Inflation is the rise in the general level of prices of goods and services in an economy over a period of time. The general prices level rises, each unit of currency buys lesser of the goods and services. Consequently, inflation also reflects erosion in the purchasing power of money. This is a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of inflation is the inflation rate, the annualized percentage change in a general price index over time.
The principal explanation for inflation is excess demand. When too much money chases few goods leads to prices being bid up. In the later half of the nineteenth century, this was taken literally through the quantity theory of money. It was believed that a change in the amount of money circulating in the economy would have a fairly immediate and proportional effect on general price levels. Although this theory was not accepted back then, many economists now agree that change in the money supply affect the economy primarily through changes in the interest rates. Inflation is generally, believed to be demand driven.
In contrast, supply side explanations for inflation depend on the existence of noncompetitive markets. If a firm, a group of firms gains sufficient power in a market, it may this market power by raising its prices in order to increase returns. The resulting prices are then registered as inflation. This strategy not only requires market power but also a buoyant economy. One of the best examples is when OPEC used its market power to quadruple the price of petroleum in the early 1970s; it was so effective that the supply side shock threw most of the capitalist world into a recession. The jumbo price rise also stimulated conservation and the use of substitutes.
Central Banks usually seek to stabilize the rate of inflation. In addition, some seek to keep the economy at full employment. To do this, they usually focus on controlling an intermediate target. In the past, this intermediate target was money supply. Currently, most central banks focus on influencing interest rates. Interest rates provide an instant feedback. The interest rate that central banks do care about is the real interest rate (the nominal rate is less than the rate of inflation). If, instead, the central bank focused on maintaining a particular nominal rate, it could lead to wide swings in the money supply. For example if the central bank targets a certain nominal interest rate, say 4 percent. To do this, say it increases the money supply. In the short run, rates fall to 4 percent. But then inflation starts to grow and the interest rates start to rise. The central bank would then increase the money supply even more. The result would be a runaway inflation. To avoid this, the central bank should focus on real rates of interest. When inflation starts to rise, real rates are likely to fall, correctly indicating that the economy is being stimulated. Should the central bank keep increasing the money supply, inflation will get worse.
Many countries use inflation targeting. With inflation targeting, the central bank announces an explicit inflation rate it wants to achieve and it commits itself to achieving this rate.
Although, the Federal Reserve Bank, the central bank in the United States, seeks price stability, it does not currently use inflation targeting. Instead, it often appears to be following what is called Taylor’s Rule; named after John Taylor who first proposed the rule. The rule predicts how the bank determines the financial funds rate (the rate private banks charge other private banks to borrow money). To illustrate the rule, assume that if the economy is at full employment, the real federal funds rate (the federal rate minus the rate of inflation) would be 2 percent. Next, assume the Fed wants the inflation rate to be 3 percent. According to Taylor’s rule, the bank might set the target federal funds rate (r) so that it equals:
Target r = 2 percent + rate of inflation + 0.5 (rate of inflation – 3 percent) + 0.5 (Real GDP gap)
The real GDP gap is the percent difference between real GDP and the full employment level of GDP (the level of GDP consistent with a stable inflation rate). If the bank was interested only in controlling inflation (ie., inflation targeting) the weight of on the real GDP gap would be zero. If the bank was interested only in keeping the economy at full employment, the weight on the (rate of inflation – 3 percent) term would be zero.
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