Since there are many possible measures of the price level, there are many possible measures of inflation. Some examples of broad price indices are the consumer price index (CPI), the personal consumption expenditure price index (PCEPI), and the GDP deflator (also known as the producer price index). However, inflation can also be used to describe a rising price level within a smaller set of assets, goods or services within the economy, such as raw materials (including food, fuel, metals), financial assets (such as stocks, bonds and real estate), services (such as entertainment and healthcare), or jobs.

Core inflation is a measure of inflation for a subset of consumer prices that excludes food and energy prices, which rise and fall more than other prices in the short term. Generally, this is the inflation rate that central banks most closely monitor; for example, the US central bank, the Federal Reserve, pays close attention to the underlying inflation rate to get a better estimate of long-term trends in future inflation overall.

Inflation is generally calculated by the rate of change of the price index over time, usually the Consumer Price Index, which measures the prices of a selection of goods and services purchased by an average consumer.

For example, in January 2007, the US Consumer Price Index was 202,416, and in January 2008 it was 211,080. The formula to calculate the percentage of the annual CPI inflation rate throughout 2007 is then.

The inflation rate resulting from the CPI in the period of one year is 4.28%. That is, the general level of prices for consumers increased approximately four percent in 2007.

To obtain the inflation of a given year, the price index of December of the previous year is taken as a basis and compared with that of December of the last year.

monetary theory

One of the explanatory schemes about the cause of inflation is the one that simply indicates that:

That is, prices will rise if the aggregate supply of goods falls in relation to the aggregate demand for said goods. Following this theory, aggregate demand is based mainly on the total amount of money existing in an economy, which means that: as the monetary mass increases, the demand for goods increases and if this is not accompanied by an increase in supply, inflation arises. Equation () is related to the Cambridge equation (although deviations from the predictions of both equations of up to 50% are observed, as shown in the attached graph for the United States economy).

There is another similar theory that relates inflation to the increase in the monetary mass over the demand for money, which would mean that "inflation is always a monetary phenomenon" as Milton Friedman states. Following this line of thought, inflation control rests on fiscal and monetary prudence; That is, the government must ensure that it is not too easy to obtain loans, nor should it incur significant debt itself. Therefore, this approach highlights the importance of controlling fiscal deficits and interest rates, as well as the productivity of the economy in the quantity of goods produced to existing demand. This explanation requires two assumptions: that absolutely all productive sectors (food, housing, transportation, clothing, etc.) simultaneously have problems satisfying demand and that consumers continue to demand all products indiscriminately.

Any of these types of inflation can occur in combination. However, the first two maintained for a substantial period of time give rise to the third. In other words, persistent high inflation caused by monetary or cost elements gives rise to inflation of expectations.

Monetarist point of view

Monetarists believe that the main factor causing inflation is the sharp increase in the amount of money. They believe that Fiscal Policy is inefficient in controlling inflation. Milton Friedman, a famous monetarist economist, has a famous phrase: "Inflation is always a monetary phenomenon."[12]​.

Monetarists affirm their beliefs in many historical studies of inflationary periods where the cause of inflation has always been a monetary phenomenon.

The quantity theory of money states that:

In this equation, the general price level is related to economic activity, the quantity of money, and the velocity of money circulation. The formula is actually an identity because the velocity of circulation of money (V) is defined as () divided by the amount of money (M).

Monetarists assume that the speed of money circulation is independent of Monetary Policy (at least in the long term) and that the level of production is determined by the productive capacity of the economy. Therefore, if we start from these assumptions, we conclude that the price level only depends on the amount of money. It is argued that in the short term the speed of circulation of money is not an exogenous variable (that is, external to the model), so in the short term this formula would not necessarily tell us that there is a stable relationship between the amount of money and the level of production. However, in the long term it is assumed that the speed of money circulation is determined by the evolution of payment methods. So if in the long run the velocity of money circulation is not affected by monetary policy, an increase in inflation must be equal to the sum of the growth rate of money minus the long-term growth rate of production. Fisher argued that it is the interest rate that determines prices, and not the monetary issue, which has given rise to one of the deepest divisions in the approach to financial problems in macroeconomics[13] (see Fisher's hypothesis).

Supply side theory

This theory states that inflation occurs when the increase in the money supply exceeds the demand for money. The value of the currency is then determined by these two factors. Inflation in the 1970s in the US is seen as caused by the increase in the money supply that occurred after this country left the Bretton Woods agreements, which tied the value of the currency to the gold standard. According to this theory, the increase in the monetary supply does not have inflationary effects as long as the demand for money increases proportionally.

This theory would explain the drop in the inflation rate in the 1980s in the US due to the economic expansion that occurred as a result of the reduction in taxes. This is explained by indicating that an expansion in the economy causes an increase in the demand for money, which counteracts the inflationary effect that normally entails an increase in the monetary mass.

Developmental theory

According to developmentalism, inflation is caused by the role of extended monopolies, more based in underdeveloped countries based on the conditions of Third World countries, inflation would be caused by a strong external imbalance in the balance of payments.[14]​.

Austrian theory

The Austrian School of Economics states that inflation is the increase in the money supply above people's demand. Producers of goods and services demand money for their products, so if the generation of money is greater than the generation of wealth, there is inflation. On the contrary, if the supply of currency is less than the demand, deflation exists. As a consequence of inflation, a chain effect of upward distortion of relative prices occurs, that is, some prices rise more than others. If all prices in the economy (including wages) rose uniformly there would be no problem, the problem arises from the non-uniform rise. In deflationary processes, the relative price distortion generated is downward. This theory flatly rejects the popular definition of "sustained increase in the price level" due to the above.

