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What is Inflation: Five Types of Inflation Defined

Over on RealMoney, Barry Ritholtz argues that the U.S. government is probably underestimating inflation because it is focusing on the wrong type of inflation. I would agree with that, having identified no less than five different types of inflation: commodity inflation, wage inflation, monetary inflation, fiscal inflation, and foreign exchange inflation. Before discussing “inflation,” it helps to define, “What is inflation” and identify which form of inflation is being talked about. Failure to do so may have caused some of the confusion that often surrounds this topic.

The inflation that most American economists remember best (from the 1960s and later) is wage inflation, otherwise known as demand-pull inflation. Workers observe rising prices and demand compensation in the form of higher wages, which creates a vicious cycle of more inflation and more wage demands. This has not been happening until recently in the United States, due to the absence of labor unions, and to what Karl Marx called the “reserve army of the unemployed” in “offshore” markets. This appears to be the form of inflation that the Fed and other U.S. government authorities are focusing on, and it has indeed been benign up to now.

A less common, but more volatile form of inflation is commodity inflation, better known as cost-push inflation. We can see it today in commodity prices such as energy and metals. Energy and food price changes are excluded from “core” inflation because of their period-to-period volatility. But over time, oil price rises have averaged 6% a year, higher than other forms of inflation, and assuming that they don’t cause inflation is really assuming away the problem. Other commodities such as timber rise at 3% a year “real” (above the rate of calculated inflation).

That’s largely because such rises are (wrongly) excluded from the calculation. Another form of commodity inflation that is excluded from the official statistics has been the parabolic rise in housing prices. (The government instead uses a calculation of “owner equivalent rents,” which are basically tied to the benign wage numbers.) Commodity inflation is the most obvious form of inflation today (after having been quiescent in the 1990s), as reflected in higher food, gasoline and gas bills, but is severely understated.

Monetary inflation was most famously seen in Weimar Germany during the 1920s, when the German government went crazy with the printing presses to the point where it took billions of marks to equal one dollar. This wiped out the savings of the middle class, most members of which were compensated with (worthless) “million mark” notes, and eventually led to the rise of Hitler. Nothing of this sort has happened in the western world since, but it is a worry when the United States has a chairman of the Federal Reserve who has talked (hopefully facetiously) of dropping money out of helicopters.

Fiscal inflation is due to excess government spending, for which the budget deficit is a reasonably good proxy. It originated in the “guns and butter” spending of President Lyndon Baines Johnson in the 1960s, and similar spending of today’s President George W. Bush. We have war spending without a “war economy” e.g. rationing or wage and price controls, and if the 1960s are any guide, we will be paying the price later this decade and in the 2010s.

The last type of inflation, foreign exchange inflation, is particularly scary to me, someone who lived in Mexico before and during the peso crisis in 1994. This happens when the local currency (pesos in this case) falls dramatically against other world currencies, thereby sharply raising the price of imported goods, and hence the overall price level.

This is a real worry for the United States when the latest annual trade deficit is somewhere over $760 billion. I’m not looking for anything like the two-thirds fall of the Mexican peso in 1994-95 as a result, but even a 20% across the board drop of the U.S. dollar against the Euro, yen and yuan (the Chinese currency was unpegged from the dollar only in 2005) would be a severe shock stateside.

Regards,

Tom Au
for The Daily Reckoning Australia

12 Comments

  1. André Levy says:

    Inflation, The Sixth Sense: Asset Inflation

    Financial assets inflation is what we’re observing all around the world at the moment. Information technology has enabled us to conquer drastic reductions in the costs of transacting financial assets, most notably stocks. With lower transaction costs, and consequent increase in traded volume (turnover in US equity markets has quadrupled since 1980), stocks have become an effective alternate to sovereign money as a means of exchange. We get paid in company stock; what could be a clearer sign?

    With higher liquidity, stocks trade at a lower discount. This means their prices go up. However, this is an illusion; an inflationary illusion. The illiquidity discount in stocks is in effect a liquidity premium on money. Prices are all relative, so what’s the difference? The difference is that money is effectively worth less in consumption units; it looses purchasing power. The shadow price for the constraints on trading adds a premium to the purchasing power of more liquid assets (including sovereign money), but leaves the purchasing power of the less liquid assets unchanged. The reason for this is that liquid assets are traded first in the interest of risk sharing. Once all liquid assets have been traded, all remaining unbalanced assets are equally illiquid, and hence no liquidity differential is created.

