a bad result.

    I am sure the real economists out there will be able to tell me why my understanding is all wrong. I look forward to more comments.

  6. Matt Nolan
    Matt Nolan says:

    Hi Paul,

    Good summary of points 🙂

    You are exactly right that higher oil prices can be deflationary, in so far as the higher relative price of fuel leads to downward pressure on all other prices in the economy. This is picked up by the CPI in time. However, I’m glad that you mentioned that there are problems with the CPI measure – after the post on inflation targeting that is coming up I was going to post about inflation measurement 🙂

    In New Zealand, petrol prices will reduce demand, which will reduce price pressure. However, petrol is also an input to production, so this will increase price pressure.

    When it comes to inflation another important question to ask is – how will workers and firms bid up prices in order to compensate themselves for the increase in petrol prices. If people take higher petrol prices as a sign that price growth is going to be greater in the future, then it will be inflationary.

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