This school assigns the cause of inflation/deflation to the existence of a currency-issuing monopoly (Central Bank) and, ultimately, to the existence of the fractional reserve of deposits in banks. As a solution to inflation, he proposes the elimination of the currency-issuing monopoly, and freeing the printing of currency to private parties, who would compete to have the strongest currency to remain in the market. It proposes returning to the currency-commodity, backing the currency with some tangible asset (gold, silver, platinum, etc.) or with some combination of several metals, thereby minimizing the volatility that the value of money could have, as in the case, for example, of using only gold, whose price volatility is high because people tend to take refuge in it in times of uncertainty.

Contenido

Un aumento en el nivel general de precios implica una disminución del poder adquisitivo de la moneda. Es decir, cuando el nivel general de precios sube, cada unidad monetaria permite comprar menos bienes y servicios. El efecto de la inflación no se distribuye uniformemente en la economía. Por ejemplo, los prestamistas o depositantes que reciben una tasa fija de interés de los préstamos o depósitos pierden poder adquisitivo de sus ingresos por intereses, mientras que los prestatarios se benefician. Las personas e instituciones con activos en efectivo experimentará una disminución de su poder adquisitivo. Los aumentos de salarios a los trabajadores y los pagos de pensiones a menudo se mantienen por debajo de la inflación, especialmente para aquellos con ingresos fijos.

Los deudores que poseen obligaciones monetarias a tasas de interés nominal fijo, observan una reducción en la tasa real proporcional a la tasa de inflación. El interés real de un préstamo, es la tasa nominal menos la tasa de inflación aproximadamente. Por ejemplo, si alguien toma un préstamo donde la tasa de interés establecida es del 6 % y la tasa de inflación es del 3 %, la tasa de interés real que pagará por el préstamo es del 3 %. Los bancos y prestamistas pueden ajustar en ocasiones incluyendo una prima de inflación en los costos de los préstamos del dinero mediante una tasa inicial más alta o mediante el establecimiento de los intereses a una tasa variable.

Negative effects

High and unpredictable inflation rates are considered harmful to the economy. They add inefficiencies and instability in the market, making it difficult to make budgets and long-term plans. Inflation can act as a drag on the productivity of companies, which are forced to withdraw capital destined for the production of goods and services in order to recover the losses caused by currency inflation. Uncertainty about the future of the currency's purchasing power discourages investment and savings.

Inflation can also impose hidden tax increases: inflated incomes can mean increased income tax rates if tax brackets are not properly indexed to inflation. However, moderate inflation rates do not seem to have negative effects on economies, thus a study by Robert Barro shows that statistically, an inflation of less than 8-10% does not show a negative correlation with the country's growth rate.[17] Other empirical studies place the threshold above which inflation can be really harmful at 20 or 40%.[18]​[19]​.

The main negative effect of inflation, in a market economy, is that it destroys the price system of the economy. On the one hand, producers make their savings-investment decisions based on the information available, so in an inflationary environment they are not able to discover if a price increase is a relative effect (only to their product) or, on the contrary, it is an absolute increase (where all product prices rise). In these cases, the investor has to spend more time knowing the prices of the products and, in particular, the prices of their competition, because these become obsolete in the short term, instead of dedicating that time to their business. On the other hand, the uncertainty in prices caused by inflation also negatively affects consumers, since they must waste time researching the price of the products they consume. Therefore, this uncertainty and less information, which produces inflation, negatively affects both investors and consumers, and with this negatively affects the growth possibilities of the economy.

Firstly, the deterioration in the value of the currency is detrimental to those people who earn a fixed salary, such as workers and pensioners. This situation is called loss of purchasing power for the aforementioned social groups. Unlike others with mobile incomes, they see how their real income is reduced month by month, when comparing what they could buy with what they can buy some time later. However, it should be noted that if salaries are quickly adjusted to inflation, the loss of purchasing power of some social groups is mitigated or eliminated.

With high inflation, purchasing power is redistributed from people, businesses and institutions with nominal fixed incomes, to those with variable incomes that can keep pace with inflation. This redistribution of purchasing power also occurs among international trading partners. If fixed exchange rates exist, one economy with higher inflation than another will make the former's exports more expensive, affecting the trade balance. Negative trade effects may also arise due to instability in currency exchange prices.

Inflation is regressive") (that is, it affects sectors with fewer resources relatively more than those with greater resources) due to the Cantillon effect, which explains that newly created money is not distributed simultaneously or uniformly throughout the population but rather benefits those who print the money. uniformly throughout the population, those who first receive the money issued are least affected by the loss of value of the money.[21]​.

Furthermore, sectors with fewer resources use cash (or monetary balances) relatively more than sectors with more resources, and they have fewer financial instruments to hedge against inflation. On the other hand, sectors with more resources have access to more financial instruments (such as deposits that are adjusted with inflation) and with these they can better protect themselves from the loss of purchasing power that inflation produces.[22][23]​.

Inflation is harmful to those creditors of fixed amounts, since the real value of the currency decreases over time and their purchasing power will decrease. On the contrary, those debtors with a fixed rate will benefit, since their real liabilities will decrease.

As a consequence of the previous points, what is usually called “self-constructed inflation” arises. This phenomenon consists of transferring the increase in prices forward in time, this is because people expect inflation to continue as in previous periods. This creates an inflationary spiral, in which contracts are indexed, salaries and prices are increased due to future expectations.

Differential inflation is a situation in which two or more countries, whose economies are strongly dependent or form a special economic area, have different rates of price increases. Differential inflation, especially if it is sustained over a long period, generally causes the country with the highest inflation rates to suffer an increase in production costs and consequently a loss of competitiveness.

