Sunday, May 31, 2009

Impact of crude oil prices on Indian Economy since 1971-2005 by Mohammad Rafee

Impact of crude oil prices on Indian Economy since 1971-2005 by Mohammad Rafee

India is the 7th largest country with the land mass of 3.29 million sq.k.m and second largest in population of over one billion. It accounts for 16 percent of the world population. The country has to produce about one trillion worth of GDP to fulfill the needs of its huge population.

In order to produce this one trillion dollar worth of output, India needs 2.5 million of oil per day which is 6.5 percent of total world demand for oil. The share of commercial energy consumption in total energy consumption has increased from 29 percent in 1953-54 to 68.2 percent in 2001-02. These ever exert demand profound influence on the growth and inflation levels in India.

International oil price assumed to affect the domestic prices. However in India’s case the sharp increase in international oil prices has not been fully transmitted in to the domestic prices. The administrative price mechanism had shielded the country from the impact of oil shocks. Now the govt of India has given up the administrated price mechanism in oil sector and linked the domestic oil prices with international oil prices. Oil price is certainly as external factor how it affects the Indian economy. This made me to undertake this research work.



Statement of the problem :- international oil price how it affects whole sale price index of India, exchange rage or rupee to dollar, growth rate of India, forex reserves of India, oil and non-oil trade balance.

Objective of the study:-

To analyse trend in oil price
To study the relationship between oil prices & inflation, exchange rate of rupee to dollar, growth rate of India, forex reserves of India, oil & non-oil trade balance.
To offer policy suggestions.

Hypothesis’:- * there is no difference between explanatory powers of international oil prices per barrel in dollar & annual percentage change in international oil price variation in explaining the change in the selected macro economic impacting variables.

Methodology:- the study relies exclusively on secondary data, pertaining to international oil price, growth rate of India, exchange rate of India, forex reserves of India, inflation & oil and non-oil trade balance. The data of oil downloaded from forbes.com. Data related to other variables were downloaded from RBI website.


Tools used:- annual percentage change has been calculated to analyse the trend behavior. Multiple linear regression models has been fitted to assess the impact of oil prices on the selected variables.

Limitations:-

The impact has been assumed with regard to the selected variables alone. So the impact assessment would be partial. Because oil prices can penetrate all the sectors of the economy.
The public sector oil companies and consumers have shared the burden of oil price increase. Public sector companies, backed by the government support. Ultimate burden shifted to people whole in the form of taxes.

Significance of the study: - Energy is the driver of economic growth. Energy from the oil is the largest source of energy supply. However significance of the oil prices has not been put into through explanation. A study that addresses the nuances of consequences of oil prices hike may guide government of world countries in policy formulation.



Period of study:-

From 1971-72 to 2005 on the study period there was energy crisis in 1973 and in 1979 and a gulf war in 1990. In 1991 India started its reforms Liberalization, privatization & globalization. These are all the major causes to undertake the study on oil prices.

About crude oil:-

Crude oil is a naturally occurring liquid composed mostly of hydrogen and carbon. It is believed to have been formed from very small plants & animals that lived in ancient seas and oceans a very long time ago. As these plants and animals die, they sink to the bottom of the sea. When thy mix with mud, sand and clay.

This mixture of mud & organic (once living) material is rich in hydrogen & carbon. Over millions of years this layer of organic rich mud becomes buried thousands of feet deep in the earth.

The temperature of the earth becomes hotter as you go deeper in to the earth. The combination of increasing temperature & pressure on the organic mixture causes change in to crude oil. If the temperature increases further crude oil can be changed in to natural gas.



Crude oil prices:

Inflation firmed up in the second half of 2005 in a no. of economies with a movement in international crude oil prices with oil price reaching record high of us $ 70.88 $ a barrel in august 2005. With that advanced countries like US, UK & European Union experienced inflation at the rate of 4.7, 2.6, and 2.5 respectively.

Crude oil price rose to US $ 70.88 a barrel on august 30, 2005 in the immediate after math of hurricane Katrina. Prices in the subsequent months moderated to below US $ 60 a barrel during November-December 2005. Reflected supply augmenting efforts by the IEA and the OPEC slowing of oil demand growth and a relative warmer weather in the US. But prices again edged up to US $ 67-68 a barrel in Jan 2006 on disruption of Russian Natural gas deliveries to Ukraine threatened supplies to Western Europe, unrest in Nigeria and tension over Iran’s Nuclear Programme.
OPEC:-
Organization of Petroliam exporting countries. Members include Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, and UAE & Venezuela. OPEC was found in Baghdad, Iraq in Sep 1960.

Oil Crisis:-
Price increase of 2004-06 oil price was $ 25 per barrel in sep 2003.but by august 11, 2005 it had rises to over $60 per barrel & a record price of $ 78.40 per barrel on July 14, 2006. Experts attributed spike in prices to a variety of factors, including North Korea’s missile launches, the crisis between Israel & Lebanon, Iranian Nuclear programme & US department showing a decline in petroleum reserves.

Testing of Hypothesis:-

** There is no difference between explanatory powers of international oil prices per barrel in dollar & annual percent change variation in oil price in explaining the change in the selected variables.

In the analysis the relationship between the oil price variation & selected variables has been showing a negative relationship. Therefore the Null hypothesis is rejected.

Findings:-

There is no significant relationship between inflation & oil prices. International oil price behaved more erratically in 1980’s. While inflation was erratic in 1970’s.
Similar behavior is found in case of inflation. The volatility of exchange rate behavior has intensified during the study period. The variance of dollar- rupee exchange rate of 1980’s is higher than 1970’s and in 1990’s.how ever the regression results suggests that international oil prices is not a significant variable in determining the exchange rate of rupee.

Growth rate of India had fluctuated in 1960’s and in 1980’s. The growth rate was stabilized and in 1990’s there was further decline in ups and downs in growth rate of Indian economy as shown in the variance.

There is seemed to prevail negative relation ship between annual percentages in oil price the growth rate reduced to 0.1 percentages.



Every unit increase in annual percentage change of international oil price can deplete 63 million of forex reserves.

The oil price is not significant variable in explaining the change in non oil trade balance of India. Every increase in oil price in dollar the non oil trade balances may be widened by 68 million dollars. Similar with every increase in oil price. The non oil trade balance may be widened by 5.60 percent.

The oil trade balance of India may widened by 12.13 percent with every unit increase in oil prices.

India lost 17.95 percent of trade balance every year during the study period with every percentage increase in international oil prices.

Conclusion:-
The study concludes that international oil price does not affect the domestic prices of a country significantly. Similarly the oil prices do not exert a strong influence on the economic growth of India. Quantity of possessions of forex reserves the exchange rate of rupee in dollar terms and trade balances.


The multiple regression co-efficient of determination R2 in the case of above variables is worked found meager 10 percent of the variation in all the above macro economic impacted variables.



Best Regards,
B.Mohammad Rafee M.A.,M.Phil,
Ph : 919786372115,9177654835
Email: basharafee@gmail.com
Website:www.mohammadrafee.tk

Recession? Depression? What's the difference?

There is an old joke among economists that states:

A recession is when your neighbor loses his job.

A depression is when you lose your job.

The difference between the two terms is not very well understood for one simple reason: There is not a universally agreed upon definition. If you ask 100 different economists to define the terms recession and depression, you would get at least 100 different answers. I will try to summarize both terms and explain the differences between them in a way that almost all economists could agree with.

Recession: The Newspaper Definition
The standard newspaper definition of a recession is a decline in the Gross Domestic Product (GDP) for two or more consecutive quarters.

This definition is unpopular with most economists for two main reasons. First, this definition does not take into consideration changes in other variables. For example this definition ignores any changes in the unemployment rate or consumer confidence. Second, by using quarterly data this definition makes it difficult to pinpoint when a recession begins or ends. This means that a recession that lasts ten months or less may go undetected.

Recession: The BCDC Definition
The Business Cycle Dating Committee at the National Bureau of Economic Research (NBER) provides a better way to find out if there is a recession is taking place. This committee determines the amount of business activity in the economy by looking at things like employment, industrial production, real income and wholesale-retail sales. They define a recession as the time when business activity has reached its peak and starts to fall until the time when business activity bottoms out. When the business activity starts to rise again it is called an expansionary period. By this definition, the average recession lasts about a year.Depression
Before the Great Depression of the 1930s any downturn in economic activity was referred to as a depression. The term recession was developed in this period to differentiate periods like the 1930s from smaller economic declines that occurred in 1910 and 1913. This leads to the simple definition of a depression as a recession that lasts longer and has a larger decline in business activity.

