What problems are related to inflation?

inflation

1. Term: Process of sustained price level increases that go beyond a certain margin. Inflation is only conceivable as a dynamic process in which inflation arises from a certain complex of causes in the economic system and has an effect on it. Only increases in the price level count towards inflation. These are to be distinguished from increases in individual prices, which are normal processes for a market economy. The flexibility of the individual prices has the important function for the market mechanism of directing or redirecting the factors of production in such a way that the supply of goods is adapted to demand. Single price increases (decreases) indicate to the providers, ceteris paribus, a higher (lower) demand, i.e. they reflect the relative scarcity conditions. If the price level is stable, these are easy to recognize based on the absolute price changes. In the case of inflation, this is more difficult, at least more expensive. Increases in the price level result from a preponderance of the increases in individual prices over simultaneous price reductions. The price level is understood as an appropriately weighted average of all goods prices. In the event of a sustained rise in prices, it can be observed that economic agents develop expectations of further losses in purchasing power, which leads to impairment of monetary functions, combined with a loss of confidence in the credit money system (no material cover). Inflation is generally only spoken when the loss of purchasing power exceeds a certain margin, the amount of which is controversial, but is usually given at around 1 to 2 percent per year.

Inflation with free pricing is known as open inflation. One speaks of backed-up inflation when inflationary tendencies are to be suppressed by measures of state price and income policy (especially price freezes) and thus a rise in the price level is to be prevented.

2. Measurement: a) Procedure: To measure the rise in price levels, certain indicators are used (deliberately avoiding individual information) that provide information on the average changes in individual prices (price index):
(1) a Price index for the gross national product measures the price development of all goods and services that go into national income.
(2) In the Consumer price index for Germany (CPI) (formerly the price index for the cost of living), on the other hand, only includes goods and services for everyday use that are regarded as representative of the “average private household”. In the Federal Republic of Germany, the Federal Statistical Office (StBA) uses the so-called Laspeyres index, which tends to exaggerate the price level development.

b) Problems Inflation measurement results from the selection of suitable indices, from the selection of the baskets on which the indices are based, the isolation of price movements from overlapping effects (changes in the structure of goods and consumption, substitution processes, quality increases), the selection of the relevant goods prices (list and special prices , Gross or net prices, inclusion of taxes, etc.) as well as in the case of effects for which it is advisable not to classify them as inflationary tendencies, although they lead to a rise in the price index, such as rising environmental costs.

3. Causes: The causes of inflation are controversial in political discussion as well as in scientific analysis. There is, however, a broad consensus that to explain a specific inflation it is usually not sufficient to concentrate on one cause or to focus solely on the most obvious causes when analyzing the causes. An in-depth root cause diagnosis is crucial in designing an appropriate anti-inflation policy. A large number of theories have been developed to explain the causes of inflation (inflation theories).

4. Effects: Inflation has predominantly economically and socially disadvantageous allocation and distribution effects. On the other hand, claimed positive growth and employment effects of inflation are theoretically ambiguous and so far hardly verifiable empirically. The extent of the effects of inflation mainly depends on the extent to which economic agents anticipate it or can be. Unpredictable inflation increases the uncertainty under which economic decisions have to be made.

a) Allocation effects: Inflation makes it more difficult, at least more expensive, for economic agents to correctly record the scarcity relations and their changes, which is associated with additional microeconomic and macroeconomic costs and consequently with welfare losses. If economic decisions due to inflation are based on misjudgments, this leads to an inefficient use of production factors (misallocation). Essential for the allocation effects of inflation is the uncertainty existing among economic agents with regard to the further development of the monetary value, which leads to a shortening of the term of contracts to a contract duration below the optimal planning horizon and to a shift in the structure of demand towards (supposedly) inflation-proof Assets leads - a misdirection of resources into artificially inflating production areas (eg escape into “concrete gold”), in which overcapacities are created. If inflation recedes in the following period, the inflation-related misallocations become visible, e.g. the fall in the price of material goods acquired in buying euphoria, company collapses and structural unemployment. The inflation-related restriction of the signaling function of prices means that economic agents are less able to invest their creative energies in profitable areas at an early stage. Ultimately, this means an impairment of economic innovation behavior. With strong and persistent inflation, economic agents increasingly lose confidence in the stability of the value of money, and an inflation mentality spreads with negative consequences for money as a means of exchange and store of value. This creates the risk of an increasing acceleration of inflation, which in borderline cases can lead to a complete elimination of the monetary functions. Overall, it can be assumed that the negative allocation effects of inflation essentially trigger inhibiting impulses for economic development, although it is sometimes claimed that a certain degree of inflation is suitable as an employment stimulus (Phillips curve).