It is the product of the increase in the costs of an important input for the production of a good or service, for example energy, and in this way generates inflation in the rest of the economic activities.[24]​.

High inflation can prompt employees to demand rapid wage increases to keep up with consumer prices. In the case of collective bargaining, wage growth will be set based on inflation expectations, which will be higher when inflation is high. This can lead to a wage spiral. In a sense, inflation can generate a situation of instability that feeds on itself: inflation generates expectations of more inflation, which in turn generates greater inflation.

People tend to buy durable and non-perishable products to partly avoid the expected losses from the decline in the purchasing power of the currency.

If inflation becomes out of control (increasing), it can seriously interfere with the normal functioning of the economy, affecting its ability to produce and distribute goods, and it can also lead to the abandonment of the use of currency as a means of exchange of goods, leading to the inefficiencies of barter.

A change in the supply or demand of a good will normally modify its price, signaling to buyers and sellers how they should reallocate resources in response to new market conditions. When prices are unstable and change markedly due to inflation, price changes due to supply/demand signals are difficult to distinguish from price changes due to general inflation. The result is a loss of efficiency.

According to the Austrian theory of the economic cycle, the fractional reserve causes the decision-making of economic agents to begin to be erroneous from the moment the money supply begins to be multiplied by the existence of the fractional reserve because both depositor and borrower believe they have possession of the same capital and therefore make savings and consumption decisions that are altered with respect to the decisions they would make if the depositor were recognized as a creditor, that is, if the depositor really had his money available. This distortion in information causes inflation to arise in the different production phases and sets the economic cycle in motion. Austrian economists argue that this is the most damaging effect of inflation.

According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to highly speculative reckless lending, which increases the probability of bad investments, which in the long term turn out to be unsustainable, generating business losses, layoffs, salary reductions and consequently in consumption and as a consequence in production, with price declines staggering after the initial rise of the expansionary phase.

Positive effects

Positive effects include the ability of state central banks to adjust nominal interest rates in order to mitigate a recession and to encourage investment in non-monetary capital projects.

Keynesians believe that nominal wages are quick to rise, but slow to adjust downward. If wages are overvalued, this difference in the speed of adjustment leads to a prolonged imbalance, generating high unemployment rates. Since inflation would be less than the real wage if nominal wages were held constant, Keynesians argue that some inflation would be good for the economy as it would allow labor markets to reach equilibrium more quickly.

The main tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations, which are central bank interventions in the bond market with the aim of affecting nominal interest rates. If an economy is in a recession with low nominal interest, then the bank finds limits to reduce rates further in order to stimulate the economy (since negative nominal interest rates are impossible). This situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates remain well above zero, so that if the need arises, the bank can reduce the nominal interest rate.

The concrete experience of individual countries seems to indicate that high inflation is compatible with rapid economic growth. In the 1960s and 1970s, Brazil had an average inflation rate of 42%, but it was one of the fastest growing economies in the world, and its per capita income increased by 4.5% annually.[25]​ During the same period, South Korea's per capita income grew by 7% annually, despite an average rate of almost 20%.[25]​.

There are several explanations for this, among them is that with high inflation, the net profitability of financial investments, which is equal to nominal interest minus inflation, declines greatly and in these circumstances non-financial investment in the productive economy is more attractive. As if that were not enough, anti-inflationary policies can be harmful to the economy. Since 1996, Brazil, after suffering from hyperflation, began to control it by raising effective interest rates to 10-12% (a figure among the highest in the world), inflation fell to 7.1% but growth also suffered, which did not exceed 1.3%.[25] South Africa also had a similar experience in 1994, when it began to give absolute priority to controlling inflation and raised interest rates to Brazilian levels.

Se han usado y sugerido diferentes métodos para detener la inflación. En casi todo el mundo, se ha impuesto la política de control de la inflación. De hecho la priorización de medidas antiinflacionistas severas produjo efectos adversos en Sudáfrica (1994) y Brasil (1996).[25]​ Economistas institucionalistas como Ha-Joon Chang han señalado que los partidarios del liberalismo han aprovechado el miedo justificado a la hiperinflación para impulsar políticas antiinflacionistas excesivas (dados los niveles de inflación en muchos lugares donde se han impulsado).

Monetary policies

Today, the main tool to control inflation is monetary policy. Central banks can significantly influence this by setting a higher interest rate and reducing the money supply. Typically at a target rate of around 2% to 3% annually, and within a low inflation target range, somewhere between 2% to 6% annually.

There are a number of methods that have been suggested to control inflation. Central banks like the US Federal Reserve can affect inflation largely through interest rates and adjustment through other operations. Interest rates and slow growth of the money supply are the traditional ways through which central banks combat or prevent inflation, although they have different approaches. For example, some pursue a symmetrical inflation target, while others only control inflation when it rises above an acceptable threshold.

Monetarist policies emphasize a constant and moderate money growth rate. Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Controlling aggregate demand can be achieved by combining monetary policy and fiscal policy (increasing taxes or reducing public spending to reduce demand).

Fixed exchange rate

Under a fixed currency exchange regime, the value of a country's currency becomes tied to the value of another currency or a basket of other currencies (or sometimes to another measure of value, such as gold or other commodities). A fixed exchange rate is generally used to stabilize the value of one currency by pegging it to another, more stable currency. It can be used as a means to control inflation. However, when the value of the reference currency rises or falls, so does the linked currency. This essentially means that the inflation rate in the country's fixed exchange rate is determined by the inflation rate of the currency to which it is linked.

A fixed exchange rate prevents a government from using national monetary policy to achieve macroeconomic stability. Additionally, it can expose countries to the danger of speculative attacks.

