01st Galloping inflation versus creeping inflation
02nd Should the level of commodity prices be stabilised or rather the wage level?
03rd Which price indices can be distinguished?
04th Is a short-term stabilisation desirable?
05th How does the inflation affect the factor allocation?
06th Can inflation be justified in an allocative way?
07th Growth policy justification for stability
08th How does inflation affect recipients of fixed income?
09th Which influence has inflation on wage incomes?
10th How does inflation change the asset position?
11th Conflicts between stability and current account compensation
01st Galloping versus creeping inflation
In this chapter, we will address the aim of monetary stability. We start our analysis with the question of what we understand by monetary stability, and how we measure the extent of inflation by help of the inflation rate.
In general, a distinction is made between a creeping and a galloping inflation. The difference between the two types lies here in the extent of inflation. Creeping inflation is present at an inflation rate of 1-5%, while a galloping inflation rate is above 5%.
However, if we take into account that inflations are not so much combated for its own sake, but simply because monetary stability is a prerequisite for achieving the most important other aims of economic policy, then is the reference to the extent of inflation quite unsatisfactory. It can be observed actually that the dangers which emanate from inflation occur to be quite different even if the inflation rate remains constant.
Much more important is the distinction according to the roles of the monetary functions. Which monetary functions are still intact, which functions became inoperative due to inflation? We generally distinguish three different functions of the money, namely:
· the function of the arithmetical unit,
· the function of the means of exchange as well as
· the function of the value retention.
We speak of creeping inflation when monetary functions are still intact, whereas we speak of galloping inflation when these monetary functions are endangered.
Money can fulfil its function as arithmetical unit in general only if the monetary value is reasonably stable over time. The scarcity relations are measured by the price relations and the price relations are expressed in monetary units. But a comparison of prices that relate to different time periods can only be reasonably accurate if the prices are expressed in equal units of value.
The same applies to the function of money as a general means of exchange. The seller of a product is not interested in the money he receives as the equivalent of the sold goods. He wants to use the money to buy goods in this indirect way. But if the value of this money fades over time, a rational planning is at least aggravated. If the deterioration of money is even very high and therefore the value of money is reduced at ever smaller intervals, the single individuals are forced to turn the money into goods as soon as possible, it becomes less and less possible to plan reasonably, to consider carefully before the buying which products meet the own needs the best way.
Generally, in times of high inflation other means of exchange substitute the money, especially those which have a relatively high value of goods and are stable in value over time and therefore can also be used as goods if necessary.
Here also, with regard to the function of money as a medium of exchange, it is less important how large the inflation rate is. It is quite conceivable that economic planning is still possible even if the money is losing value period by period. Much more important than the intensity of inflation per period is the question of how far the devaluation progresses preferably in equal steps. If the individuals would know e.g. that in each period (say every month), the money would rise by a very specific amount, say by 1%, then the single individuals could take this foreseeable devaluation into account in their plans, and one would pass on the expected losses due to monetary devaluation as costs in the price of the individual goods.
Not much is won therewith, however. As a rule, the rate of annual depreciation can not be defined clearly at all. Once a specific inflation has grossed, then the speed with which the inflation spreads depends not only on how much the circulating money supply increases per period. This would still be a reasonably calculable value. But the monetary value depends on both the volume of the circulating money as well as on the circulation speed of the money.
And how the circulation speed of an inflation changes depends first and foremost on how fast the individuals react and how long therefore a banknote remains on average in the register of the household or enterprise. But as this rate of adjustment itself depends again on the extent of inflation, leads this process to an ever-increasing inflation. Since nobody can foresee how fast the single individuals respond to the monetary erosion, thus the speed with which inflation spreads can not be calculated. There remains a high degree of uncertainty and it is primarily this uncertainty that takes away the feature as a medium of exchange from the money at the event of inflation.
Finally, say a few words about value retention. Here also, the money is only suitable as a means of value retention if the monetary value is relatively stable. The value of money kept in money decreases exactly by the amount of inflation.
However, for this question it is less the degree of uncertainty than rather the size of the currency devaluation that is decisive for the loss of assets due to inflation. At most, one could say that it becomes more difficult to plan dispositions of assets by the degree of uncertainty about how quickly inflation spreads.
With regard to the value retention function of money there is a large number of evasion strategies. Firstly, value retention clauses can be agreed in money transactions that run for a longer time. So e.g. when concluding a loan agreement that runs for more than 10 years, it could be agreed that at the end of the contract period, the borrower will not only have to repay the nominal amount of the loan received, but also the loss that has occurred as a result of the currency devaluation.
