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Saturday, 5 December 2009

Who drives inflation - Part 1

Who drives inflation, Kalinka asked a day or two ago.

Inflation is always and everywhere the destruction of the real value of money.

Mainstream economists state that inflation is a rise in the general level of prices of goods and services in the economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation destroys the purchasing power of money – the destruction of the real value of the internal medium of exchange and unit of account in the economy. Monetarists believe the most significant factor influencing inflation is the management of money supply through the easing or tightening of credit via the central bank’s interest rate policy.

The Austrian School states that inflation is an excessive increase in the money supply by central banks. They want to ban them and go back to the gold standard.

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied.

Rational expectations result in the outcome depending partly on what people expect to happen.

Adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past. For example, if inflation has been higher than expected in the past, people would expect the same to happen in the future.

Structural inflation (built-in inflation) is an economic term referring to inflation that results from past events and persists in the present. It then becomes a normal aspect of the economy, via inflationary expectations and the price/wage spiral.

Inflationary expectations play a role because if workers and employers expect inflation to persist in the future, they will increase their (nominal) wages and prices now. This means that inflation happens now simply because of subjective views about what may happen in the future. Of course, following the generally accepted theory of adaptive expectations, such inflationary expectations arise because of persistent past experience with inflation.

The price/wage spiral refers to the adversarial nature of the wage bargain in modern capitalism. Workers and employers usually do not get together to agree on the value of real wages. Instead, workers attempt to protect their real wages (or to attain a target real wage) by pushing for higher money (or nominal) wages. Thus, if they expect price inflation - or have experienced price inflation in the past - they push for higher money wages. If they are successful, this would raise the costs faced by their employers – if they do not inflation-adjust their selling prices – which they do. To protect the real value of their profits (or to attain a target profit rate or rate of return on investment), employers then pass the higher costs on to consumers in the form of higher prices. This encourages workers to push for higher money wages again as the cycle starts all over.
In the end, built-in inflation involves a vicious circle of both subjective and objective elements, so that inflation encourages inflation to persist.

Inertial inflation is a concept coined by structuralist inflation theorists. It refers to a situation where all prices of non-monetary items in an economy are continuously adjusted with relation to a price index by force of contracts as Brazil did for 30 years from 1964 to 1994 and as required by International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies
Changes in price indices trigger changes in prices of all non-monetary items. Contracts are made to accommodate this price-changing scenario by means of indexation. Indexation in a hyperinflationary economy is evident when, for instance, a given price must be recalculated at a later date, incorporating inflation accumulated over the period to correct the nominal price.

In other cases, local currency prices can be expressed in terms of a foreign currency: normally the US Dollar like in Zimbabwe. In some point in the future, prices are converted back from the foreign currency equivalent into local currency. This conversion from a stronger currency equivalent value (ie, the foreign currency) is intended to protect the real value of goods, as the nominal value depreciates.

In the medium-to-long term, economic agents begin to forecast inflation and to use those forecasts as de facto price indexes that can trigger price adjustments before the actual price indices are made known to the public. This cycle of forecast-price adjustment-forecast closes itself in the form of a feedback loop and inflation indices get beyond control since current inflation becomes the basis for future inflation (more formally, economic agents start to adjust prices solely based on their expectations of future inflation).

South Africa does not have inertial inflation. There is no indexation of all non-monetary items by contract.

So, Kalinka who drives inflation in SA?

We will have a look next time.

Kindest regards,

Nicolaas Smith