With the Bretton Woods agreements, most countries used rates fixed to the value of the US dollar. The agreement was broken in the 1970s, and countries gradually turned to floating exchange rates. However, in the latter part of the century, some countries that suffered hyperinflationary processes temporarily returned to a fixed exchange rate to stabilize their currencies. This policy was used in many South American countries: for example, Argentina 1991-2002, Bolivia, Brazil, Chile (1979-1982)[26]​ and Venezuela (since 2003 with the entry into force of CADIVI).

Although fixing the exchange rate could be a way to control inflation (assuming that the country has many reserves of international assets) in the short term, empirical evidence shows that in the long term this policy causes the real exchange rate to fall, given that internal inflation is higher than external inflation, and this makes the economy lose competitiveness and, in many cases, put the country's balance of payments in deficit. The above happened, in the 1980s, in several Latin American countries, including Chile,[26] Argentina and Brazil. These countries had a deficit trade balance (because they had lost competitiveness by having fixed the exchange rate and, with this, having caused their real exchange rate to fall sharply) and by reducing their inflow of external credits (due to the external crisis of the early 1980s), they had no choice but to resort to the International Monetary Fund (IMF) to balance their balance of payments. The IMF forced them to comply with a tough plan to stabilize their accounts, both internal and external, at great economic cost and in some countries, such as Chile, unemployment exceeded 20%.

gold pattern

The gold standard is a monetary system in which the means of exchange for goods and services is paper money that can be freely converted into pre-established quantities of gold (or other commodities with market value such as silver). The standard specifies how gold backing is carried out, including the amount of specie per unit of paper currency. The currency itself has no intrinsic value, but is accepted by merchants as they can be redeemed for the equivalent amount in kind. A US silver certificate, for example, could be exchanged for a real piece of silver.

The gold standard was partially abandoned through the international adoption of the Bretton Woods system. Under this system, all other major currencies were tied at a fixed rate to the dollar, which in turn was tied to gold at a rate of $35 per ounce. The Bretton Woods system broke down in 1971 and most countries began using floating rates between paper and backed money.

Economies based on the gold standard rarely experience inflation above 2% annually. Under the gold standard, the long-term rate of inflation (or deflation) is determined by the rate of growth of the supply of gold relative to total production. Critics argue that this can cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be set by mining policies.

Some authors believe that this policy contributed to the Great Depression, while other theories, such as monetarist and Austrian theories, disagree. Hypotheses about the causes of the Great Depression are controversial.

The main problem with the Gold Standard is that in modern times a gigantic amount of gold would be needed for Central Banks to be able to back up all their money issued, with the consequent cost of hoarding and safeguarding it. Furthermore, in modern times it is thought that the demand for money depends on several factors (including expectations, interest rates, inflation and income level[27]​) and these are not related to the variation in gold production. For the above reasons, the use of the gold standard was abandoned in the first half of the century.

Price control

Another method used throughout history to try to stop inflation is control over prices and wages. This method was implemented, for example, by the Nixon administration in the early 1970s with negative results.

Some economists agree that price controls do not achieve their objectives of price stability and are counterproductive since they distort the functioning of an economy, since the impossibility of increasing prices in a period of increasing production costs causes shortages of goods and services, and decreases their quality, among other effects. Governments frequently attempt to remedy shortages by subsidizing goods and services that have become unprofitable due to increased costs and fixed prices. Another drawback with price controls is that compliance by the vast number of businesses and markets in a country is often difficult for government authorities to monitor and verify, so prices rise anyway.

The economic history of the last 50 years, especially Latin American history, generally shows that price controls have led to excess demand or shortages, since these price controls do not eliminate the cause of inflation.[28] Economists related to the Austrian School argue that, precisely, the experiences of price controls on a massive scale in human history (including ancient Rome and revolutionary France) have always generated a negative result for the economies involved.

Balance between currency and prices

The theory of currency price equilibrium proposes that when any product increases its price, all, including the product itself, must absorb that increase. For example, when inflation for a month is 2%, all products must decrease by 1.96%, thus absorbing that increase, ensuring that the value of the currency is constant and does not devalue. Thus, you will be able to purchase less of the products that increase in price, but you will be compensated by being able to purchase more of the products that decrease in price. To achieve this, this theory proposes the creation of a Regulatory Entity, in which representatives of businessmen, union members, consumers, and the State agree on prices, based on the value of the currency, with the aim of avoiding devaluation. It has something in common with the Nash equilibrium of game theory.

Hyperinflation causes a sharp decrease in the value of the currency, that is, as prices increase rapidly, the amount of goods and services that money can acquire decreases. During hyperinflation, we say that money loses its store of value property, people do not use currency to save, and as a unit of measurement, goods are not valued using currency. A characteristic of hyperinflation is that once it starts, it reproduces itself, since consumers, knowing that the value of their money decreases rapidly over time, try to spend it as quickly as possible, causing prices to continue their upward race.[29]​.

Among the most studied hyperinflationary processes in the world are the hyperinflation in the Weimar Republic, the Bolivian hyperinflation), the hyperinflation in Venezuela and the Argentine hyperinflation of 1989.

Hidden inflation or hidden inflation is inflation not included in official statistics. It is different from inflation involving a hidden tax[30]​ and from redflation (charging the same for product containers that have been reduced in size). Inflation is calculated by taking on different dates the prices of a basket of products or services, which are assumed to be the most frequently consumed by the average consumer. If a commonly consumed product or service is not found in this basket and its price varies, real inflation will be different from that measured by statistics, then there will be hidden inflation.[31]​ In the United States, services of this type are, for example, home insurance or babysitting rates.[31]​ This phenomenon has analogies with hidden unemployment.

