This informal CPD article on Inflation: measurement and Central Bank policies was provided by Robert Jacek Wlodarski, research intern at The Institute of International Monetary Research, an educational charity that promotes research into how developments in banking and finance affect the wider economy.
Hit by a global pandemic in March 2020 and the subsequent lockdown, central banks have responded by slashing their (policy) interest rates, providing more liquidity to banks and resuming Quantitative Easing programmes on a large scale. Some economists have raised concerns about the inflationary effects of these policies.
What is inflation?
In a dynamic market economy, prices and wages are subject to change very frequently. Seeing customers willing to pay more for bread, a baker will increase the price charged for each loaf. With the need for more loaves, eventually he or she will need to hire more workers. Eager to attract more clients, he/she will want to find the best bakers by offering higher wages. As a result, both prices and wages increase in this sector.
This is what we call a change in relative prices. Prices in one sector rise as compared to others. But what determines overall inflation – that is, the increase in the price level in general – is the amount of money in the economy. Expanding the quantity of money beyond that which the production of goods and services demand will lead to an increase in the price level (i.e. inflation). A State/Central Bank deciding to print extra money to fund greater public spending demand will spark inflation in the medium to the long term.
This is how Milton Friedman put it back in 1970: ‘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.’
One way of calculating inflation is by measuring changes in the level of a representative ‘shopping basket’ of goods and services. This measure is called the Consumer Price Index (CPI), which does not include asset prices. National statistical offices regularly update the basket to reflect changing consumption patterns in a country. For example, in the UK, the National Statistics Office have recently added owner-occupiers’ housing costs and removed 14 other products from the basket to make sure the product choices stay up to date.
How do Central Banks react to inflation?
Primarily responsible for maintaining price stability, central banks design their policies to avoid inflation and deflation. They usually aim to keep the annual inflation rate, as measured by the CPI, at between 2 and 3 per cent in most advanced economies. The most common pattern is for central banks to counteract deflation during recessions when markets ‘cool down’ and keep inflation down during booms when economies ‘overheat’.
Traditionally, central banks manipulate the (policy) interest rate charged to private banks in their regular lending operations to keep inflation on target; a rate that will ultimately affect the interest rates offered by banks to consumers and companies. If inflation is too low, cutting the policy rate will lead to more lending in the economy and thus more bank deposits (i.e. the money we use to make transactions); which will foster households’ and companies’ spending.
But central banks have other – more powerful – measures to create more money any time (let alone under a financial crisis), such as asset purchase programmes, usually referred to as “Quantitative Easing.” These have been implemented at a large scale since 2008. You can find out more about them in our previous article on ‘Central Banks and the Covid-19 Crisis’.
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