The Difference
So how can we tell the difference between a recession and a depression? A good rule of thumb for determining the difference between a recession and a depression is to look at the changes in GNP. A depression is any economic downturn where real GDP declines by more than 10 percent. A recession is an economic downturn that is less severe.

By this yardstick, the last depression in the United States was from May 1937 to June 1938, where real GDP declined by 18.2 percent. If we use this method then the Great Depression of the 1930s can be seen as two separate events: an incredibly severe depression lasting from August 1929 to March 1933 where real GDP declined by almost 33 percent, a period of recovery, then another less severe depression of 1937-38. The United States hasn’t had anything even close to a depression in the post-war period. The worst recession in the last 60 years was from November 1973 to March 1975, where real GDP fell by 4.9 percent. Countries such as Finland and Indonesia have suffered depressions in recent memory using this definition.

Now you should be able to determine the difference between a recession and a depression without resorting to the poor humor of the dismal scientists.

Do Changes in Stock Prices Cause Recessions?

The economy and the stock market are closely related. Many people examine the stock market to find out how the economy is doing. It's long been known that if the stock market is in a period of decline, the economy is sure to follow. However there is little evidence that the stock market causes the economy to rise or fall. The stock market does not directly affect the economy. It is simply a mirror of people's generally correct beliefs about what is about to happen in the economy. The best way to understand this is to realize that a stock market index the Dow Jones Industrial Average (DJI) is simply a price. Because the value of index is a price, it only has two determinants: supply and demand.

Supply
Any first year college textbook in Economics states that for most goods if the supply increases in the short run then the price of the good should decline. For example, if the car companies suddenly doubled their supply of cars then we would expect the price of cars to fall.

If we thought that changes in the supply of stocks are the main cause of stock market rises and declines then, according to this rule, when a company issues new stock we would expect the price of stock to decline. If stock prices are largely determined by the supply of stocks and the market declines prior to an economic decline, we should see a flood of new stock issues before a recession. This does not happen in practice, as new stock issues tend to occur as the economy enters a growth period. This is because the money made from a stock issue is used to increase the output of the company, which causes economic growth to rise.Demand
It appears that if we want to understand why the economy tends to move in the same direction as the stock market, we'll have to consider the demand for stocks. To do this, we'll need to understand what motivates an investors decision to buy or sell shares. Many investors such as Warren Buffett evaluate their stock portfolios on their inherent value. The inherent value is the total expected earnings of the company over a time period, discounted by the fact that a dollar today is not worth as much as a dollar tomorrow. If investors believe that a recession is coming, then they will believe that company earnings will be less in the future (since that typically takes place in a recession) which will decrease the inherent value of the stock. When the inherent value of the stock is far below its current price, investors will sell the stock, driving the price of the stock down. If investors believe a boom is coming, they will increase their estimates of the inherent value because future earnings should be higher than they previously expected. Often this will lead to the inherent value being far higher than the current price of the stock, so investors buy the stock. This leads the price of the stock to rise.

The belief that the stock market drives the economy is due to an error in logic. Generally we think that if A came before B that A caused B. Philosophers refer to this as the post hoc, propter hoc fallacy. In this case, the expectation of a decline in the economy causes the stock market to decline today. Or in logical terms, A came before B, because the expectation of B caused A. It's also important to realize that it's not the expectation of future economic changes that is causing changes in stock prices. It's the fact that people are acting on these expectations. If investors bought and sold stocks based on astrological factors or Barry Bonds' current homerun total then these would be causing the price of stocks to change. In a situation like that, it would seem that the stars are causing the price of stocks to change; the economy would have nothing to do with it.

It is because a large number of investors act on this inherent value principle that the economy tends to follow the stock market. Investors are constantly watching macroeconomic variables to try and determine when the next downturn in the economy will happen. Investors are often right when they predict the future growth rate of the economy. As a result, they often sell off their shares before the economy goes into a decline making it look like the stock market is causing a recession. In reality the causality runs the other way because the two things that causes price to change are changes in supply or changes in demand.

Are recessions good for the economy?

Question from Reader E-mail: I have come to believe that a recession is good for an economy because it culls away weak businesses and teaches the strong to survive by cutting the fat that is not needed. I was wondering, though, do you think a depression is good for an economy and why?
A: I don't agree that even recessions are good for the economy. Joseph Schumpeter passionately argued in his 1942 book Capitalism, Socialism and Democracy that recessions are a necessary evil in capitalist societies. The idea that recessions are a necessary evil is still around today. Mark Rostenko, the editor of the Sovereign Strategist wrote the following in an editorial titled The Dips Don't See a "Double-Dip":

The "job" of a recession is to clean the "fat" out of the system, mop up excess, and pave the way for the next expansion. Until that process is complete, there isn't much from which a legitimate expansion can arise.

Recessions put weak companies out of business. In so doing, resources (skilled workers, capital) are freed up to be deployed more efficiently elsewhere. For example, Wall Street analysts who touted bankrupt Internet stocks are redeployed at local fast food restaurants to serve people in a capacity for which they are much better suited.

Stronger businesses that have used the contraction to firm up their bottom lines and grow more efficient are able to take advantage of these resources during the ensuing expansion. The economy emerges from a recession leaner, more efficient and in good shape for the next wave of growth and progress.

While the logic seems sound, it doesn't seem to match the data. If recessions were necessary to "clean the fat out of the system", we'd expect there to be a lot of bankruptcies and firm closures during recessions and little during booms. The data, however, does not support this as you can see in the table on the bottom of the page.

I have data for five different years, 1990, 1995, 2000, 2001 and 2002. The only year in the chart that overlaps with a recession is 1990, as the National Bureau for Economic Research indicates that the United States had a recession from July 1990 until March 1991. For the five years here, the GDP growth rate was positive in each year, from a high of 3.8% in 2000 to 0.3% in 2001.

Notice how little firm closures differ between these five years. We do not see great differences in firm closures between periods of high growth and periods of low growth. While 1995 was the beginning of a period of exceptional growth, almost 500,000 firms closed shop. The year 2001 saw almost no growth in the economy, but we only had 14% more business closures than in 1995 and fewer businesses filed for bankruptcy in 2001 than 1995.

Rostenko is correct when he claims that firm closures are a necessary part of capitalism since it allows "resources (skilled workers, capital) [to be] freed up to be deployed more efficiently elsewhere." When we look at the data, though, we see that we do not need recessions for this to occur; firms do not close that much more frequently in busts than in booms. So at least in this regard, recessions are not necessary at all.

Cost-Push Inflation vs. Demand-Pull Inflation

Q:] What do the terms "Cost-Push Inflation" and "Demand-Pull Inflation" mean? What's the difference between the two.

[A:] Thanks for your question!

The terms cost-push inflation and demand-pull inflation are associated with Keynesian Economics. Without going into a primer on Keynesian Economics (a good one can be found at Econlib) we can still understand the difference between two terms.

In articles such as "Why Does Money Have Value?", "The Demand For Money", and "Prices and Recessions" we've seen that inflation is caused by a combination of four factors. Those factors are:

* The supply of money goes up.
* The supply of goods goes down.
* Demand for money goes down.
* Demand for goods goes up.

Let's look at the definition of cost-push and demand-pull inflation and see if we can understand them using our four factors.
Definition of Cost-Push Inflation
The text "Economics" (2nd Edition) by Parkin and Bade gives the following explanation for cost-push inflation:

"Inflation can result from a decrease in aggregate supply. The two main sources of decrease in aggregate supply are

* An increase in wage rates
* An increase in the prices of raw materials

These sources of a decrease in aggregate supply operate by increasing costs, and the resulting inflation is called cost-push inflation

Other things remaining the same, the higher the cost of production, the smaller is the amount produced. At a given price level, rising wage rates or rising prices of raw materials such as oil lead firms to decrease the quantity of labor employed and to cut production." (pg. 865)

Aggregate supply is the "the total value of the goods and services produced in a country" or simply factor 2, "The supply of goods". The supply of goods can be influenced by factors other than an increase in the price of inputs (say a natural disaster), so not all factor 2 inflation is cost-push inflation.