b) Distribution effects: These are shown in a changed or distorted distribution of income and wealth compared to an inflation-free development. Changes in the distribution structure due to inflation generally always occur when different types of income and asset structures can (can) be adapted to the development of price increases to different extents and at different speeds. These differences lie in the different ability of economic agents to correctly anticipate inflation and to carry out adjustment actions autonomously and promptly, as well as in a delayed adjustment of interest rates. There are different arguments and hypotheses for this:
(1) Creditor-debtor argument: Inflation causes the real value of all money denominated claims to decrease. The creditors suffer a real loss, which is offset by a real gain on the debtor side.

(2) wage-Lag hypothesis: If the wage increases lag behind the price increases, e.g. due to the duration of collective agreements, there is a redistribution in favor of the profits and thus the recipients of entrepreneurial income.

(3) Transfer income lag hypothesis: Institutional regulations mean that transfer incomes such as pensions, child benefit, etc. are adjusted too late, while the market-determined factor incomes react more quickly to the rise in price levels. This worsens the distribution situation of transfer income recipients.

(4) Tax burden argument: Inflation leads to a change in the effective tax burden. Especially in the case of a progressive taxation of income, in which the tax increases disproportionately with growing nominal income (in the case of inflation-oriented wage and salary increases), there is an inflation-related redistribution in favor of the state.

c) Growth and employment effects: The effects of inflation on growth and employment cannot be clearly proven empirically. There is only broad agreement that extreme inflation rates have an adverse effect on growth and employment if they distort price relations to such an extent that considerable misallocations are triggered, for which only relatively minor accelerator and multiplier effects have been triggered in the meantime with regard to the positive growth and employment effects ( Accelerator, multiplier). There are different, sometimes contradicting arguments for the connection between creeping inflation and economic growth. Those arguments that claim a positive correlation are based in turn on the assumption of different adjustments of the respective prices and incomes to the inflation process with the consequence of the inflation-related improvement of the distribution situation of the corporate sector.

(1) The so-called Demand pressure hypothesis assumes that permanent (inflationary) excess demand will secure full employment and stimulate companies to invest. Another argument based on the demand side is that the inflation-related “flight into real assets” stimulates the demand for goods, which subsequently leads to an increase in investment activity with corresponding multiplier effects.

(2) From the Wage lag hypothesis the conclusion is drawn that an increase in the share of entrepreneurial income leads to an improvement in the profit situation and thus the investment climate.

(3) The so-called. Real interest rate argument claims that if the (nominal) rise in interest rates lags behind the rise in prices, the real interest burden on loan-financed investment projects is reduced and thus (creeping) inflation stimulates investment here as well.

(4) From the Creditor-debtor hypothesis the same conclusions can be drawn.

Against the positive connection between creeping inflation and growth or employment that can be asserted in this way, the first objection that can be made is that the arguments cited remain limited to the case of demand inflation. The positive effects mentioned are also partially offset by the inflation-related impairment of the allocative efficiency and the associated possible reduction in factor productivity. In addition, the assumption of the growth-promoting impulses resulting from inflation-related distribution effects appears plausible at best in the event of a one-off, unexpected inflationary surge and in the presence of money illusion; In the case of persistent inflation, however, it is to be expected that the economic agents take into account the general inflationary trend in their dispositions (inflation compensation components in collective agreements, introduction of sliding clauses in loan agreements, etc.) and thus also the difference in the speed of adjustment of wages and interest compared to the Level prices. In addition, the competitive effect of inflation can be used to derive the argument that a stronger increase in the domestic price level in relation to foreign countries will lead to a deterioration in the current account, which, ceteris paribus, has a more negative impact on national income and employment via the export multiplier.