(This is a current extract from the Patterns of Power Repository.  An archived copy of this page is held at http://www.patternsofpower.org/edition02/3383.htm)

Inflation, in economic terms, can be loosely described as an increase in the prices paid by individuals and companies for goods and services and a fall in the purchasing power of money.  It can be caused by increases in the prices of imports, or by wage demands which are not accompanied by corresponding increases in productivity, or by governments printing money.  Printing money, for example by issuing bonds, can help a government to make debt repayments; it also indirectly reduces the pain of having a structural deficit ( and high debts:

·      Inflation causes nominal prices and incomes to rise, which reduces the fiscal deficit by increasing the tax revenue.[1]

·      Those who lend money to governments by buying fixed-interest securities find that their real value has been diminished by the time that repayment falls due.

Inflation is a politically easy solution; by the time its effect is felt people don’t connect the pain to the political decisions that caused it.

Inflation reduces the real value of people’s incomes and savings – so very high inflation causes hardship, as was the case in Germany in the 1920s.[2]  Deflation (falling prices), as experienced during the Great Depression and in Japan in the 1990s,[3] creates unemployment.  Control of inflation is therefore important, and various approaches have been tried:

·      Some governments have attempted to apply direct controls to prices and incomes, but this has been unsuccessful (3.3.6).

·      Governments can increase interest rates to reduce people's willingness to borrow, which reduces the money supply and thereby controls inflation with the type of ‘monetarist’ approach that was advocated by Milton Friedman, among others.[4]  This policy also reduces economic activity by reducing demand and by increasing the costs of providing goods and services.   When it was applied in the UK during the 1980s, in order to correct a previous period of high inflation, the resulting unemployment was painful.[5]

·      It is also possible to restrain inflation by increasing taxes to reduce demand and slow the rate of economic growth; this in turn reduces wages, as there is less demand for labour, and shoppers become keener on finding lower prices.  Keynes advocated this use of fiscal policy to control inflation, but monetarism is more popular now.[6]

Nowadays the central banks manage inflation in most countries, in accordance with targets set by government, using a monetarist approach.  A depoliticised monetary policy prevents governments from using easy credit as a way of engineering an economic boom to win an election (but a disciplined fiscal policy is also necessary to achieve stability).[7]

© PatternsofPower.org, 2014

[1] Gene Epstein described how inflation had the effect of reducing a government’s debt repayments, in an EconTalk podcast in June 2008.  The 1985 reform that indexed the federal tax brackets reduced, but has not eliminated, the phenomenon.  The relevant point appears in paragraph 3 of the text transcript of the podcast highlights, which was available in April 2014 at http://www.econtalk.org/archives/2008/06/gene_epstein_on.html#highlights.

[2] The Economist published an article on German hyperinflation, entitled Loads of money, on 23 December 1999.  It was available in April 2014 at http://www.economist.com/node/347363.

[3] Both the Great Depression and Japan in the 1990s were cited in an Economist article entitled Diagnosing depression which was published on 30 December 2008.  It was available in April 2014 at http://www.economist.com/node/12852043.

[4] Milton Friedman's contribution to economic thinking was summarised in a special article: A heavyweight champ, at five foot two, in the Economist, 23 November 2006.  The article, which was available in April 2014 at http://www.economist.com/node/8313925, cited his 1971 book A Monetary History of the United States, 1867-1960, which demonstrated the link between money supply and inflation.

[5] An article in The Independent, 15 March 2001, entitled Mass unemployment belongs to the past, and it must remain that way, pointed out that “Under Mrs Thatcher, unemployment more than tripled.”  The article was available in in April 2014 at http://www.highbeam.com/doc/1P2-5136580.html.

[6] Samuelson and Nordhaus compare the efficacy of fiscal and monetarist policies in chapter 23 of Economics.

[7] An article in the Economist on 29 July 2004, entitled Boom, bust and hubris, commented on the British government distorting its management of the economy for electoral reasons:

“In short: contrary to Mr Brown's claims, monetary and fiscal policy are no longer working together to achieve stability. Instead they are pulling in different directions. Fiscal policy remains highly expansionary: the budget deficit will remain around 3% of GDP this year and next. That's because, with an election looming in summer 2005, the chancellor has run scared of new tax increases.”

This article was available in April 2014 at http://www.economist.com/node/2968857.

As the Economist had warned, the housing boom had to end and Britain was not well placed for the economic crisis of 2008.