Of course, the next question would be "What caused the price of inputs to rise?". Any combinations of the four factors could cause that, but the two most likely are factor 2 (Raw materials such as oil have become more scarce), or factor 4 (The demand for raw materials and labor have risen).

Definition of Demand-Pull Inflation
Parkin and Bade give the following explanation for demand-pull inflation:

"The inflation resulting from an increase in aggregate demand is called demand-pull inflation. Such an inflation may arise from any individual factor that increases aggregate demand, but the main ones that generate ongoing increases in aggregate demand are

1. Increases in the money supply
2. Increases in government purchases
3. Increases in the price level in the rest of the world

"(pg. 862)

Inflation caused by an increase in aggregate demand, is inflation caused by factor 4 (An increase in the demand for goods). The three most likely causes of an increase in aggregate demand will also tend to increase inflation:

1. Increases in the money supply This is simply factor 1 inflation.

2. Increases in government purchases The increased demand for goods by the government causes factor 4 inflation.

3. Increases in the price level in the rest of the world Suppose you are living in the United States. If the price of gum rises in Canada, we should expect to see less Americans buy gum from Canadians and more Canadians purchase the cheaper gum from American sources. From the American perspective the demand for gum has risen causing a price rise in gum; a factor 4 inflation.

Inflation in Summary
Cost-push inflation and demand-pull inflation can be explained using our four inflation factors. Cost-push inflation is inflation caused by rising prices of inputs that causes factor 2 (The supply of goods goes down) inflation. Demand-pull inflation is factor 4 inflation (The demand for goods goes up) which can have many causes.

Supply & Demand: How They Move Currencies

Supply and Demand

In Forex trading, you will see that technical indicators (charts, moving average lines, etc.) are very important for determining how currency prices move. Of course, fundamental analysis (economic data, current events, etc.) is also useful for predicting how a currency price will change. Underlying the fundamental and technical methods is the basic economic principle of supply and demand. In the free marketplace, prices can change dramatically from changes in the supply of a currency and differences in the demand for a currency. This principle also applies to stocks, bonds, and commodities. Keeping this concept of supply and demand in your mind can keep your forecasting and predictions on track.

The Demand Factor

At the most fundamental level, a currency price will change because there is more or less demand for it. More demand means the currency pair will experience a higher price. Less demand means the currency pair price will fall. An example of increased demand for a currency is economic data suggesting a strong economy while demand for a currency could decline if the central bank lowers interest rates. True price movement is based on the demand for the currency. In fact, currencies rally when demand increases.

The Supply Side

A basic economic principle of supply shows that the value of a currency will change as the levels of supply rise and fall. A larger supply of a currency will diminish its value and price. A lower supply of a currency will increase its value and price. While the supply side is important, look to the demand factor as the primary moving force behind a currency’s value and price.

Focus on the Demand-Supply Model

The trader must remember that real price movements are based on the level of demand for a currency. So currency prices are easy to predict, right? Wrong! A host of factors affect the demand and net supply for a currency. Everything from current events to the weather can affect the supply and demand for a currency. Think back to the Internet boom in 2001. People around the world wanted to participate in this booming industry centered in Silicon Valley. Demand for the US dollar soared. Supplies grew tight. The value of the dollar sharply increased.

Long-term vs. Short-term

Long-term supply and demand usually refers to a time period of a year or more. Short-term is typically thirty days or less. The same factors can affect currency prices in both time periods. The trader should be aware of the time factor in which a trade is placed. Long- and short-term price movements can run parallel. However, they can also diverge, leading to inconsistent price movements. Hence, you should always remember the trading environment and the time frame when making your Forex trade.

Determine which Factors affect Supply and Demand

The next step is to examine the broad categories of factors that can affect supply and demand. Most of these factors are fundamental, but technical factors can also affect supply and demand. Focusing on the factors that affect demand will keep you grounded and eliminate much of the “trading noise” and distractions that can impair your forecasting skills. It will also prepare you to interpret any event and analyze its impact on the long- and short-term price of a currency.

Why Don't Prices Decline During A Recession?

[Q:]When there is an economic expansion, demand seems to outpace supply, particularly for goods and services that take time and major capital to increase supply. As a result, prices generally rise (or there is at least price pressure) and particularly for goods and services that cannot rapidly meet the increased demand such as housing in urban centers (relatively fixed supply), advanced education (takes time to expand/build new schools), but not cars because automotive plants can gear up pretty quickly.

First, do you agree with this and if not, how do you see it?

Second, when there is an economic contraction, supply initially outpaces demand. However prices for most goods and services don't go down, and neither do wages.

My main question is why don't prices go down for goods and services? I expect for wages, it's just stickiness from the corporate/human culture... people don't like to give pay cuts... managers tend to lay off before they give pay cuts (though I've seen exceptions). Why don't prices go down for most goods and services?

[A:] Great question! Your analysis is spot on. Now on to your question:

In my article titled Why Does Money Have Value we saw that changes in the level of prices (inflation) was due to a combination of the following four factors:

1. The supply of money goes up.
2. The supply of goods goes down.
3. Demand for money goes down.
4. Demand for goods goes up.

In a boom, we would expect that the demand for goods to rise faster than the supply. All else being equal, we would expect factor 4 to outweigh factor 2 and the level of prices to rise. Since deflation is the opposite of inflation, deflation is due to a combination of the following four factors:

1. The supply of money goes down.
2. The supply of goods goes up.
3. Demand for money goes up.
4. Demand for goods goes down.

We would expect the demand for goods to decline faster than the supply, so factor 4 should outweigh factor 2, so all else being equal we should expect the level of prices to fall.

From my article titled A Beginner's Guide to Economic Indicators we saw that measures of inflation such as the Implicit Price Deflator for GDP are procyclical coincident economics indicators, so the inflation rate is high during booms and low during recessions. The information above shows that the inflation rate should be higher in booms than in busts, but why is the inflation rate still positive in recessions?

The answer is that all else is not equal. The money supply is constantly expanding, so the economy has a consistent inflationary pressure given by factor 1. The Federal Reserve has a table listing the M1, M2, and M3 money supply. (To learn about these definitions, see How much is the per capita money supply in the U.S.?). From Recession? Depression? we saw that during the worst recession America has experienced since World War II, from November 1973 to March 1975, real GDP fell by 4.9 percent. This would have caused deflation, except that the money supply rose rapidly during this period, with the seasonally adjusted M2 rising 16.5% and the seasonally adjusted M3 rising 24.4%. Data from Economagic shows that the Consumer Price Index rose 14.68% during this severe recession. A recessionary period with a high inflation rate is known as stagflation, a concept made famous by Milton Friedman. While inflation rates are generally lower during recessions, we can still experience high levels of inflation through the growth of the money supply.

So the key point here is that while the inflation rate rises during a boom and falls during a recession, it generally does not go below zero due to a consistently increasing money supply.

What is the Demand For Money?

A:] Excellent question!

In those articles, we discussed that inflation was caused by a combination of four factors. Those factors are:

1. The supply of money goes up.
2. The supply of goods goes down.
3. Demand for money goes down.
4. Demand for goods goes up.

You would think that the demand for money would be infinite. Who doesn't want more money? The key thing to remember is that wealth is not money. The collective demand for wealth is infinite as there is never enough to satisfy everyones desires. Money, as illustrated in "How much is the per capita money supply in the U.S.?" is a narrowly defined term which includes things like paper currency, travellers checks, and savings accounts. It doesn't include things like stocks and bonds, or forms of wealth like homes, paintings, and cars. Since money is only one of many forms of wealth, it has plenty of substitutes. The interaction between money and its substitutes explain why the demand for money changes.

