Identify the cause of inflation and deflation?

Question

best long detailed accurate answer 10 point.

Answer 1

There are different schools of thought as to what causes inflation. Most can be divided into two broad areas: quality theories of inflation, and quantity theories of inflation. Many theories of inflation combine the two. The quality theory of inflation rests on the expectation of a buyer accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the equation of the money supply, its velocity, and exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.


Keynesian economic theory proposes that money is transparent to real forces in the economy, and that visible inflation is the result of pressures in the economy expressing themselves in prices.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":

* Demand pull inflation -- inflation from high demand for goods and low unemployment.
* Cost push inflation -- presently termed "supply shock inflation," from an event such as a sudden decrease in the supply of oil.
* Built-in inflation -- induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This has been seen most graphically when governments have financed spending in a crisis by printing money excessively (from war or civil war conditions), often leading to hyperinflation where prices rise at extremely high rates (such as, doubling every month). Another cause can be a rapid decline in the demand for money as happened in Europe during the black plague.

The money supply is also thought to play a major role in determining levels of more moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics by contrast typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians, the money supply is only one determinant of aggregate demand.

A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggested that price stability was a trade off against employment. Therefore some level of inflation could be considered desirable in order to minimize unemployment. The Philips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s.

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.

Another Keynesian concept is the potential output (sometimes called the "natural gross domestic product"), a level of GDP where the economy is at its optimal level of production, given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.

However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under Prime Minister Margaret Thatcher in the UK may have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed (also see unemployment), unable to find jobs that fit their skills in the British economy. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.



From a monetary perspective deflation is caused by a reduction in the velocity of money and/or the amount of money supply per person. In a hard money economy, with limited specie sources, deflation is the more natural state of the economy - people multiply and economies grow faster than hard money is created. Within the market mechanism, capitalism is generally an engine of deflation: as capital stocks improve, and there are more competitors, the supply of goods goes up, which means prices must fall until they balance demand. Capitalism also drives efficiency and innovation which has a downward pull on prices. These are referred to as "Smithian" and "Schumpterian" capital effects respectively.

A distinction then, is sometimes drawn between deflation in hard currency economies, such as those on the gold standard and economies which run on credit. In modern credit based economies, a deflationary spiral may be caused by the central bank initiating higher interest rates to reduce inflation or inflation risks, thereby possibly popping an asset bubble. It is also associated with the collapse of a command economy which has been run at higher level of production than its allocation of capital and labor can support. In a credit based economy, a fall in money supply leads to a credit crunch. This reduces the level of demand, which, in turn contracts the money supply, and a consequent sharp fall-off in demand for goods. Demand falls, and with the falling of demand, there is a fall in prices as a supply glut develops. This in turn leads holders of inventories to sell their stocks at lower prices, often at a loss, further depressing prices.

This becomes a deflationary spiral when prices fall below the costs of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets which have fallen dramatically in value since they loaned the funds, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans, as in Japan, most recently. This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.

In unstable currency economies, barter and other alternate currency arrangements are common, and therefore when legal tender becomes scarce, or unusually unreliable, commerce can still continue. Since in such economies the central government is often unable, even if it were willing, to adequately control the internal economy, there is no pressing need for individuals to acquire official currency except to pay for imported goods. In effect, barter acts as protective tariff in such economies, encouraging local consumption of local production. It also acts as a spur to mining and exploration, since one way to make money in such an economy is to dig it out of the ground.

When the central bank has lowered nominal interest rates all the way to zero, it can no longer further stimulate demand by lowering interest rates - "deflation is when the central bank cannot give money away". This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to "lend" money at a zero nominal rate of interest, which could still be a very high real rate of interest, due to the inflation rate in order to intentionally increase the money supply.

This cycle has been traced out on the broad scale during the Great Depression. Specifically when the collapse of the Viennese Credit-Anstalt bank led to the subsequent collapse of the entire global financial system.[3] International trade contracted sharply, severely reducing demand for goods, thereby idling a great deal of capacity, and setting off a string of bank failures. A similar situation in Japan, beginning with the stock and real estate market collapse in the early 1990s, was arrested by the Japanese government preventing the collapse of most banks and taking over direct control of several in the worst condition. These occurrences are the matter of intense debate. There are economists who argue that the post-2000 recession had a period where the US was at risk of severe deflation, and that therefore the Federal Reserve central bank was right in holding interest rates at an "accommodative" stance from 2001 on. Other economists, however, say that this is postponing the inevitable so that in the coming years deflation will occur in a level greater than if they had risen interest rates in 2001.

Keynesians insist on the distinction between consuming goods and producing goods, and less often between exogeneous and endogeneous money supply.

For a given money supply, if wages rise faster than productivity, profits will fall, and with them the price of productive goods, while consuming goods will rise. This happens in times when labor supply is tight and bargaining power is strong. When wages rise slower than productivity, profits rise as do the prices of assets relative to consuming goods. This can occur when labor supply is great and bargaining power is weak. In the first case there should, all other things being equal, be inflation, because there is higher consumption demand and less investment. In the second case, all other things being equal, there should be deflation, as there is a drop in consuming demand and a rise in investment. A deflationary spiral occurs when the drop in demand is sufficient to also reduce expected profits for long enough to reduce the value of capital as well. Thus less consumption and less investment feed off of each other.

Since, in the Keynesian view, the source of deflation is a lack of consumer demand, and a lack of confidence to invest Keynesians advocate "pump priming" or government creation of credit/money that has a cost interest rate below inflation or market rates. As witnessed since 1990 in Japan, and in the 1930's in the USA, this policy is not very effective unless government creates employment via public works projects or military manufacturing.

The reason this view has become the dominant one in deflation fighting is because the most important alternate view prior to Keynes was that increasing business confidence was the way to end business downturns, and the most important steps to doing this were to instill confidence in holders of currency that their buying power was secure. Classical political economy held that Say's Law was true, and that economies would self-right themselves after a period of monetary adjustment, unless there was interference from some external, probably government, source. Hence, the previous policy regime prescribed balancing government budgets by lowering expenditures and raising taxes, and raising interest rates to give holders of currency more incentive to lend. The general view in mainstream economics is that this lead to the "Great Contraction" of money supply in the 1928-1932 period, which was a contributing, or even primary, cause of turning a downturn in business into what is known as The Great Depression.

In modern monetarist theory, monetary policy is thought to be a more effective means of ending deflationary spirals, by flooding an economy with liquidity. It was this policy which was pursued by the United States in the early 2000s in order to fight off what was seen as a potential deflationary spiral.

With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates (i.e., reducing the "cost" of money). This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early 1990s and in 2000 - 2002, respectively. Economists now worry about the inflationary impact of monetary policies on asset prices. Sustained low real rates can be the direct cause of higher asset prices and excessive debt accumulation. Therefore lowering rates may prove only a temporarily palliative, leading to the aggravation of an eventual future debt deflation crisis. These arguments parallel some made during the 1880-1920 period about the possibility that over-investment could be a cause, or contributing cause, in economic downturns.