Since there are many possible measures of the price level, there are many possible measures of inflation. Some examples of broad price indices are the consumer price index (CPI), the personal consumption expenditure price index (PCEPI), and the GDP deflator (also known as the producer price index). However, inflation can also be used to describe a rising price level within a smaller set of assets, goods or services within the economy, such as raw materials (including food, fuel, metals), financial assets (such as stocks, bonds and real estate), services (such as entertainment and healthcare), or jobs.

Core inflation is a measure of inflation for a subset of consumer prices that excludes food and energy prices, which rise and fall more than other prices in the short term. Generally, this is the inflation rate that central banks most closely monitor; for example, the US central bank, the Federal Reserve, pays close attention to the underlying inflation rate to get a better estimate of long-term trends in future inflation overall.

Inflation is generally calculated by the rate of change of the price index over time, usually the Consumer Price Index, which measures the prices of a selection of goods and services purchased by an average consumer.

For example, in January 2007, the US Consumer Price Index was 202,416, and in January 2008 it was 211,080. The formula to calculate the percentage of the annual CPI inflation rate throughout 2007 is then.

The inflation rate resulting from the CPI in the period of one year is 4.28%. That is, the general level of prices for consumers increased approximately four percent in 2007.

To obtain the inflation of a given year, the price index of December of the previous year is taken as a basis and compared with that of December of the last year.

monetary theory

One of the explanatory schemes about the cause of inflation is the one that simply indicates that:

That is, prices will rise if the aggregate supply of goods falls in relation to the aggregate demand for said goods. Following this theory, aggregate demand is based mainly on the total amount of money existing in an economy, which means that: as the monetary mass increases, the demand for goods increases and if this is not accompanied by an increase in supply, inflation arises. Equation () is related to the Cambridge equation (although deviations from the predictions of both equations of up to 50% are observed, as shown in the attached graph for the United States economy).

There is another similar theory that relates inflation to the increase in the monetary mass over the demand for money, which would mean that "inflation is always a monetary phenomenon" as Milton Friedman states. Following this line of thought, inflation control rests on fiscal and monetary prudence; That is, the government must ensure that it is not too easy to obtain loans, nor should it incur significant debt itself. Therefore, this approach highlights the importance of controlling fiscal deficits and interest rates, as well as the productivity of the economy in the quantity of goods produced to existing demand. This explanation requires two assumptions: that absolutely all productive sectors (food, housing, transportation, clothing, etc.) simultaneously have problems satisfying demand and that consumers continue to demand all products indiscriminately.

Any of these types of inflation can occur in combination. However, the first two maintained for a substantial period of time give rise to the third. In other words, persistent high inflation caused by monetary or cost elements gives rise to inflation of expectations.

Monetarist point of view

Monetarists believe that the main factor causing inflation is the sharp increase in the amount of money. They believe that Fiscal Policy is inefficient in controlling inflation. Milton Friedman, a famous monetarist economist, has a famous phrase: "Inflation is always a monetary phenomenon."[12]​.

Monetarists affirm their beliefs in many historical studies of inflationary periods where the cause of inflation has always been a monetary phenomenon.

The quantity theory of money states that:

In this equation, the general price level is related to economic activity, the quantity of money, and the velocity of money circulation. The formula is actually an identity because the velocity of circulation of money (V) is defined as () divided by the amount of money (M).

Monetarists assume that the speed of money circulation is independent of Monetary Policy (at least in the long term) and that the level of production is determined by the productive capacity of the economy. Therefore, if we start from these assumptions, we conclude that the price level only depends on the amount of money. It is argued that in the short term the speed of circulation of money is not an exogenous variable (that is, external to the model), so in the short term this formula would not necessarily tell us that there is a stable relationship between the amount of money and the level of production. However, in the long term it is assumed that the speed of money circulation is determined by the evolution of payment methods. So if in the long run the velocity of money circulation is not affected by monetary policy, an increase in inflation must be equal to the sum of the growth rate of money minus the long-term growth rate of production. Fisher argued that it is the interest rate that determines prices, and not the monetary issue, which has given rise to one of the deepest divisions in the approach to financial problems in macroeconomics[13] (see Fisher's hypothesis).

Supply side theory

This theory states that inflation occurs when the increase in the money supply exceeds the demand for money. The value of the currency is then determined by these two factors. Inflation in the 1970s in the US is seen as caused by the increase in the money supply that occurred after this country left the Bretton Woods agreements, which tied the value of the currency to the gold standard. According to this theory, the increase in the monetary supply does not have inflationary effects as long as the demand for money increases proportionally.

This theory would explain the drop in the inflation rate in the 1980s in the US due to the economic expansion that occurred as a result of the reduction in taxes. This is explained by indicating that an expansion in the economy causes an increase in the demand for money, which counteracts the inflationary effect that normally entails an increase in the monetary mass.

Developmental theory

According to developmentalism, inflation is caused by the role of extended monopolies, more based in underdeveloped countries based on the conditions of Third World countries, inflation would be caused by a strong external imbalance in the balance of payments.[14]​.

Austrian theory

The Austrian School of Economics states that inflation is the increase in the money supply above people's demand. Producers of goods and services demand money for their products, so if the generation of money is greater than the generation of wealth, there is inflation. On the contrary, if the supply of currency is less than the demand, deflation exists. As a consequence of inflation, a chain effect of upward distortion of relative prices occurs, that is, some prices rise more than others. If all prices in the economy (including wages) rose uniformly there would be no problem, the problem arises from the non-uniform rise. In deflationary processes, the relative price distortion generated is downward. This theory flatly rejects the popular definition of "sustained increase in the price level" due to the above.