We'll look at a few factors which can cause the demand for money to change. For a more formal treatment of theories of the demand for money see Paul Turner's Notes on "The Demand For Money".
1. Interest Rates
Two of the more important stores of wealth are bonds and money. These two items are substitutes, as money is used to purchase bonds and bonds are redeemed for money. The two differ in a few key ways. Money generally pays very little interest (and in the case of paper currency, none at all) but it can be used to purchase goods and services. Bonds do pay interest, but cannot be used to make purchases, as the bonds must first be converted into money. If bonds paid the same interest rate as money, nobody would purchase bonds as they are less convenient than money. Since bonds pay interest, people will use some of their money to purchase bonds. The higher the interest rate, the more attractive bonds become. So a rise in the interest rate causes the demand for bonds to rise and the demand for money to fall since money is being exchanged for bonds. So a fall in interest rates cause the demand for money to rise.2. Consumer Spending
This is directly related to the fourth factor, "Demand for goods goes up". During periods of higher consumer spending, such as the month before Christmas, people often cash in other forms of wealth like stocks and bonds, and exchange them for money. They want money in order to purchase goods and services, like Christmas presents. So if the demand for consumer spending increases, so will the demand for money.
3. Precautionary Motives
If people think that they will suddenly need to buy things in the immediate future (say it's 1999 and they're worried about Y2K), they will sell bonds and stocks and hold onto money, so the demand for money will go up. If people think that there will be an opportunity to purchase an asset in the immediate future at a very low cost, they will also prefer to hold money.
4. Transaction Costs for Stocks and Bonds
If it becomes difficult or expensive to quickly buy and sell stocks and bonds, they will be less desirable. People will want to hold more of their wealth in the form of money, so the demand for money will rise.
5. Change in the General Level of Prices
If we have inflation, goods become more expensive, so the demand for money rises. Interestingly enough, the level of money holdings tends to rise at the same rate as prices. So while the nominal demand for money rises, the real demand stays precisely the same. (To learn the difference between nominal demand and real demand, see "What's the Difference Between Nominal and Real?")
6. International Factors
Usually when we discuss the demand for money, we're implicitly talking about the demand for a particularly nation's money. Since Canadian money is a substitute for American money, international factors will influence the demand for money. From "A Beginner's Guide to Exchange Rates and the Foreign Exchange Market" we saw that the following factors can cause the demand for a currency to rise:

1. An increase in the demand of that country's goods abroad.
2. An increase in the demand for domestic investment by foreigners.
3. The belief that the value of the currency will rise in the future.
4. A central banking wanting to increase its holdings of that currency.

To understand these factors in detail, see "Canadian-to-American Exchange Rate Case Study" and "The Canadian Exchange Rate"
Demand for Money Wrap Up
The demand for money is not at all constant. There are quite a few factors which influence the demand for money.
Factors Which Increase the Demand for Money

1. A reduction in the interest rate.
2. A rise in the demand for consumer spending.
3. A rise in uncertainty about the future and future opportunities.
4. A rise in transaction costs to buy and sell stocks and bonds.
5. A rise in inflation causes a rise in the nominal money demand but real money demand stays constant.
6. A rise in the demand for a country's goods abroad.
7. A rise in the demand for domestic investment by foreigners.
8. A rise in the belief of the future value of the currency.
9. A rise in the demand for a currency by central banks (both domestic and foreign).

terms of intenational trade SEZ & FDI

Quota
What Does It Mean?
What Does Quota Mean?
In the context of international trade, this is a limit put on the amount of a specific good that can be imported.
Investopedia Says
Investopedia explains Quota
Quotas are used to prevent other countries from "dumping."

Special Economic Zone - SEZ
What Does It Mean?
What Does Special Economic Zone - SEZ Mean?
Designated areas in countries that possess special economic regulations that are different from other areas in the same country. Moreover, these regulations tend to contain measures that are conducive to foreign direct investment. Conducting business in a SEZ usually means that a company will receive tax incentives and the opportunity to pay lower tariffs.
Investopedia Says
Investopedia explains Special Economic Zone - SEZ
While many countries have set up special economic zones, China has been the most successful in using SEZ to attract foreign capital. In fact, China has even declared an entire province (Hainan) to be an SEZ, which is quite distinct, as most SEZs are cities.
Tariff
What Does It Mean?
What Does Tariff Mean?
A taxation imposed on goods and services imported into a country. Also known as a duty tax.
Investopedia Says
Investopedia explains Tariff
Governments generally impose tariffs to raise revenue and protect domestic industries from foreign competition caused by factors like government subsidies, or lower priced goods and services.
Dumping
What Does It Mean?
What Does Dumping Mean?
1. In international trade, this occurs when one country exports a significant amount of goods to another country at prices much lower than in the domestic market.

2. A slang term for selling a stock with little regard for price.
Investopedia Says
Investopedia explains Dumping
1. Dumping is fought through the use of tariffs and quotas
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Foreign Direct Investment - FDI
What Does It Mean?
What Does Foreign Direct Investment - FDI Mean?
An investment abroad, usually where the company being invested in is controlled by the foreign corporation.
Investopedia Says
Investopedia explains Foreign Direct Investment - FDI
An example of FDI is an American company taking a majority stake in a company in China.

Special Economic Zone - SEZ
What Does It Mean?
What Does Special Economic Zone - SEZ Mean?
Designated areas in countries that possess special economic regulations that are different from other areas in the same country. Moreover, these regulations tend to contain measures that are conducive to foreign direct investment. Conducting business in a SEZ usually means that a company will receive tax incentives and the opportunity to pay lower tariffs.
Investopedia Says
Investopedia explains Special Economic Zone - SEZ
While many countries have set up special economic zones, China has been the most successful in using SEZ to attract foreign capital. In fact, China has even declared an entire province (Hainan) to be an SEZ, which is quite distinct, as most SEZs are cities.

Protectionism
What Does It Mean?
What Does Protectionism Mean?
Government actions and policies that restrict or restrain international trade, often done with the intent of protecting local businesses and jobs from foreign competition. Typical methods of protectionism are import tariffs, quotas, subsidies or tax cuts to local businesses and direct state intervention.
Investopedia Says
Investopedia explains Protectionism
Any time a government undertakes any of these actions, they are engaging in protectionism. There is significant debate surrounding the merits of protectionism. Critics argue that, over the long term, protectionism often ends up hurting the people it is intended to protect and often promotes free trade as a superior alternative to protectionism.

globalalisation

Globalization
What Does It Mean?
What Does Globalization Mean?
The tendency of investment funds and businesses to move beyond domestic and national markets to other markets around the globe, thereby increasing the interconnectedness of different markets. Globalization has had the effect of markedly increasing not only international trade, but also cultural exchange.
Investopedia Says
Investopedia explains Globalization
The advantages and disadvantages of globalization have been heavily scrutinized and debated in recent years. Proponents of globalization say that it helps developing nations "catch up" to industrialized nations much faster through increased employment and technological advances. Critics of globalization say that it weakens national sovereignty and allows rich nations to ship domestic jobs overseas where labor is much cheaper.
Protectionism
What Does It Mean?
What Does Protectionism Mean?
Government actions and policies that restrict or restrain international trade, often done with the intent of protecting local businesses and jobs from foreign competition. Typical methods of protectionism are import tariffs, quotas, subsidies or tax cuts to local businesses and direct state intervention.
Investopedia Says
Investopedia explains Protectionism
Any time a government undertakes any of these actions, they are engaging in protectionism. There is significant debate surrounding the merits of protectionism. Critics argue that, over the long term, protectionism often ends up hurting the people it is intended to protect and often promotes free trade as a superior alternative to protectionism

forex reserves and foreign trade

Forex - FX
What Does It Mean?
What Does Forex - FX Mean?
The market in which currencies are traded. The forex market is the largest, most liquid market in the world with an average traded value that exceeds $1.9 trillion per day and includes all of the currencies in the world.
Investopedia Says
Investopedia explains Forex - FX
There is no central marketplace for currency exchange; trade is conducted over the counter. The forex market is open 24 hours a day, five days a week and currencies are traded worldwide among the major financial centers of London, New York, Tokyo, Zürich, Frankfurt, Hong Kong, Singapore, Paris and Sydney.

The forex is the largest market in the world in terms of the total cash value traded, and any person, firm or country may participate in this market...........


