Inflation and price

Inflation rate is usually measured by CPI, which is to measure changes in the price level of market basket of consumer goods and services purchased by households. Therefore, it is reasonable to accumulate individual consumption and production, these microeconomic factors to model the inflation rate, which is a macroeconomic concept. Nowadays, accumulating microeconomic models to model the macroeconomic issues has become very common and popular.

To accumulate individual consumptions to model the total demand in the economy, I think we need an equation that contains the consumption as the dependent variable, and wealth, goods’ elasticities of demand and other relevant factors as the independent variables. And the total supply should include the individual costs of production, other productive factors.

The problem in this way of modelling is that we have to take account of all factors that determine the different individuals’ consumption decisions and form a general formulate which is suitable for the majority of the population. In addition, we have to ensure that the sums of the factors that are included in the general formula are measurable or at least estimable. On the other hand, the general formula for the supply side should have the similar quality.

Price interaction

Prices can interact across different markets. We all know that the demand of a good increases when the price of its complementary good decreases, and the demand for a good increases when the price of its substitute increases. Basic economics teaches us to use the cross elasticity of demand to distinguish the relationship between goods (services).

Nowadays, almost all goods and services can be related together. For example, food price can be tightly related to the price of some financial products. The pricing of financial products is based on their financial companies’ economic models, in any economic model, inflation is an impossibly omitted factor, and food price is one of many determinants of inflation; therefore, food price is related to the price of financial products. Moreover, based on our individual preferences, it is not hard to find the reason that why every good is related.

Our consumption decision is based on two factors: budget constraint and personal preference. Any good or service consumes some proportion of the budget and difference utilities can be gained from different combinations of goods and services. Therefore, once our budget is pre-determined, to maximise our preference or achieve a certain level of utility, any change in consumption of one good or service must result in changes in consumption of other goods and services.

Therefore, all prices interact, some might show relatively weaker correlations than the others, this is because the interaction involves more complicated factors.

Excess capacity

Yesterday I talked about how a bad inflation is caused by a lack of sufficient productive factors, today I want to discuss the issue of excess capacity in the economy. Excess capacity can be caused by various reasons, and often can lead to a reduction in the price level. Excess capacity rarely takes place on a large scale and causes a deflation in the economy, as in general, people often prefer more than less. Excess capacity takes place when a specific good or service no longer meets the market demand and requirement.

For example, last century, quartz watches were invented and rapidly took over the majority of the market which had been owned by the mechanic watches, this is because watches were seen as the tools to track precise time at the time, and quartz watches met the market requirement better than mechanic watches. Many Swiss watchmakers went bankruptcy during that period. There is another example, the Chinese coal and steel industries have been marked as industries with excess capacity. I think this issue is only partially caused by an unthoughtful investment in the industries, the main reason for it is the Chinese market demands better qualities of coal and steel, which can meet the environmentally friendly standards, the needs of high-tech industries (for the aerospace industry, the car industry and other industries). Moreover, the poor quality steel and coal have no advantage to win any market share in the global market, which means the excess supply of steel and coal cannot be exported to other countries.

Therefore, based on the above two examples, I think that the excess capacity is not only caused by an increase in investment and production, it is also caused by a shift of the market “taste”. 

How to distinguish between a good inflation and a bad inflation

Inflation can be put into two categories based on its causes: demand-pull inflation, cost-push inflation. However, this does not necessarily help to distinguish between a good inflation and a bad inflation. Usually, we distinguish based on the degree of volatility, we see a moderate inflation as a good inflation and a volatile inflation (hyperinflation) as a bad inflation.

I think we should find a way to distinguish a bad inflation and a good inflation based on its causes, in order to prevent further damage from a bad inflation when we can see a sign of it.

Both demand-pull inflation and cost-push inflation can be a bad inflation; however, we usually see that cost-push inflation is rather a bad inflation, as we expect a healthy economy tends to lower the costs of production due to the improvement of efficiency of resource allocation.

I see bad inflations always happen when the supply side loses its ability to meet the demand side due to the lack of production factors. Therefore, some cost-push inflations can be eased automatically by improving efficiency and productivity, when production factors are available, so they are not long term problems that need us to worry too much. On the other hands, many catastrophic hyperinflations are caused by the lack of production factors. For example, Germany after the first World War suffered a period of hyperinflation because many factories were destroyed and many men were killed in the War and Germany lost sufficient production factors to meet the domestic demand during its post-war period. Such inflation problem often requires a structural reform and help from the outside world.