This school assigns the cause of inflation/deflation to the existence of a currency-issuing monopoly (Central Bank) and, ultimately, to the existence of the fractional reserve of deposits in banks. As a solution to inflation, he proposes the elimination of the currency-issuing monopoly, and freeing the printing of currency to private parties, who would compete to have the strongest currency to remain in the market. It proposes returning to the currency-commodity, backing the currency with some tangible asset (gold, silver, platinum, etc.) or with some combination of several metals, thereby minimizing the volatility that the value of money could have, as in the case, for example, of using only gold, whose price volatility is high because people tend to take refuge in it in times of uncertainty.

Contenido

Un aumento en el nivel general de precios implica una disminución del poder adquisitivo de la moneda. Es decir, cuando el nivel general de precios sube, cada unidad monetaria permite comprar menos bienes y servicios. El efecto de la inflación no se distribuye uniformemente en la economía. Por ejemplo, los prestamistas o depositantes que reciben una tasa fija de interés de los préstamos o depósitos pierden poder adquisitivo de sus ingresos por intereses, mientras que los prestatarios se benefician. Las personas e instituciones con activos en efectivo experimentará una disminución de su poder adquisitivo. Los aumentos de salarios a los trabajadores y los pagos de pensiones a menudo se mantienen por debajo de la inflación, especialmente para aquellos con ingresos fijos.

Los deudores que poseen obligaciones monetarias a tasas de interés nominal fijo, observan una reducción en la tasa real proporcional a la tasa de inflación. El interés real de un préstamo, es la tasa nominal menos la tasa de inflación aproximadamente. Por ejemplo, si alguien toma un préstamo donde la tasa de interés establecida es del 6 % y la tasa de inflación es del 3 %, la tasa de interés real que pagará por el préstamo es del 3 %. Los bancos y prestamistas pueden ajustar en ocasiones incluyendo una prima de inflación en los costos de los préstamos del dinero mediante una tasa inicial más alta o mediante el establecimiento de los intereses a una tasa variable.

Negative effects

High and unpredictable inflation rates are considered harmful to the economy. They add inefficiencies and instability in the market, making it difficult to make budgets and long-term plans. Inflation can act as a drag on the productivity of companies, which are forced to withdraw capital destined for the production of goods and services in order to recover the losses caused by currency inflation. Uncertainty about the future of the currency's purchasing power discourages investment and savings.

Inflation can also impose hidden tax increases: inflated incomes can mean increased income tax rates if tax brackets are not properly indexed to inflation. However, moderate inflation rates do not seem to have negative effects on economies, thus a study by Robert Barro shows that statistically, an inflation of less than 8-10% does not show a negative correlation with the country's growth rate.[17] Other empirical studies place the threshold above which inflation can be really harmful at 20 or 40%.[18]​[19]​.

The main negative effect of inflation, in a market economy, is that it destroys the price system of the economy. On the one hand, producers make their savings-investment decisions based on the information available, so in an inflationary environment they are not able to discover if a price increase is a relative effect (only to their product) or, on the contrary, it is an absolute increase (where all product prices rise). In these cases, the investor has to spend more time knowing the prices of the products and, in particular, the prices of their competition, because these become obsolete in the short term, instead of dedicating that time to their business. On the other hand, the uncertainty in prices caused by inflation also negatively affects consumers, since they must waste time researching the price of the products they consume. Therefore, this uncertainty and less information, which produces inflation, negatively affects both investors and consumers, and with this negatively affects the growth possibilities of the economy.

Firstly, the deterioration in the value of the currency is detrimental to those people who earn a fixed salary, such as workers and pensioners. This situation is called loss of purchasing power for the aforementioned social groups. Unlike others with mobile incomes, they see how their real income is reduced month by month, when comparing what they could buy with what they can buy some time later. However, it should be noted that if salaries are quickly adjusted to inflation, the loss of purchasing power of some social groups is mitigated or eliminated.

With high inflation, purchasing power is redistributed from people, businesses and institutions with nominal fixed incomes, to those with variable incomes that can keep pace with inflation. This redistribution of purchasing power also occurs among international trading partners. If fixed exchange rates exist, one economy with higher inflation than another will make the former's exports more expensive, affecting the trade balance. Negative trade effects may also arise due to instability in currency exchange prices.

Inflation is regressive") (that is, it affects sectors with fewer resources relatively more than those with greater resources) due to the Cantillon effect, which explains that newly created money is not distributed simultaneously or uniformly throughout the population but rather benefits those who print the money. uniformly throughout the population, those who first receive the money issued are least affected by the loss of value of the money.[21]​.

Furthermore, sectors with fewer resources use cash (or monetary balances) relatively more than sectors with more resources, and they have fewer financial instruments to hedge against inflation. On the other hand, sectors with more resources have access to more financial instruments (such as deposits that are adjusted with inflation) and with these they can better protect themselves from the loss of purchasing power that inflation produces.[22][23]​.

Inflation is harmful to those creditors of fixed amounts, since the real value of the currency decreases over time and their purchasing power will decrease. On the contrary, those debtors with a fixed rate will benefit, since their real liabilities will decrease.

As a consequence of the previous points, what is usually called “self-constructed inflation” arises. This phenomenon consists of transferring the increase in prices forward in time, this is because people expect inflation to continue as in previous periods. This creates an inflationary spiral, in which contracts are indexed, salaries and prices are increased due to future expectations.

Differential inflation is a situation in which two or more countries, whose economies are strongly dependent or form a special economic area, have different rates of price increases. Differential inflation, especially if it is sustained over a long period, generally causes the country with the highest inflation rates to suffer an increase in production costs and consequently a loss of competitiveness.