Exchange Rate
What Does It Mean?
What Does Exchange Rate Mean?
The price of one country's currency expressed in another country's currency. In other words, the rate at which one currency can be exchanged for another. For example, the higher the exchange rate for one euro in terms of one yen, the lower the relative value of the yen.
Investopedia Says
Investopedia explains Exchange Rate
In most financial papers, currencies are expressed in terms of U.S. dollars, while the dollar is commonly compared to the Japanese yen, the British pound and the euro. As of the beginning of 2006, the exchange rate of one U.S. dollar for one euro was about 0.84, which means that one dollar can be exchanged for 0.84 euros

Real Effective Exchange Rate - REER
What Does It Mean?
What Does Real Effective Exchange Rate - REER Mean?
The weighted average of a country's currency relative to an index or basket of other major currencies adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one country's currency, with each other country within the index.
Investopedia Says
Investopedia explains Real Effective Exchange Rate - REER
This exchange rate is used to determine an individual country's currency value relative to the other major currencies in the index, as adjusted for the effects of inflation. All currencies within the said index are the major currencies being traded today: U.S. dollar, Japanese yen, euro, etc.

This is also the value that an individual consumer will pay for an imported good at the consumer level. This price will include any tariffs and transactions costs associated with importing the good.
Nominal Effective Exchange Rate - NEER
What Does It Mean?
What Does Nominal Effective Exchange Rate - NEER Mean?
The unadjusted weighted average value of a country's currency relative to all major currencies being traded within an index or pool of currencies. The weights are determined by the importance a home country places on all other currencies traded within the pool, as measured by the balance of trade.
Investopedia Says
Investopedia explains Nominal Effective Exchange Rate - NEER
The NEER represents the relative value of a home country's currency compared to the other major currencies being traded (U.S. dollar, Japanese yen, euro, etc.). A higher NEER coefficient (above 1) means that the home country's currency will usually be worth more than an imported currency, and a lower coefficient (below 1) means that the home currency will usually be worth less than the imported currency. The NEER also represents the approximate relative price a consumer will pay for an imported good.
Balance Of Trade - BOT
What Does It Mean?
What Does Balance Of Trade - BOT Mean?
The difference between a country's imports and its exports. Balance of trade is the largest component of a country's balance of payments. Debit items include imports, foreign aid, domestic spending abroad and domestic investments abroad. Credit items include exports, foreign spending in the domestic economy and foreign investments in the domestic economy. A country has a trade deficit if it imports more than it exports; the opposite scenario is a trade surplus.

Also referred to as "trade balance" or "international trade balance"
Investopedia Says
Investopedia explains Balance Of Trade - BOT
The balance of trade is one of the most misunderstood indicators of the U.S. economy. For example, many people believe that a trade deficit is a bad thing. However, whether a trade deficit is bad thing is relative to the business cycle and economy. In a recession, countries like to export more, creating jobs and demand. In a strong expansion, countries like to import more, providing price competition, which limits inflation and, without increasing prices, provides goods beyond the economy's ability to meet supply. Thus, a trade deficit is not a good thing during a recession but may help during an expansion.
Special Drawing Rights - SDR
What Does It Mean?
What Does Special Drawing Rights - SDR Mean?
An international type of monetary reserve currency, created by the International Monetary Fund (IMF) in 1969, which operates as a supplement to the existing reserves of member countries. Created in response to concerns about the limitations of gold and dollars as the sole means of settling international accounts, SDRs are designed to augment international liquidity by supplementing the standard reserve currencies.
Investopedia Says
Investopedia explains Special Drawing Rights - SDR
You can think of SDRs as an artificial currency used by the IMF and defined as a "basket of national currencies". The IMF uses SDRs for internal accounting purposes. SDRs are allocated by the IMF to its member countries and are backed by the full faith and credit of the member countries' governments.
International Monetary Fund - IMF
What Does It Mean?
What Does International Monetary Fund - IMF Mean?
An international organization created for the purpose of:

1. Promoting global monetary and exchange stability.

2. Facilitating the expansion and balanced growth of international trade.

3. Assisting in the establishment of a multilateral system of payments for current transactions.
Investopedia Says
Investopedia explains International Monetary Fund - IMF
The IMF plays three major roles in the global monetary system. The Fund surveys and monitors economic and financial developments, lends funds to countries with balance-of-payment difficulties, and provides technical assistance and training for countries requesting it.
World Trade Organization - WTO
What Does It Mean?
What Does World Trade Organization - WTO Mean?
An international organization dealing with the global rules of trade between nations. Its main function is to ensure that trade flows as smoothly, predictably, and freely as possible.
Investopedia Says
Investopedia explains World Trade Organization - WTO
Some, especially multinational corporations, believe that the WTO is great for business. Others believe the WTO will undermine the principles of democracy and simply make the rich much richer.
Organization for Economic Cooperation and Development - OECD
What Does It Mean?
What Does Organization for Economic Cooperation and Development - OECD Mean?
The OECD is a group of 30 member countries who discuss and develop economic and social policy.
Investopedia Says
Investopedia explains Organization for Economic Cooperation and Development - OECD
The OECD has been called a think tank, monitoring agency, rich man's club, and unacademic university. Whatever you want to call it, the OECD has a lot of power, as the member nations account for two thirds of the worlds goods and services.

marco economic variables

Gross Domestic Product - GDP
What Does It Mean?
What Does Gross Domestic Product - GDP Mean?
The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

GDP = C + G + I + NX

where:

"C" is equal to all private consumption, or consumer spending, in a nation's economy
"G" is the sum of government spending
"I" is the sum of all the country's businesses spending on capital
"NX" is the nation's total net exports, calculated as total exports minus total imports. (NX = Exports - Imports)
National Income Accounting
What Does It Mean?
What Does National Income Accounting Mean?
A term used in economics to refer to the bookkeeping system that a national government uses to measure the level of the country's economic activity in a given time period. National income accounting records the level of activity in accounts such as total revenues earned by domestic corporations, wages paid to foreign and domestic workers, and the amount spent on sales and income taxes by corporations and individuals residing in the country.
Investopedia Says
Investopedia explains National Income Accounting
National income accounting provides economists and statisticians with detailed information that can be used to track the health of an economy and to forecast future growth and development. Although national income accounting is not an exact science, it provides useful insight into how well an economy is functioning, and where monies are being generated and spent.

Some of the metrics calculated by using national income accounting include gross domestic product (GDP), gross national product (GNP) and gross national income (GNI).


Aggregate Demand
What Does It Mean?
What Does Aggregate Demand Mean?
The total amount of goods and services demanded in the economy at a given overall price level and in a given time period. It is represented by the aggregate-demand curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally there is a negative relationship between aggregate demand and the price level. Also known as "total spending".
Investopedia Says
Investopedia explains Aggregate Demand
Aggregate demand is the demand for the gross domestic product (GDP) of a country, and is represented by this formula:

Aggregate Demand (AD) = C + I + G (X-M) C = Consumers' expenditures on goods and services. I = Investment spending by companies on capital goods. G = Government expenditures on publicly provided goods and services. X = Exports of goods and services. M = Imports of goods and services.
Aggregate Supply
What Does It Mean?
What Does Aggregate Supply Mean?
The total supply of goods and services produced within an economy at a given overall price level in a given time period. It is represented by the aggregate-supply curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally, there is a positive relationship between aggregate supply and the price level. Rising prices are usually signals for businesses to expand production to meet a higher level of aggregate demand.

Also known as "total output".
Investopedia Says
Investopedia explains Aggregate Supply
A shift in aggregate supply can be attributed to a number of variables. These include changes in the size and quality of labor, technological innovations, increase in wages, increase in production costs, changes in producer taxes and subsidies, and changes in inflation. In the short run, aggregate supply responds to higher demand (and prices) by bringing more inputs into the production process and increasing utilization of current inputs. In the long run, however, aggregate supply is not affected by the price level and is driven only by improvements in productivity and efficiency.
Related Terms
Change In Supply
What Does It Mean?
What Does Change In Supply Mean?
A term used in economics to describe when the suppliers of a given good or service have altered their production or output. A change in supply can be brought on by new technologies, making production more efficient and less expensive, or by a change in the number of competitors in the market.
Investopedia Says
Investopedia explains Change In Supply
A change in supply will lead to a shift in the supply curve, which will cause an imbalance in the market that is corrected by changing prices and demand. If the change in supply increases supply, you will see the supply curve shift to the right, while a decrease in supply from a change in supply will shift the supply curve left.

For example, if there is a new technology that makes the production of DVD players a lot cheaper, according to the law of supply, there will be an increase in the output of DVD players. With more outputs in the market, the price of DVD players will likely fall, creating greater demand in the marketplace and more overall sales of DVD players.
Consumer Price Index - CPI
What Does It Mean?
What Does Consumer Price Index - CPI Mean?
A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.

