What Is Inflation Exactly? When Is It Good?
Inflation is a much used word that somehow evades all attempts at precise definition.
A commonly used one is provided by Milton Friedman, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”.
Which is just a long way of saying that inflation is always caused by an increase in the supply of money.
But is it?
Inflation comes in many forms, not least of which are food, asset price, currency value, and goods & services inflation.
Asset inflation is when demand for assets is high, causing people to bid up asset prices.
Currency inflation is when a currency falls in value, causing asset values to rise proportionally.
And finally, goods and services inflation is when demand for goods/services drives up their prices.
Asset price inflation is closely tied to currency value inflation, since asset values are expressed in terms of the domestic currency.
This means that when asset prices increase, they do so relative to the domestic currency. A good example of asset inflation would be the large rise in residential property prices in the US housing market going into 2008.
This appreciation can broadly be attributed to two factors:
1) Asset Price Inflation: The US housing market was in a generational bull market with strong demand for houses for dwelling, investment, and speculative purposes.
2) Currency Value Inflation: The USD was in a bear market going into 2008, with investors preferring to swap their dollars for higher yielding assets; no one really wanted to hold on to dollars. The weak USD meant that assets, when priced in dollars, had higher nominal prices.
Monetary policy has the potential to affect asset and currency inflation, because modern central banks execute their policies by influencing interest rates. This may affect the cost of financing for assets, and thus their prices, while simultaneously changing the yield on holding the domestic currency, hence demand for it.
Goods & Services Inflation works like asset price inflation, except that it pertains to goods and services that are not seen as investments in the way “assets” are.
This is important because if goods and services inflation is broad based and present in both essential and non-essential goods/services, this could* be a result of an economy that is growing robustly.
This is what economists call rising aggregate demand, and is a result of the type of economic growth that central banks are trying to engender through their monetary policies.
It leads to higher disposable income, then higher consumer spending which feeds back into corporate profits and expansion, bringing more people into the labor force in a virtuous cycle.
All of which ultimately shows up as the “good kind” of demand inflation.
“Good” because the virtuous cycle mentioned above is a rising tide that lifts all boats. Incomes across the general population increase, labor force participation is high and unemployment low, and general living standards improve.
In other words, it’s the kind of economy that we all want.
Every instance of “non-standard” monetary policy implemented by central banks over the last decade (last two decades for the Bank of Japan), has been in pursuit of the “good kind” of inflation. Unfortunately, all it has brought so far is asset and currency inflation, with little in the way of healthy goods and services inflation.
*A collapse in the domestic currency’s value would cause the same kind of broad based inflation, but be really bad for the economy – think Venezuela.
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