Even though such value retention clauses could provide with full protection against devaluation for the lender, but the assessment for these value clauses is much worse if we ask for their macroeconomic effects. We remember that price variations in a market economy have a function always: they serve to overcome scarcity relationships as soon as possible.
As scarcity increases, incentives are set to increase supply and to reduce demand. Now these functions will be partially undermined if value retention clauses are agreed. But with the consequence that precisely because the lender strives to hedge against inflation-related losses, these incentives are getting reduced, so there is a risk that then prices will increase even more and even faster than before.
Secondly, a lender can prevent the loss of assets associated with inflation by effecting compensation with the interest the borrower has to pay. If e.g. inflation was expected to be 5%, thus interest would just rise by 5%, hence the lender would not be worse off than if the monetary value had remained stable.
For this second way is particularly indicative that this compensation occurs automatically - thus by itself - that there is no need for additional regulations to ensure this compensation. In fact, it can also be observed that the interest rate for largely safe investments approximates the expected rate of inflation.
The interest rate paid on financial investments consists therefore of two components: firstly, the compensation for the respective currency devaluation, which is paid in all – secure as well as unsecure - monetary transactions and a risk component, which is granted to the extent of the expected risk.
A third way to invest ones assets is to invest increasingly in real goods. Here, it can be assumed that the real value will be maintained approximately even if the monetary value decreases steadily. However, this protection remains suboptimal. On the one side, there is an optimal allocation of assets to the various investment options. If the real investment forms are increasingly selected due to the threat of inflation, this leads away from the macroeconomic optimum. Therefore, it requires a financial investment up to a certain degree.
As long as it is not clear whether a planned investment is worthwhile for an enterprise, it is expedient for this entrepreneur to initially finance the individual necessary purchases with such loans, which can also be repaid relatively quickly if it turns out that this investment is not profitable. Only when it has been ensured that an investment is profitable in the long-term it is worthwhile to hedge this investment by such capital contributions that cannot be liquidated again without major costs.
On the other hand, it must of course be expected always that real assets are also associated with insecurity. The one who invests his assets e.g. by buying shares of an enterprise, must be prepared for the possibility that just this enterprise has to file for bankruptcy and that therefore the shareholder suffers particularly high losses just at this investment.
There is broad agreement that galloping inflation leads to devastating macroeconomic losses and must therefore be avoided by all means. But opinions differ with regard to creeping inflation. Keynes and his supporters assume that a small amount of inflation is even necessary to guarantee the aim of full employment, while liberalists fear that it is usually not possible to limit inflation to a few percentage points, and that inflation as such gives incentives to increase inflation.
In order to prevent us from accidentally ending up in galloping inflation, it was therefore necessary to avoid any kind of inflation, regardless of whether or not a slight inflation has some positive effects.
02nd Should the level of commodity prices be stabilised or rather the wage level?
In general, a stabilisation of the commodity prices is aspired. Milton Friedman, however, argued that it was not so much commodity prices but wage rates that should be stabilised. Efforts should be made to lower commodity prices to the extent, thus become deflated, as the productivity increases.
This opinion is based thereon that more justice can be achieved in this way, because there was groups of people who are not organised in interest groups and thus have to expect lower income growth. A price reduction benefits everyone in his capacity as a consumer, while income increases reach generally only those who have joined together in interest groups and were able to win higher wage rates by use of instruments of power such as e.g. strike threats.
The ability to organise in interest groups depends on the type of interest and is therefore distributed very unevenly among the population. The larger a group is, the more difficult it becomes to organise in an interest group.
On one side, the costs that need to be raised to form an efficient organisation will increase with the group size. If a group consists of just a few entrepreneurs, it is easy to take joint action at meetings that generally take place anyway. No additional organisational effort is required.
However, if the group is large, then an administration must be formed first, it must be researched, who ever counts to the group, the potential members must be contacted, in some circumstances it may be necessary to take promotional measures to recruit new members. Since this administration cause costs, contributions must be charged and other sources of money may have to be tapped in some cases.
The greater the group is that has to be represented, the greater is the risk that there will be individual freeloaders who, while seeking to take advantage of the benefits gained by this organisation, are unwilling to participate in the costs of the organisation. This group takes advantage of the fact that the services of the organisation are provided mainly as collective services. According to a proposal by M. Olson, public goods are characterised by the fact that it is difficult to exclude beneficiaries who do not participate in the costs from the consumption of this good. Therefore it also requires a constant abuse control, which again increases the administrative costs.