Sometimes referred to as "headline inflation".

Investopedia Says
Investopedia explains Consumer Price Index - CPI
The U.S. Bureau of Labor Statistics measures two kinds of CPI statistics: CPI for urban wage earners and clerical workers (CPI-W), and the chained CPI for all urban consumers (C-CPI-U). Of the two types of CPI, the C-CPI-U is a better representation of the general public, because it accounts for about 87% of the population.

CPI is one of the most frequently used statistics for identifying periods of inflation or deflation. This is because large rises in CPI during a short period of time typically denote periods of inflation and large drops in CPI during a short period of time usually mark periods of deflation.


Cost-Push Inflation
What Does It Mean?
What Does Cost-Push Inflation Mean?
A phenomenon in which the general price levels rise (inflation) due to increases in the cost of wages and raw materials.
Investopedia Says
Investopedia explains Cost-Push Inflation
Cost-push inflation develops because the higher costs of production factors decreases in aggregate supply (the amount of total production) in the economy. Because there are fewer goods being produced (supply weakens) and demand for these goods remains consistent, the prices of finished goods increase (inflation).
Demand-Pull Inflation
What Does It Mean?
What Does Demand-Pull Inflation Mean?
A term used in Keynesian economics to describe the scenario that occurs when price levels rise because of an imbalance in the aggregate supply and demand. When the aggregate demand in an economy strongly outweighs the aggregate supply, prices increase. Economists will often say that demand-pull inflation is a result of too many dollars chasing too few goods.
Investopedia Says
Investopedia explains Demand-Pull Inflation
This type of inflation is a result of strong consumer demand. When many individuals are trying to purchase the same good, the price will inevitably increase. When this happens across the entire economy for all goods, it is known as demand-pull inflation.


Keynesian Economics
What Does It Mean?
What Does Keynesian Economics Mean?
An economic theory stating that active government intervention in the marketplace and monetary policy is the best method of ensuring economic growth and stability.
Investopedia Says
Investopedia explains Keynesian Economics
A supporter of Keynesian economics believes it is the government's job to smooth out the bumps in business cycles. Intervention would come in the form of government spending and tax breaks in order to stimulate the economy, and government spending cuts and tax hikes in good times, in order to curb inflation..


ISLM Model
What Does It Mean?
What Does ISLM Model Mean?
A macroeconomic model that graphically represents two intersecting curves, called the IS and LM curves. The investment/saving (IS) curve is a variation of the income-expenditure model incorporating market interest rates (demand for this model), while the liquidity preference/money supply equilibrium (LM) curve represents the amount of money available for investing (supply for this model).
Investopedia Says
Investopedia explains ISLM Model
The model attempts to explain the investing decisions made by investors given the amount of money they have available and the interest rate they will receive. Equilibrium occurs when the amount of money invested equals the amount of money available for investing.

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Money Supply
What Does It Mean?
What Does Money Supply Mean?
The entire quantity of bills, coins, loans, credit and other liquid instruments in a country's economy.
Investopedia Says
Investopedia explains Money Supply
Money supply is divided into multiple categories - M0, M1, M2 and M3 - according to the type and size of account in which the instrument is kept. The money supply is important to economists trying to understand how policies will affect interest rates and growth.

Liquidity Squeeze
What Does It Mean?
What Does Liquidity Squeeze Mean?
When concern about the short-term availability of money causes reluctance among financial institutions to lend out money from their reserves. This hold on reserves causes the interbank market rate to rise, making it more expensive for banks to borrow from each other. Ultimately, this causes credit standards to tighten, making it more difficult and expensive for consumers to receive loans.
Investopedia Says
Investopedia explains Liquidity Squeeze
In order to limit the impact of liquidity squeezes, central banks will often increase liquidity by injecting more money into the economy through lower interest rates. Doing so gives financial institutions a less expensive alternative to borrowing. This process also serves to alleviate the fear of insufficient liquidity in the short run and make bank loans more accessible to consumers and businesses.

M0
What Does It Mean?
What Does M0 Mean?
A measure of the money supply which combines any liquid or cash assets held within a central bank and the amount of physical currency circulating in the economy. In the United Kingdom, the M0 supply is also referred to as narrow money.
Investopedia Says
Investopedia explains M0
M0 (M-zero) is the most liquid measure of the money supply. It only includes cash or assets that could quickly be converted into currency. This measure is known as narrow money because it is the smallest measure of the money supply.

M1
What Does It Mean?
What Does M1 Mean?
A category of the money supply that includes all physical money such as coins and currency; it also includes demand deposits, which are checking accounts, and Negotiable Order of Withdrawal (NOW) Accounts.
Investopedia Says
Investopedia explains M1
This is used as a measurement for economists trying to quantify the amount of money in circulation. The M1 is a very liquid measure of the money supply, as it contains cash and assets that can quickly be converted to currency.

M2
What Does It Mean?
What Does M2 Mean?
A category within the money supply that includes M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds.
Investopedia Says
Investopedia explains M2
M2 is a broader classification of money than M1. Economists use M2 when looking to quantify the amount of money in circulation and trying to explain different economic monetary conditions.
M3
What Does It Mean?
What Does M3 Mean?
The category of the money supply that includes M2 as well as all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets.
Investopedia Says
Investopedia explains M3
This is the broadest measure of money; it is used by economists to estimate the entire supply of money within an economy.

Monetary Policy
What Does It Mean?
What Does Monetary Policy Mean?
The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates.
Investopedia Says
Investopedia explains Monetary Policy
In the United States, the Federal Reserve is in charge of monetary policy.
Open Market Operations - OMO
What Does It Mean?
What Does Open Market Operations - OMO Mean?
The buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. Purchases inject money into the banking system and stimulate growth while sales of securities do the opposite.
Investopedia Says
Investopedia explains Open Market Operations - OMO
Open market operations are the principal tools of monetary policy. (The discount rate and reserve requirements are also used.) The U.S. Federal Reserve's goal in using this technique is to adjust the federal funds rate--the rate at which banks borrow reserves from each other.

Macroeconomic Analysis

When the price of a product you want to buy goes up, it affects you. But why does the price go up? Is the demand greater than the supply? Did the cost go up because of the raw materials that make the CD? Or, was it a war in an unknown country that affected the price? In order to answer these questions, we need to turn to macroeconomics.

What Is It?
Macroeconomics is the study of the behavior of the economy as a whole. This is different from microeconomics, which concentrates more on individuals and how they make economic decisions. Needless to say, macroeconomy is very complicated and there are many factors that influence it. These factors are analyzed with various economic indicators that tell us about the overall health of the economy.

Macroeconomists try to forecast economic conditions to help consumers, firms and governments make better decisions.

* Consumers want to know how easy it will be to find work, how much it will cost to buy goods and services in the market, or how much it may cost to borrow money.
* Businesses use macroeconomic analysis to determine whether expanding production will be welcomed by the market. Will consumers have enough money to buy the products, or will the products sit on shelves and collect dust?
* Governments turn to the macroeconomy when budgeting spending, creating taxes, deciding on interest rates and making policy decisions.

Macroeconomic analysis broadly focuses on three things: national output (measured by gross domestic product (GDP)), unemployment and inflation. (For background reading, see The Importance Of Inflation And GDP.)

National Output: GDP
Output, the most important concept of macroeconomics, refers to the total amount of goods and services a country produces, commonly known as the gross domestic product. The figure is like a snapshot of the economy at a certain point in time.

When referring to GDP, macroeconomists tend to use real GDP, which takes inflation into account, as opposed to nominal GDP, which reflects only changes in prices. The nominal GDP figure will be higher if inflation goes up from year to year, so it is not necessarily indicative of higher output levels, only of higher prices.

The one drawback of the GDP is that because the information has to be collected after a specified time period has finished, a figure for the GDP today would have to be an estimate. GDP is nonetheless like a stepping stone into macroeconomic analysis. Once a series of figures is collected over a period of time, they can be compared, and economists and investors can begin to decipher the business cycles, which are made up of the alternating periods between economic recessions (slumps) and expansions (booms) that have occurred over time.

From there we can begin to look at the reasons why the cycles took place, which could be government policy, consumer behavior or international phenomena, among other things. Of course, these figures can be compared across economies as well. Hence, we can determine which foreign countries are economically strong or weak.

