What is inflation?

ricardian ambivalence has a great piece:

First of all, it seemed to confuse inflation — a general rise in the price of goods and services — with rising prices. They are not the same thing.

Inflation is not an increase in the cost of living. At least not the sort of inflation that monetary policy might control.

Central banks control the money supply, and the inflation we mean when we talk about policy is a decrease in the value of money due to its excess supply relative to the production of goods and services. Money and credit aggregates are growing very slowly (even more sub-trend than real output) so I cannot see signs of an excess supply of money as a cause of inflation.

This is one of my great bug bears – inflation is a monetary problem.

The confusion comes about through measurement. The CPI measures changes in prices. Some price changes are due to inflation, others due to changes in scarcity, and then public policy distorts prices too. Okay. What the RBA does is attempt to unravel those price changes, and then target the inflation. The devil is in the detail – in how the RBA unravels the price changes to identify the inflationary component.

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15 Responses to What is inflation?

  1. Max says:

    This is one of my great bug bears – inflation is a monetary problem.

    I never new how Friedman got away with this fraud.

    “inflation is a monetary problem” is not the whole story – what about the supply side like the oil price shocks, or asset price inflation due to new credit technology like home loan securitisation?

    afterall prices are set by Supply and Demand

  2. Keith says:

    It is said that RBA uses the trimmed mean CPI in its considerations. Currently the trimmed mean is advancing faster than the headline rate.

  3. Sinclair Davidson says:

    They use the average of the trimmed mean and the weighted median.

  4. Sinclair Davidson says:

    Prices are set by supply and demand and inflation distorts those prices. It is the distortion that is the problem not the prices per se.

  5. Keith says:

    They use the average of the trimmed mean and the weighted median.

    Nevertheless the derived figure should be less volatile than the headline rate.

  6. Sinclair Davidson says:

    That is the case.

  7. Sleetmute says:

    ricardian ‘ambivalence’

  8. Sinclair Davidson says:

    thanks – Freudian slip there. 🙂

  9. . says:

    afterall prices are set by Supply and Demand

    Arbitrary changes in purchasing power, generally are not.

  10. Pedro says:

    I sometimes figure it is more accurate to say that the RBA targets inflationary pressure within the economy. In the long run inflation is a monetary phenomena, but in the short run you can have inflationary pressure from supply and demand factors.

    I recall in the run up to 2007 there was good reason to criticise the RBA for the rate rises given the pressure seemed to be coming from OS, but I still had some sympathy for the decisions.

    If our currency declines quickly then we will be in for an interesting ride on this score.

  11. SteveC says:

    A genuine question, as a non-economist, at the risk of being smacked in the head. Why does the RBA have a target range for inflation that has a lower bound greater than zero. The target is 2 to 3, why isn’t is 0 to 3 ? Is some inflation considered a good thing?

  12. . says:

    There is no point in explaining the flaws of the 2-3% target band to a left wing troll.

  13. Pedro says:

    Don’t be nasty Mark 😉

    It’s basically because a little bit of inflation is easier to manage than anything else.

  14. . says:

    Pedro is sort of right.

    It helps monetise debt on ALP white elephants, it is a stealth tax which makes balancing budgets easier and it gets rid of wage rigidities caused by the minimum wage, thus stopping mass unemployment.

    At the same time it creates a highly speculative capital structure, destroys savings and long run productive capacity.

    The idea that a little inflation is “easy to manage” and is “better than the alternatives” is a result of historical ignorance.

    The long recession saw deflation and increasing output.

  15. wreckage says:

    Stealth tax: it bumps people up tax brackets

    Wage rigidities: you can’t reduce ticket wages in Australia so you need to reduce real wages.

    Government borrowing: paying back devalued dollars is effectively cheaper.

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