Furthermore, arrangements are necessary to organise meetings. From a certain group size on, it is extremely difficult to find meeting rooms that can accommodate all members. Then, it becomes necessary in some cases that delegates are selected, which in turn requires further organisational efforts.
But the ability to organise does not decrease only because the organisational costs increase at increasing size. Along with growing in size, the different needs and ideas about how these aims can be realised increase also. The strength of an organisation depends, though, decisively on the group acting with a uniform will.
Now, if the interests of the individual members drift apart more and more, the chances of success decrease, since the other side can play off the interests of each other. Or else the management tries to reduce the differences by joint discussions and by help of advertisement, in order that the chances of success may increase again. In this case, however, the costs of the organisation increase again. Thus, little is won finally.
Trade unions are opposed to the attempt to pass on productivity gains to consumers in form of price reductions. They fear that entrepreneurs will not be willing to cut prices despite productivity gains. In our society the prices of goods were inflexible downwards. Therefore, cost reductions would not always be passed on to consumers. The enterprises actually had a monopolistic position of power, and therefore they were not like entrepreneurs in competition with each other and thus did not feel pressurised to pass on cost reductions in the prices of goods.
These objections are certainly to be taken seriously. In fact, entrepreneurs often have a monopolistic (or also oligopolistic) market power on the goods markets. It is clear: the proposal to pass on productivity gains to the population in form of price reductions rather than wage increases presupposes that - as demanded by Walter Eucken - competition has previously been guaranteed broadly on the part of the state, that means monopoly ties are prevented. The demand to pass on productivity gains in form of price reductions is the better way, requires, though, that in a first step monopoly positions will be eliminated on almost all goods markets.
Theoretically, there is of course also the risk of a natural monopoly, thus the total demand for certain goods is so small that this quantity of goods could be produced by a single enterprise, and therefore the attempt to divide production into two or more enterprises would lead thereto that none of these enterprises could produce without loss. In industrial production, there is usually a minimum quantity of goods from which on loss-free production can begin at all. This is due to the fact that there are fixed costs and that for these reasons the fixed unit costs are initially extremely high.
But this risk may not be particularly high in reality if we take into account that the international division of labour has increased together with economic growth. However, it is hard to imagine that there are goods which could be produced in a single enterprise for all the need of the world.
03rd Which price indices can be distinguished?
The monetary value is measured by the reciprocal of the price level, which means the average of the individual prices. The monetary value decreases to the extent that the average of the prices increases. Thus the aim of monetary stability is reached just when the price level remains constant. Of course, this does not mean that then all prices must remain constant over time. Quite the contrary, the price variations in the context of a market economy are of crucial importance. They shall reflect the scarcity of individual goods and resources. Crucial is here, that it does not depend on the absolute level of prices, but only on the relationship of the prices to each other.
When determining a price index, we now form for all relevant goods the calculated product of the individual price pi and the requested quantity xi and add these products together. The resulting sum:
then forms the price sum, which is set equal to 100 for the reference year.
Now, if for the following years, one sets the price sums calculated for these years in relation to the price sum in the base year, one gets the respective price index for the individual periods.
Let us take an example:
For the base year, the likewise calculated price sum would amount to 2000. For the following year, the price sum increased to 2200, thus by 10%. Now, if we set the price sum of the base year equal to 100, then the ratios of the price sums to the base year measure the extent of the inflation:
In general, a distinction is made between different price indices, whereat the difference lies therein to which individual goods this index refers to and with which weight the individual goods quantities are considered. In particular, a distinction is made between the following three price indices:
· the price index of the trading volume,
· the price index of the domestic product and
· the cost-of-living index with a consumer basket of selected households.
The price index of the trading volume refers here to all goods and services traded within a national economy. Hereby, the weights of the individual goods refer to the goods actually traded on the markets.
Whereas the price index of the domestic product covers the price level of the entire domestic product. Both indices intend to capture a price level for all goods produced and sold in a national economy in the broader sense of the word. The difference is that the price index of the trading volume excludes the question of double counting, which may arise from the fact that the raw material used in a commodity is considered several times, when selling the raw material, when selling the semi-finished product in which this raw material was processed and finally when selling the end-product, in which the semi-finished products are processed and thus contains the value of the raw material again.