Based on what they learn from the past, analysts can then begin to forecast the future state of the economy. It is important to remember that what determines human behavior and ultimately the economy can never be forecasted completely.

Unemployment
The unemployment rate tells macroeconomists how many people from the available pool of labor (the labor force) are unable to find work. (For more about employment, see Surveying The Employment Report.)

Macroeconomists have come to agree that when the economy has witnessed growth from period to period, which is indicated in the GDP growth rate, unemployment levels tend to be low. This is because with rising (real) GDP levels, we know that output is higher, and, hence, more laborers are needed to keep up with the greater levels of production.

Inflation
The third main factor that macroeconomists look at is the inflation rate, or the rate at which prices rise. Inflation is primarily measured in two ways: through the Consumer Price Index (CPI) and the GDP deflator. The CPI gives the current price of a selected basket of goods and services that is updated periodically. The GDP deflator is the ratio of nominal GDP to real GDP. (For more on this, see The Consumer Price Index: A Friend To Investors and The Consumer Price Index Controversy.)

If nominal GDP is higher than real GDP, we can assume that the prices of goods and services has been rising. Both the CPI and GDP deflator tend to move in the same direction and differ by less than 1%. (If you'd like to learn more about inflation, check out All About Inflation.)

Demand and Disposable Income
What ultimately determines output is demand. Demand comes from consumers (for investment or savings - residential and business related), from the government (spending on goods and services of federal employees) and from imports and exports.

Demand alone, however, will not determine how much is produced. What consumers demand is not necessarily what they can afford to buy, so in order to determine demand, a consumer's disposable income must also be measured. This is the amount of money after taxes left for spending and/or investment.

In order to calculate disposable income, a worker's wages must be quantified as well. Salary is a function of two main components: the minimum salary for which employees will work and the amount employers are willing to pay in order to keep the worker in employment. Given that the demand and supply go hand in hand, the salary level will suffer in times of high unemployment, and it will prosper when unemployment levels are low.

Demand inherently will determine supply (production levels) and an equilibrium will be reached; however, in order to feed demand and supply, money is needed. The central bank (the Federal Reserve in the U.S.) prints all money that is in circulation in the economy. The sum of all individual demand determines how much money is needed in the economy. To determine this, economists look at the nominal GDP, which measures the aggregate level of transactions, to determine a suitable level of money supply.

Greasing the Engine of the Economy - What the Government Can Do

Monetary Policy
A simple example of monetary policy is the central bank's open-market operations. (For more detail, see the Federal Reserve Tutorial.) When there is a need to increase cash in the economy, the central bank will buy government bonds (monetary expansion). These securities allow the central bank to inject the economy with an immediate supply of cash. In turn, interest rates, the cost to borrow money, will be reduced because the demand for the bonds will increase their price and push the interest rate down. In theory, more people and businesses will then buy and invest. Demand for goods and services will rise and, as a result, output will increase. In order to cope with increased levels of production, unemployment levels should fall and wages should rise.

On the other hand, when the central bank needs to absorb extra money in the economy, and push inflation levels down, it will sell its T-bills. This will result in higher interest rates (less borrowing, less spending and investment) and less demand, which will ultimately push down price level (inflation) but will also result in less real output.

Fiscal Policy
The government can also increase taxes or lower government spending in order to conduct a fiscal contraction. What this will do is lower real output because less government spending means less disposable income for consumers. And, because more of consumers' wages will go to taxes, demand as well as output will decrease.

A fiscal expansion by the government would mean that taxes are decreased or government spending is increased. Ether way, the result will be growth in real output because the government will stir demand with increased spending. In the meantime, a consumer with more disposable income will be willing to buy more.

A government will tend to use a combination of both monetary and fiscal options when setting policies that deal with the macroeconomy.

Conclusion
The performance of the economy is important to all of us. We analyze the macroeconomy by primarily looking at national output, unemployment and inflation. Although it is consumers who ultimately determine the direction of the economy, governments also influence it through fiscal and monetary policy.

Inflation in India

The 1990s is widely described in general as a price stability era all over the globe. During the early part of the decade developed and developing countries alike experienced "a distinct ebbing of inflation", so observes India's central banking authorities, Reserve Bank of India (RBI). Inflation in India, barring some external factors like bouts of increase in international oil price and natural disasters like drought or flood, is showing an ebbing trend. The first half of India's fiscal 2002-03 (beginning April 1, 2002) witnessed uptrend in inflation largely due to increase in oil prices twice during the period and adverse impact of drought on agri- products leading to increase in prices – particularly of oilseeds and edible oils. The efficient handling of supply management helped inflation eased in the second half of the fiscal. As a whole at the end of the fiscal 2002-03 inflation was up 3.3 percentage points. In the light of overall variation in wholesale price inflation, the inflation in fiscal 2002-03 was dominated by non-food items unlike preceding years, according to a RBI report.

One of the major import contents of India's inflation in fiscal 2002-03 were edible oils and oil cakes that recorded highest price increase. Acute shortfall in production of the commodity led to about half the domestic demand met by imports. The RBI report also states that the underlying inflation (measured by average WPI) during this fiscal was dominated by manufactured product groups. Within manufactures again, edible oils, oil cakes and manmade fibres were largely responsible uppish trend in inflation. Inflation measured by average consumer price index for industrial workers (CPI-IW) however eased in fiscal 2002-03.

Inflation

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.[1] When the general price level rises, each unit of the functional currency buys fewer goods and services; consequently, inflation is a decline in the real value of money—a loss of purchasing power in the internal medium of exchange which is also the monetary unit of account in an economy.[2] A chief measure of general price-level inflation is the general inflation rate, which is the percentage change in a general price index (normally the Consumer Price Index) over time.[3]

Inflation can have adverse effects on an economy. For example, uncertainty about future inflation may discourage investment and saving. High inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future.

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply.[4] Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.[5][6]

Today, most economists favor a low steady rate of inflation.[7] Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.[8]
Contents
[hide]

* 1 Origins
* 2 Related definitions
* 3 Measures
o 3.1 Issues in measuring
* 4 Effects
o 4.1 Negative
o 4.2 Positive
* 5 Causes
o 5.1 Keynesian view
o 5.2 Monetarist view
o 5.3 Rational expectations theory
o 5.4 Austrian theory
o 5.5 Real bills doctrine
o 5.6 Anti-classical or backing theory
* 6 Controlling inflation
o 6.1 Monetary policy
o 6.2 Fixed exchange rates
o 6.3 Gold standard
o 6.4 Wage and price controls
o 6.5 Cost-of-living allowance
* 7 See also
* 8 Notes
* 9 References
* 10 Further reading
* 11 External links

[edit] Origins

Inflation originally referred to the debasement of the currency. When gold was used as currency, gold coins could be collected by the government (e.g. the king or the ruler of the region), melted down, mixed with other metals such as silver, copper or lead, and reissued at the same nominal value. By diluting the gold with other metals, the government could increase the total number of coins issued without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in seigniorage.[9] This practice would increase the money supply but at the same time lower the relative value of each coin. As the relative value of the coins decrease, consumers would need more coins to exchange for the same goods and services. These goods and services would experience a price increase as the value of each coin is reduced.[10]

By the nineteenth century, economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the value or resource costs of the good, a change in the price of money which then was usually a fluctuation in metallic content in the currency, and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. Following the proliferation of private bank note currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable bank notes outstripped the quantity of metal available for their redemption. The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods.[11]

This relationship between the over-supply of bank notes and a resulting depreciation in their value was noted by earlier classical economists such as David Hume and David Ricardo, who would go on to examine and debate to what effect a currency devaluation (later termed monetary inflation) has on the price of goods (later termed price inflation, and eventually just inflation).[12]

[edit] Related definitions

The term "inflation" usually refers to a measured rise in a broad price index that represents the overall level of prices in goods and services in the economy. The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some examples of broad price indices. The term inflation may also be used to describe the rising level of prices in a narrow set of assets, goods or services within the economy, such as commodities (which include food, fuel, metals), financial assets (such as stocks, bonds and real estate), and services (such as entertainment and health care). The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Asset price inflation is a rise in the price of assets, as opposed to goods and services. Core inflation is a measure of price fluctuations in a sub-set of the broad price index which excludes food and energy prices. The Federal Reserve Board uses the core inflation rate to measure overall inflation, eliminating food and energy prices to mitigate against short term price fluctuations that could distort estimates of future long term inflation trends in the general economy.[13]

Other related economic concepts include: deflation – a fall in the general price level; disinflation – a decrease in the rate of inflation; hyperinflation – an out-of-control inflationary spiral; stagflation – a combination of inflation, slow economic growth and high unemployment; and reflation – an attempt to raise the general level of prices to counteract deflationary pressures.