    If sovereign money has lost its purchasing power, we should observe a rise in consumption goods. The reason why we don’t is that the progress in information and transportation technologies has allowed us to tap into the excess capacity in offshore labour markets, as Tom points out.

    So what does this mean? This means

    1. The end of Equity Premium Puzzle – as the liquidity portion of stock returns has been realised at present value in the last decades;

    2. Significant devaluation of OECD money against consumption goods – as the excess capacity in offshore labour markets are dried up (and we are already starting to see some of that in China);

    3. Sharp decline in demand for consumption, especially in those countries with the lowest saving rates (i.e. the US);

    4. Substitution of US consumption for consumption in China – as the lifting of the masses above the poverty line allows consumption to climb the exponential curve of wealth distribution;

    5. China stops rolling over its stake at the US debt (currently $1.2 trillion) – as it no longer sees the need to finance its main client;

    6. Oil producing countries also sell off their US Treasury assets (currently valued at $1.3 trillion);

    7. Japan may remain loyal to the US, as their protectors and benefactors, but only to their own detriment, as a broke nation will be unlikely to defend them against China;

    8. Devaluation of the USD against other currencies – as US interest rates go through the roof (this is the foreign exchange inflation Tom pointed out);

    9. Further substitution of the US for China as the global trade partner, especially for commodity and energy producing countries (i.e. Brazil, Australia, Venezuela, and countries in Africa and the Middle East) as well as service providers;

    10. Major shift in geopolitical power. What happens to Japan and Israel?

  2. Economist Ramon the great says:

    Monetary inflation is better advocated utilizing the equation of exchange and the quantity theory of money, the former, which is MV=PT (money supply x velocity of circulation = price levels x total transactions) and the latter, explains that the velocity of circulation be will equal to the level of transactions, therefore after removing them from the equation, only M=P remains, hence saying that any change in the money supply will bring about a change in the level of prices.

  3. dear sir/madam
    iam krishnamoorthi mphil scholar in buss admn in annamalai university,your information very useful for me bcoz iam finance specialization student thank you for your valuable information my wishes to your service to the world,

  4. miss Nelson says:

    please sir what i need is type of inflation.please can you help me

    thanks

  5. rag says:

    http://mises.org/story/3522

    http://www.mises.org – cover story on inflation – what you see and what you dont see – web link to story above

  6. yaseen says:

    we are extremely sorry to say that i did not get your point and to explain please it

  7. What is inflation by defination: inflation is persistent rising in price of commondities. If looks around the world todays inflation has caused alots of damages to our economy. If we are to examines the types of inflation that occur in 1960s around the world is not even caused damage to economy alone, but to well-being of nations affected. In ours’ nation today the rate of inflation had gone beyoung the normal standard of economic statistics. Independent of money(sovereignty of money) it means when money valuation-standard without been inflated.

  8. (1) Creeping inflation: a period of gentle level continuous rise in the general price level of <5%/ year. (2) Hyper inflation: rapid rise the general price level causing serious instability in the economy. (3) Walking inflation: prise rise moderatly&annual inflation rate is a single digit of between 5-10%. (4) Running inflation: price rise at the rate of 10-20% (annualy). (5) Pure inflation: A situation in which all price inculding wages & order source of income rise at an equal rate. (6) Shock inflation: A sudden change in the price level that is caused by a rise of an important goods.

  9. Faith says:

    What I really need to know is what triggers inflation and what are the remedies that curve inflation.
    Thank you

  10. krishna regmi says:

    if the demand pull and cost push inflation is explained with hep of figure it become more clear

  11. Inflation is man-made – a consequence of man’s agenda for profit and business interests. Inflation does not simply pop out of thin air. Man raises or lowers the price of his commodities or services to pursue his business direction ( popularly known as corporate goals). You may categorize inflation into such names as wage, monetary, commodities,foreign exchange, etc.. yet they are all one and the same. The common denominator is the Price, the rise and fall of which changes the value of the money in our pockets.Man himself and his lieutenants under a corporate mantel known as corporation or whatever business forms they are, bring about inflation.

  12. Ssebakka Richard says:

    tell me more how inflation can affect the performance of small scale businesses most especially in Africa

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