Today's entry I am considering inflationary pressures that arise from nominal demand (spending) growth outstripping the real capacity of the economy to react to it with output responses. In other words, I am excluding inflation that may arise from supply shocks – such as a rise in an imported raw material (for example, oil). That is another issue altogether.
The reason I am excluding supply-driven inflationary impulses is because the mainstream attack on the current use fiscal policy (and monetary policy) is really about demand pressures. We are continually reading crude statements such as there is “too much money” in the system.
Further, the mechanisms through which the supply shocks manifest are different and this deserves a separate analysis, which will come in a subsequent posting.
However, the solution to both sources of inflation is not that dissimilar although additional measures might be brought to bear to handle the case of a price hike in an imported raw material.
First we should make sure what we are talking about. Many conservative commentators think that when workers get a pay rise it is inflation. It is not. Those on the left think that when the corporate sector increase the price of a good or service it is inflation. It is not.
It is also not inflation when the exchange rate falls pushing the price of imports up a step. So a depreciation in the currency does not constitute inflation. It might stimulate inflation but is not in itself inflation.
It is also not inflation when the government increases a particular tax (say the VAT or GST) by x per cent to some new level.
So while a price rise is a necessary condition for inflation it is not a sufficient condition. Observing a price rise alone will not be sufficient to categorise the phenomena that you are observing as being an inflationary episode.
Inflation is the continuous rise in the price level. That is, the price level has to be rising each period that you observe it. So if the price level or a wage level rises by 10 per cent every month, then you have an inflationary episode. In this case, the inflation rate would be considered stable – a constant rise per period.
If the price level was rising by 10 per cent in month one, then 11 per cent in month two, then 12 per cent in month three and so on, then you have accelerating inflation. Alternatively, if the price level was rising by 10 per cent in month one, 9 per cent in month two etc then you have falling or decelerating inflation.
If the price level starts to continuously fall then we call that a deflationary episode.
Hyper-inflation is just inflation big-time!
So a price rise can become inflation but is not necessarily inflation. Many commentators, economists and ordinary folks get this basic understanding wrong – often and continually.