It is the product of the increase in the costs of an important input for the production of a good or service, for example energy, and in this way generates inflation in the rest of the economic activities.[24]​.

High inflation can prompt employees to demand rapid wage increases to keep up with consumer prices. In the case of collective bargaining, wage growth will be set based on inflation expectations, which will be higher when inflation is high. This can lead to a wage spiral. In a sense, inflation can generate a situation of instability that feeds on itself: inflation generates expectations of more inflation, which in turn generates greater inflation.

People tend to buy durable and non-perishable products to partly avoid the expected losses from the decline in the purchasing power of the currency.

If inflation becomes out of control (increasing), it can seriously interfere with the normal functioning of the economy, affecting its ability to produce and distribute goods, and it can also lead to the abandonment of the use of currency as a means of exchange of goods, leading to the inefficiencies of barter.

A change in the supply or demand of a good will normally modify its price, signaling to buyers and sellers how they should reallocate resources in response to new market conditions. When prices are unstable and change markedly due to inflation, price changes due to supply/demand signals are difficult to distinguish from price changes due to general inflation. The result is a loss of efficiency.

According to the Austrian theory of the economic cycle, the fractional reserve causes the decision-making of economic agents to begin to be erroneous from the moment the money supply begins to be multiplied by the existence of the fractional reserve because both depositor and borrower believe they have possession of the same capital and therefore make savings and consumption decisions that are altered with respect to the decisions they would make if the depositor were recognized as a creditor, that is, if the depositor really had his money available. This distortion in information causes inflation to arise in the different production phases and sets the economic cycle in motion. Austrian economists argue that this is the most damaging effect of inflation.

According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to highly speculative reckless lending, which increases the probability of bad investments, which in the long term turn out to be unsustainable, generating business losses, layoffs, salary reductions and consequently in consumption and as a consequence in production, with price declines staggering after the initial rise of the expansionary phase.

Positive effects

Positive effects include the ability of state central banks to adjust nominal interest rates in order to mitigate a recession and to encourage investment in non-monetary capital projects.

Keynesians believe that nominal wages are quick to rise, but slow to adjust downward. If wages are overvalued, this difference in the speed of adjustment leads to a prolonged imbalance, generating high unemployment rates. Since inflation would be less than the real wage if nominal wages were held constant, Keynesians argue that some inflation would be good for the economy as it would allow labor markets to reach equilibrium more quickly.

The main tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations, which are central bank interventions in the bond market with the aim of affecting nominal interest rates. If an economy is in a recession with low nominal interest, then the bank finds limits to reduce rates further in order to stimulate the economy (since negative nominal interest rates are impossible). This situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates remain well above zero, so that if the need arises, the bank can reduce the nominal interest rate.

The concrete experience of individual countries seems to indicate that high inflation is compatible with rapid economic growth. In the 1960s and 1970s, Brazil had an average inflation rate of 42%, but it was one of the fastest growing economies in the world, and its per capita income increased by 4.5% annually.[25]​ During the same period, South Korea's per capita income grew by 7% annually, despite an average rate of almost 20%.[25]​.

There are several explanations for this, among them is that with high inflation, the net profitability of financial investments, which is equal to nominal interest minus inflation, declines greatly and in these circumstances non-financial investment in the productive economy is more attractive. As if that were not enough, anti-inflationary policies can be harmful to the economy. Since 1996, Brazil, after suffering from hyperflation, began to control it by raising effective interest rates to 10-12% (a figure among the highest in the world), inflation fell to 7.1% but growth also suffered, which did not exceed 1.3%.[25] South Africa also had a similar experience in 1994, when it began to give absolute priority to controlling inflation and raised interest rates to Brazilian levels.

Se han usado y sugerido diferentes métodos para detener la inflación. En casi todo el mundo, se ha impuesto la política de control de la inflación. De hecho la priorización de medidas antiinflacionistas severas produjo efectos adversos en Sudáfrica (1994) y Brasil (1996).[25]​ Economistas institucionalistas como Ha-Joon Chang han señalado que los partidarios del liberalismo han aprovechado el miedo justificado a la hiperinflación para impulsar políticas antiinflacionistas excesivas (dados los niveles de inflación en muchos lugares donde se han impulsado).

Monetary policies

Today, the main tool to control inflation is monetary policy. Central banks can significantly influence this by setting a higher interest rate and reducing the money supply. Typically at a target rate of around 2% to 3% annually, and within a low inflation target range, somewhere between 2% to 6% annually.

There are a number of methods that have been suggested to control inflation. Central banks like the US Federal Reserve can affect inflation largely through interest rates and adjustment through other operations. Interest rates and slow growth of the money supply are the traditional ways through which central banks combat or prevent inflation, although they have different approaches. For example, some pursue a symmetrical inflation target, while others only control inflation when it rises above an acceptable threshold.

Monetarist policies emphasize a constant and moderate money growth rate. Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Controlling aggregate demand can be achieved by combining monetary policy and fiscal policy (increasing taxes or reducing public spending to reduce demand).

Fixed exchange rate

Under a fixed currency exchange regime, the value of a country's currency becomes tied to the value of another currency or a basket of other currencies (or sometimes to another measure of value, such as gold or other commodities). A fixed exchange rate is generally used to stabilize the value of one currency by pegging it to another, more stable currency. It can be used as a means to control inflation. However, when the value of the reference currency rises or falls, so does the linked currency. This essentially means that the inflation rate in the country's fixed exchange rate is determined by the inflation rate of the currency to which it is linked.

A fixed exchange rate prevents a government from using national monetary policy to achieve macroeconomic stability. Additionally, it can expose countries to the danger of speculative attacks.