Overall, we do not need to worry too much about inflation due to higher demand, higher costs due to bad management or inefficiency, the inflation that we need to worry is the one caused by the lack of production factors. 

Globalisation of inflation

Inflation can also be globalised just like many other things via the forex market as well as the international trading network. Inflation is a phenomenon of price changing, and the price is determined by supply and demand in the market.

Different countries have different inflation rates because the demand related to the element measuring the inflation is domestic demand. Each country has its unique demand, so when the demands for goods are different in different countries, the price levels in these countries will also be different; therefore, the inflation rates in different countries are different. However, many countries have similar inflation trends, this is because the supply for all countries is relatively similar.

Nowadays, we have an international trading network so all goods and services can be supplied by the entire world. In addition, the international trading network tends to make prices of the same goods and services have similar prices everywhere around the world. When some places have got higher prices for some goods and (or) services, more such goods and (or) services will be supplied into these places and lower the local prices. However, due to our different trading policies, supply is not exactly the same everywhere, some countries have higher transport costs or higher tariffs, the supply will be lowered than somewhere with cheaper transport costs or lower tariffs.

Overall, under the current circumstance, globalisation tends to distribute the inflation pressure across the world, and all countries which have access to the global market have similar inflation trends.

The inflation and the growth

The Bank of Japan keeps its monetary policy on hold to keep inflation moving toward the 2.0% target. The Bank of England also sets its inflation target at 2.0%, and other central banks also have similar targets. Previously I have explained why inflation is important for governments, today I want to discuss how inflation relates to economic growth.

Inflation usually implies an increase in the prices in the domestic markets on average; however, when a country actually measures its domestic inflation, it only measures the change in the average prices of a basket of several selected goods and services, as it is impossible to measure all price changes all cross the economy. Therefore, sometimes some price decreases are not observed in our inflation sample.

Growth does not necessarily lead to an inflation; however, sometimes an inflation can lead to an economic growth. Inflation can redistribute the resources in the economy. Inflation signals price increases in some sectors of the economy. Once price increases usually imply increases in demand, so the market is likely to react to the increases in demand and increase the supply. Such process can help to improve the efficiency of the resource distribution. Once the resources are distributed more efficiently, the economy will grow.

I explained the reason for why an economic growth does not necessarily lead to an inflation previously, so I will only give a simple example to explain this question again. We usually think the price for smart phones has a slowly increasing trend; however, that is not true. Apple’s iPhone is a famous smartphone, once the new version of iPhone usually has a slightly higher price than its previous version. However, when we look at the inflation, we do not see this as a price increase. Once the new version is released, the price of the older version decreases, so it is a price decrease (deflation).

Overall, I believe, inflation causes an economic inflation as inflation implies a shortage of supply in the economy that pushes the supply as well as the production in the economy, thus leading to an economic growth.

Under what situation the government will be no longer able to control the inflation rate?

The government has fiscal tools and monetary tools to control the domestic inflation rate; however, sometimes it may not be able to use such tools to influence the domestic inflation. Inflation implies the currency is being devalued. As a currency is backed by its government, when its government’s credit is questioned by the international market or large financial institutions, the value of the currency will also be badly damaged.

Inflation also means the currency is devalued against goods and services. When there is a shortage in the supply side, the currency will be oversupplied to the market, when the equilibrium of the demand and supply for money changes, the values will change, and the currency is devalued and there is an inflation in the economy. Therefore, when an economy lacks sufficient supply and production of goods and services, the government cannot control the value of its currency.

In addition, the inflation can get out of the government’s hands especially nowadays because of the economy’s trade with other countries. Countries are trading with each other and countries do not need to produce everything by themselves now. However, once one country has an important resource that it has to depend on imports but the supply from imports decreases for some reason (natural disaster caused decrease in production in other countries, political reason such as sanctions), the currency will depreciate in the forex market, and as it is an important resource for the domestic economy, the prices of goods and services that relate to this resource in the domestic markets will increase sharply and lead to inflation.

These are the several situations where the government lacks of tools to lower the inflation, and all these reasons tight relate to one important reason that the economy does not have the ability to generate sufficient production.