The price index of the trading volume is based on the mere exchange acts and thus ignores that parts of the sold goods have already been the subject of a purchase. When calculating the price index of the domestic product it is intended to avoid this double counting the way that only the value increase is determined which this good has experienced by the processing. In this way, double counting is avoided when calculating the price index of the domestic product.
The size of the difference between the two indices depends on the degree of specialisation. If we imagine an economy in which a product on from the extraction of raw materials way through the production of semi-finished products and finally to the sale of the end product to the end consumer would be pooled together in one enterprise, both indices would correspond, the individual goods would always be traded only once in markets namely as end products.
The cost-of-living index limits the determination of the price development to the goods which are directly relevant for the living conditions of the individual households. In the consumer basket essential for the cost-of-living enter only consumer goods, and also here only such that are consumed by the recipients of middle income groups. The price index of the domestic product, though, determines the price changes for completely all produced or traded goods.
The answer to the question as to which term should be applied in detail depends on the problem that is to be dealt with:
• for growth aims, the domestic product or trade volume is to be selected,
• for distribution aims, however, the cost-of-living.
Economic growth depends primarily on the total domestic product. Especially, if a large part of the scarce resources is used for the production of investment goods, the production capacity increases and thereby the possibilities to increase the production in the future. However, if the share of consumer goods turns out low, there is the risk that just the cost-of-living will increase and thus the real income available to households will turn out to be low. Thus, although growth opportunities are good in this example, by choosing the price indices (of the cost-of-living) it is suggested as if the welfare of individual consumers was diminished due to reduced consumption possibilities.
However, if we are dealing with distribution problems, the main question is to what extent consumer goods will benefit the recipients of lower incomes. Here, the cost-of-living index renders a much better picture of how middle income recipients are affected by inflationary processes.
04th Is a short-term stabilisation desirable?
The demand for price stability applies initially for each period! If we assume, as we will show yet, that welfare losses emanate from changes in the price level, then the aim of monetary stability should actually apply for each individual period, and if we consider a longer period, it may well be expected that this aim will be corresponded even more the closer we approach each aim in this particular period.
Joseph Alois Schumpeter has argued, though, that both price increases in the upturn as well as price reductions in the downturn have quite positive functions. After that, we do move away from this aim of monetary stability certainly not because prices generally rise in times of boom or because we can expect general price reductions in times of economic downturn.
The classicists of economic theory assumed the thesis that in a market economy only the relations of prices to each other have a positive function, in view of the price level it would be completely indifferent which price level appeared. The production control realised by means of the mediation of the price relations was the same with constant price relations, if the absolute prices in the one case were twice as high as in the other case.
Schumpeter now seems to contradict this general view. The price level also plays a decisive function for the allocation. It is only desirable for the price level to remain largely constant in the long term, e.g. for an entire economic cycle, but it is just not desirable for the price level to remain constant also in the short term, i.e. in each year compared to the previous year.
What are these functions intended for the price level? Price increases in the upswing thus have the function of boosting the economy, price reductions in the downturn, however, have the function to ensure that only profitable enterprises are able to persist in the market.
Initially, we look at an upswing phase. It is characterised thereby that the demand is increasing and the supply is adjusting to this increase. But this adjustment takes time and this means that now there are temporary excess demands, supply can not meet demand immediately. But in free markets demand overhangs are reflected in price increases. These price increases, like any price increase, have the function of reducing the imbalance between demand and supply as soon as possible by encouraging suppliers to produce more and, at the same time, providing incentives for the demanders to reduce their demand.
Thus if in the upswing phase it is all about reducing free production capacity and, in order to achieve this task, from a certain moment on prices tend to rise in general, then this generally desirable upswing is at the same time associated therewith that price increases also allow such entrepreneurs to start production, which under normal conditions would not be able to carry out a profitable production at all. The excess demand makes it possible for the entrepreneurs to charge any price. Under normal competitive conditions, customers changed to the competition at these inflated prices, with the result that these unprofitable enterprises would not have been able to commence production at all.
And the general decline in prices in the economic downturn has just the task of ensuring that enterprises that are unable to commence production under normal conditions are eliminated again from the market.
From a macroeconomic point of view, it is now necessary - once the free capacity has been largely reduced - to ensure that the scarce resources continue to be used by enterprises that can maintain their production even under competitive conditions. For this purpose, it is desirable that the unprofitable enterprises release their occupied resources, and this task takes place the way that in times of economic downturn these enterprises leave the market by bankruptcy.