With the Bretton Woods agreements, most countries used rates fixed to the value of the US dollar. The agreement was broken in the 1970s, and countries gradually turned to floating exchange rates. However, in the latter part of the century, some countries that suffered hyperinflationary processes temporarily returned to a fixed exchange rate to stabilize their currencies. This policy was used in many South American countries: for example, Argentina 1991-2002, Bolivia, Brazil, Chile (1979-1982)[26]​ and Venezuela (since 2003 with the entry into force of CADIVI).

Although fixing the exchange rate could be a way to control inflation (assuming that the country has many reserves of international assets) in the short term, empirical evidence shows that in the long term this policy causes the real exchange rate to fall, given that internal inflation is higher than external inflation, and this makes the economy lose competitiveness and, in many cases, put the country's balance of payments in deficit. The above happened, in the 1980s, in several Latin American countries, including Chile,[26] Argentina and Brazil. These countries had a deficit trade balance (because they had lost competitiveness by having fixed the exchange rate and, with this, having caused their real exchange rate to fall sharply) and by reducing their inflow of external credits (due to the external crisis of the early 1980s), they had no choice but to resort to the International Monetary Fund (IMF) to balance their balance of payments. The IMF forced them to comply with a tough plan to stabilize their accounts, both internal and external, at great economic cost and in some countries, such as Chile, unemployment exceeded 20%.

gold pattern

The gold standard is a monetary system in which the means of exchange for goods and services is paper money that can be freely converted into pre-established quantities of gold (or other commodities with market value such as silver). The standard specifies how gold backing is carried out, including the amount of specie per unit of paper currency. The currency itself has no intrinsic value, but is accepted by merchants as they can be redeemed for the equivalent amount in kind. A US silver certificate, for example, could be exchanged for a real piece of silver.

The gold standard was partially abandoned through the international adoption of the Bretton Woods system. Under this system, all other major currencies were tied at a fixed rate to the dollar, which in turn was tied to gold at a rate of $35 per ounce. The Bretton Woods system broke down in 1971 and most countries began using floating rates between paper and backed money.

Economies based on the gold standard rarely experience inflation above 2% annually. Under the gold standard, the long-term rate of inflation (or deflation) is determined by the rate of growth of the supply of gold relative to total production. Critics argue that this can cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be set by mining policies.

Some authors believe that this policy contributed to the Great Depression, while other theories, such as monetarist and Austrian theories, disagree. Hypotheses about the causes of the Great Depression are controversial.

The main problem with the Gold Standard is that in modern times a gigantic amount of gold would be needed for Central Banks to be able to back up all their money issued, with the consequent cost of hoarding and safeguarding it. Furthermore, in modern times it is thought that the demand for money depends on several factors (including expectations, interest rates, inflation and income level[27]​) and these are not related to the variation in gold production. For the above reasons, the use of the gold standard was abandoned in the first half of the century.

Price control

Another method used throughout history to try to stop inflation is control over prices and wages. This method was implemented, for example, by the Nixon administration in the early 1970s with negative results.

Some economists agree that price controls do not achieve their objectives of price stability and are counterproductive since they distort the functioning of an economy, since the impossibility of increasing prices in a period of increasing production costs causes shortages of goods and services, and decreases their quality, among other effects. Governments frequently attempt to remedy shortages by subsidizing goods and services that have become unprofitable due to increased costs and fixed prices. Another drawback with price controls is that compliance by the vast number of businesses and markets in a country is often difficult for government authorities to monitor and verify, so prices rise anyway.

The economic history of the last 50 years, especially Latin American history, generally shows that price controls have led to excess demand or shortages, since these price controls do not eliminate the cause of inflation.[28] Economists related to the Austrian School argue that, precisely, the experiences of price controls on a massive scale in human history (including ancient Rome and revolutionary France) have always generated a negative result for the economies involved.

Balance between currency and prices

The theory of currency price equilibrium proposes that when any product increases its price, all, including the product itself, must absorb that increase. For example, when inflation for a month is 2%, all products must decrease by 1.96%, thus absorbing that increase, ensuring that the value of the currency is constant and does not devalue. Thus, you will be able to purchase less of the products that increase in price, but you will be compensated by being able to purchase more of the products that decrease in price. To achieve this, this theory proposes the creation of a Regulatory Entity, in which representatives of businessmen, union members, consumers, and the State agree on prices, based on the value of the currency, with the aim of avoiding devaluation. It has something in common with the Nash equilibrium of game theory.

Hyperinflation causes a sharp decrease in the value of the currency, that is, as prices increase rapidly, the amount of goods and services that money can acquire decreases. During hyperinflation, we say that money loses its store of value property, people do not use currency to save, and as a unit of measurement, goods are not valued using currency. A characteristic of hyperinflation is that once it starts, it reproduces itself, since consumers, knowing that the value of their money decreases rapidly over time, try to spend it as quickly as possible, causing prices to continue their upward race.[29]​.

Among the most studied hyperinflationary processes in the world are the hyperinflation in the Weimar Republic, the Bolivian hyperinflation), the hyperinflation in Venezuela and the Argentine hyperinflation of 1989.

Hidden inflation or hidden inflation is inflation not included in official statistics. It is different from inflation involving a hidden tax[30]​ and from redflation (charging the same for product containers that have been reduced in size). Inflation is calculated by taking on different dates the prices of a basket of products or services, which are assumed to be the most frequently consumed by the average consumer. If a commonly consumed product or service is not found in this basket and its price varies, real inflation will be different from that measured by statistics, then there will be hidden inflation.[31]​ In the United States, services of this type are, for example, home insurance or babysitting rates.[31]​ This phenomenon has analogies with hidden unemployment.