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Key Takeaways
- Stagflation occurs with high inflation, slow growth, and high unemployment.
- Hyperinflation can devastate economies, as shown in 1920s Germany.
- Deflation leads to unemployment due to cost cutting by businesses.
- Monetarists attribute inflation to money supply expansion.
Understanding Inflation: Types, Causes, and Economic Impacts
Inflation refers to the rise in prices across the economy. But inflation can take many forms, and it has complex causes.
For example, stagflation, which occurred in the 1970s, combines high inflation with slow growth, while hyperinflation, which is what Zimbabwe experienced, is extremely high inflation.
Economists use theories like Keynesian and monetarist approaches to explain why inflation happens.
Discover the complexities of inflation, including stagflation, hyperinflation, and deflation. Learn their causes, effects on the economy, and key economic theories.
Different Types of Inflation
Stagflation
Stagflation (a time of economic stagnation combined with inflation) can wreak havoc. This type of inflation is a witch’s brew of economic adversity, combining poor economic growth, high unemployment, and severe inflation all in one.
Although recorded instances of stagflation are rare, the phenomenon occurred as recently as the 1970s, when it gripped the United States and the United Kingdom—much to the dismay of both nations’ central banks.
Stagflation poses a particularly daunting challenge to central banks because it increases the risks associated with fiscal and monetary policy responses. Whereas central banks can usually raise interest rates to combat high inflation, doing so in a period of stagflation could risk further increasing unemployment.
Conversely, central banks are limited in their ability to decrease interest rates in times of stagflation because doing so could cause inflation to rise even further. As such, stagflation acts as a kind of checkmate against central banks, leaving them with no moves left to make. Stagflation is arguably the most difficult type of inflation to manage.
Hyperinflation
Although as consumers, we may hate rising prices, many economists believe a moderate degree of inflation is healthy for a nation’s economy. Typically, central banks aim to maintain inflation around 2% to 3%. Increases in inflation significantly beyond this range can lead to fears of possible hyperinflation, a devastating scenario in which inflation rises rapidly out of control.
There have been several notable instances of hyperinflation throughout history. The most famous example is Germany during the early 1920s, when inflation reached 30,000% per month. Zimbabwe offers an even more extreme example. According to research by Steve H. Hanke and Alex K.F. Kwok, monthly price increases in Zimbabwe reached an estimated 79,600,000,000% in November 2008.
Deflation
Deflation, also known as negative inflation, occurs when prices drop for various reasons. Having a smaller money supply increases the value of money, which in turn decreases prices. A reduction in demand, either because there is too large a supply or a reduction in consumer spending, can also cause deflation.
Deflation may seem like a good thing because it reduces the prices of goods and services, thus making them more affordable, but it can negatively affect the economy in the long run. When businesses make less money on their products, they are forced to cut costs, which often means laying off or terminating employees, thereby increasing unemployment.
Important
Keynesian economists argue that inflation results from economic pressures such as the increased cost of production and look to government intervention as a solution. Monetarist economists believe inflation stems from the expansion of the money supply and that central banks should maintain stable growth for the money supply in line with gross domestic product (GDP).
Key Theories Behind Inflation
Keynesian Economics
The Keynesian school believes inflation results from economic pressures such as rising costs of production or increases in aggregate demand.
Specifically, it distinguishes between two broad types of inflation: cost-push inflation and demand-pull inflation.
- Cost-push inflation results from general increases in the costs of the factors of production. These factors—which include capital, land, labor, and entrepreneurship—are the necessary inputs required to produce goods and services. When the cost of these factors rises, producers wishing to retain their profit margins must increase the price of their goods and services. When these production costs rise on an economy-wide level, it can lead to increased consumer prices throughout the whole economy, as producers pass on their increased costs to consumers. Consumer prices, in effect, are thus pushed up by production costs.
- Demand-pull inflation results from an excess of aggregate demand relative to aggregate supply. For example, consider a popular product where demand for the product outstrips supply. The price of the product would increase. The theory of demand-pull inflation is that if aggregate demand exceeds aggregate supply, then prices will increase economy-wide.
Monetarism
Monetarists have historically explained inflation as a consequence of an expanding money supply. The monetarist view is perfectly encapsulated by Milton Friedman’s remark that “inflation is always and everywhere a monetary phenomenon.” According to this view, the principal factor underlying inflation has little to do with things like labor, materials costs, or consumer demand. Instead, it is all about the supply of money.
What Causes Inflation?
The main causes of inflation are classified as demand-pull inflation, cost-push inflation, and built-in inflation. Demand-pull inflation is when the demand for goods and services exceeds production capacity; cost-push inflation is when an increase in production costs increases prices; and built-in inflation is when prices rise and wages rise, too, in order to maintain purchasing parity.
Who Gains from Inflation?
When prices rise, borrowers generally benefit from inflation because they are paying back debts with money that has depreciated since prices increased. For example, if they have a fixed monthly payment of $1,000 and prices go up, that $1,000 is worth less than what it was before. Borrowers can also benefit from inflation, as the increase in prices may result in people needing to borrow money more.
What Are the Worst Investments in Times of Inflation?
During periods of inflation, some of the worst sectors to invest in are retail, durable goods, and technology. This is because when inflation happens, people tend to spend less due to the higher prices, and these sectors are often the ones where people begin to cut back on spending.
The Bottom Line
Inflation can range from simple price increases to more severe forms like stagflation or hyperinflation, as seen in the 1970s or in Zimbabwe. Economists use different theories to understand these trends, and central banks play a key role in managing inflation through monetary policy.
Recognizing the various types of inflation helps individuals and policymakers make informed financial and economic decisions.