05th How does the inflation affect the factor allocation?
Now, in the following sections of this chapter we like to turn to the question, for which reasons then monetary stability is required. We have already noted above that monetary stability is generally not pursued for its own sake, thus has no intrinsic value which has to be preserved, but is primarily demanded since inflation contravenes other economic policy aims. The aim of stability is thus only of instrumental nature.
A stability of the monetary value is firstly a prerequisite for an optimal allocation. The allocation is indeed - as we have seen above - only directly dependent on the price relations initially. If we start from the general equilibrium system as described by Walras, the market data only fixes the prices and quantities of goods and factors of production and thus the absolute level of prices and, of course, also the price level as the average of those prices is insignificant for the market situation. If all prices were doubled without changing these price relations, the results of the markets would not change.
But why does an inflation process still have an impact on the market results? The reason is that in the course of an inflation process the price relations are postponed at least temporarily and for this reason undesirable allocation effects are triggered. For we can observe that the increases in individual prices are not all simultaneous, but occur at different times. Almost every inflation starts with excess demands in a single or a few markets, causing the prices of these goods to rise.
There are many connections between the individual markets of an economy, however. Thus, price increases at the one good will certainly also bring about repercussions on the goods, which are in a substitutive relationship with the first good. Let us suppose the price of butter rises. Just because the purchase of butter has become more expensive now, many consumers may turn to other fats like e.g. the margarine. Now, since the demand for margarine has increased, it must also be reckoned with a price increase of the margarine price.
Furthermore, inflations are triggered mostly by the fact that either the circulating money supply has been increased or that the speed of circulation increases at the same amount of money. The demand for several goods will rise as a rule in both cases simply because, according to the second Gossen's law, a maximum utility can only be achieved if the marginal utility of all goods is balanced.
Now, if more is demanded of one good, then according to the first Gossen's law the marginal utility of this good lowers and therefore an increase in benefits can be achieved, when there is also more demand for the other commodities. While in the first example we have examined the relations of goods which are in a substitutive relationship, this second connection occurs predominantly in goods which are in a complementary relation to one another. Who consumes more bread, will generally ask for more spreads, too.
Therefore, it has to be assumed that the increases in demand, which trigger an inflation process, are distributed gradually and not suddenly across the entire economy and that in this way the actual price relations deviate temporarily from the ratios that would guarantee an optimal allocation.
Obviously, these are initially only temporary distortions in the price relations. One might therefore assume that these misallocations are of lesser importance, since these price relations which produce an optimal result will attune in the long run. One could point out that we do just not live in an ideal world and therefore would have to accept certain friction losses. Such friction losses can be expected even if other data changes occur and therefore the prices would have to be adapted to these new data. Here, too, a certain amount of time passes, in which, precisely because prices are not yet corresponding to the changed scarcity conditions, temporary welfare losses occur.
However, there are good reasons why the price relations will change over the long term if inflation processes occur and thus the price relationships will also deviate from the scarcity conditions in the long run. The inflation process does not only refer to the prices of goods, but also the compensation rates of the production factors are affected. Thus e.g. the demand for labour force is always in a complementary relationship to the production of goods. If production shall be expanded, an increased use of production factors is also required. Thus the factor prices - again with a certain delay - will increase, too.
But if factor prices rise, then this leads mostly to an increase in the nominal incomes, although one can not assume that wage incomes will always increase proportionally with wage rates. The wage incomes result from the product of wage rate and labour input, and this usually declines when wage rates rise.
But if incomes change, then a change in the demand structure has to be expected also. The demand structure differs from household to household, so that changes in the composition of the demand for goods arrive usually.
One will have to reckon now with the fact that these changes continue over a longer period of time and generally are not reversed anymore by returning to the initial position. Most income groups will indeed strive to catch up. But we have already seen that the organisational capacity of each interest group is very different, thus this adaptation occurs also very different. This means, however, that the changes initiated by the inflation process thus occur mostly also permanently.
But even if all income groups were able to recapture their previous position within the income hierarchy, long-term welfare losses would still persist due to the inflation process. Although these losses may be negligible if a one-time increase in the price level occurs. In reality, however, we have to expect that prices rise in general almost every year, and that only in times of depression the prices will stop growing temporarily. In this case, though, the individual losses add up to a considerable sum in the long run.