[edit] Measures
Annual inflation rates in the United States from 1666 to 2004.

Inflation is usually measured by calculating the inflation rate of a price index, usually the Consumer Price Index.[14] The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer".[15] The inflation rate is the percentage rate of change of a price index over time.

For example, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is

\left(\frac{211.080-202.416}{202.416}\right)=4.28%

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007.[16]

Other widely used price indices for calculating price inflation include the following:

* Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes.
* Producer price indices (PPIs) which measures average changes in prices received by domestic producers for their output. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any eventual increase in the CPI. Producer price index measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index.
* Commodity price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee.
* Core price indices: because food and oil prices can change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when those prices are included. Therefore most statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a broad price index like the CPI. Because core inflation is less affected by short run supply and demand conditions in specific markets, central banks rely on it to better measure the inflationary impact of current monetary policy.

Other common measures of inflation are:

* GDP deflator is a measure of the price of all the goods and services included in Gross Domestic Product (GDP). The US Commerce Department publishes a deflator series for US GDP, defined as its nominal GDP measure divided by its real GDP measure.
* Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US.
* Historical inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology.
* Asset price inflation is an undue increase in the prices of real or financial assets, such as stock (equity) and real estate. While there is no widely-accepted index of this type, some central bankers have suggested that it would be better to aim at stabilizing a wider general price level inflation measure that includes some asset prices, instead of stabilizing CPI or core inflation only. The reason is that by raising interest rates when stock prices or real estate prices rise, and lowering them when these asset prices fall, central banks might be more successful in avoiding bubbles and crashes in asset prices.[dubious – discuss]

[edit] Issues in measuring

Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. For example, if the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price difference represents inflation. This single price change would not, however, represent general inflation in an overall economy. To measure overall inflation, the price change of a large "basket" of representative goods and services is measured. This is the purpose of a price index, which is the combined price of a "basket" of many goods and services. The combined price is the sum of the weighted average prices of items in the "basket". A weighted price is calculated by multiplying the unit price of an item to the number of those items the average consumer purchases. Weighted pricing is a necessary means to measuring the impact of individual unit price changes on the economy's overall inflation. The Consumer Price Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price.[8]

Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Over time adjustments are made to the type of goods and services selected in order to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time in order to keep pace with the changing marketplace.

Inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost shifts. For example, home heating costs are expected to rise in colder months, and seasonal adjustments are often used when measuring for inflation to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices.

When looking at inflation economic institutions may focus only on certain kinds of prices, or special indices, such as the core inflation index which is used by central banks to formulate monetary policy.

[edit] Effects

[edit] Negative

An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services.[17] The effect of inflation is not distributed evenly, and as a consequence there are hidden costs to some and benefits to others from this decrease in purchasing power. For example, with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments.[8]

High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation.[8] Uncertainty about the future purchasing power of money discourages investment and saving.[18] And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates.

With high inflation, purchasing power is redistributed from those on fixed incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation.[8] This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.

Cost-push inflation
Rising inflation can prompt employees to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral.[19] In a sense, inflation begets further inflationary expectations.

Hoarding
People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.

Hyperinflation
If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.

Allocative efficiency
A change in the supply or demand for a good will normally cause its price to change, signalling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, genuine price signals get lost in the noise, so agents are slow to respond to them. The result is a loss of allocative efficiency.

Shoe leather cost
High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.

Menu costs
With high inflation, firms must change their prices often in order to keep up with economy wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly.

Business cycles
According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.[20]

[edit] Positive

Labor-market adjustments
Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster.

Debt relief
Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The “real” interest on a loan is the nominal rate minus the inflation rate. (R=n-i) For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate.

Room to maneuver
The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.

Tobin effect
The Nobel prize winning economist James Tobin at one point had argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects. See Tobin monetary model[21]

[edit] Causes
The Bank of England, central bank of the United Kingdom, monitors causes and attempts to control inflation.

Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the quantity equation of money, that relates the money supply, its velocity, and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.[citation needed]

Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.[22] The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.

[edit] Keynesian view

Keynesian economic theory proposes that money is transparent to real forces in the economy, and that visible inflation is the result of pressures in the economy expressing themselves in prices.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":[23]

* Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
* Cost-push inflation: also called "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
* Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively, often leading to hyperinflation, a condition where prices can double in a month or less. Another cause can be a rapid decline in the demand for money, as happened in Europe during the Black Death.

The money supply is also thought to play a major role in determining moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics, by contrast, typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians the money supply is only one determinant of aggregate demand. Some economists disagree with the notion that central banks control the money supply, arguing that central banks have little control because the money supply adapts to the demand for bank credit issued by commercial banks. This is the theory of endogenous money. Advocated strongly by post-Keynesians as far back as the 1960s, it has today become a central focus of Taylor rule advocates. This position is not universally accepted: banks create money by making loans, but the aggregate volume of these loans diminishes as real interest rates increase. Thus, central banks influence the money supply by making money cheaper or more expensive, and thus increasing or decreasing its production.

A fundamental concept in inflation analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment. The Phillips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s.

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.

Another concept of note is the potential output (sometimes called the "natural gross domestic product"), a level of GDP, where the economy is at its optimal level of production given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.

However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under British Prime Minister Margaret Thatcher might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed (also see unemployment), unable to find jobs that fit their skills. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.

[edit] Monetarist view
For more details on this topic, see Monetarists.

Monetarists believe the most significant factor influencing inflation or deflation is the management of money supply through the easing or tightening of credit. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation.[24]

Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. This theory begins with the identity:

M \cdot V = P \cdot Q

where

P is the general price level;
V is the velocity of money in final expenditures;
Q is an index of the real value of final expenditures;
M is the quantity of money.

In this formula, the general price level is affected by the level of economic activity (Q), the quantity of money (M) and the velocity of money (V). The formula is an identity because the velocity of money (V) is defined to be the ratio of final expenditure ( P \cdot Q ) to the quantity of money (M).

Velocity of money is often assumed to be constant, and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With constant velocity, the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not constant, and can only be measured indirectly and so the formula does not necessarily imply a stable relationship between money supply and nominal output. However, in the long run, changes in money supply and level of economic activity usually dwarf changes in velocity. If velocity is relatively constant, the long run rate of increase in prices (inflation) is equal to the difference between the long run growth rate of money supply and the long run growth rate of real output.[5]

[edit] Rational expectations theory
Main article: Rational expectations theory

Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.

A core assertion of rational expectations theory is that actors will seek to "head off" central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession.

[edit] Austrian theory

For more details on this topic, see The Austrian view of inflation

The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation.[25] Austrian economists measure the inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time.[26][27][28] This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply.[29] In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.[30]

Austrians argue that the state uses inflation as one of the three means by which it can fund its activities (inflation tax), the other two being taxation and borrowing.[31] Various forms of military spending is often cited as a reason for resorting to inflation and borrowing, as this can be a short term way of acquiring marketable resources and is often favored by desperate, indebted governments.[32]

In other cases, Austrians argue that the government actually creates economic recessions and depressions, by creating artificial booms that distort the structure of production. The central bank may try to avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions or depressions by artificially trying to "stimulate" the economy through "encouraging" money supply growth and further borrowing via artificially low interest rates.[33] Accordingly, many Austrian economists support the abolition of the central banks and the fractional-reserve banking system, and advocate returning to a 100 percent gold standard, or less frequently, free banking.[34][35] They argue this would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth (and inflation) would never spiral out of control.[36][37]

[edit] Real bills doctrine
Main article: Real bills doctrine

Within the context of a fixed specie basis for money, one important controversy was between the quantity theory of money and the real bills doctrine (RBD). Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. Currency and banking schools of economics argue the RBD, that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the 19th century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as currency boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of the Federal Reserve going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with libertarian principles of laissez-faire, even though almost all libertarian economists are opposed to the RBD.

The debate between currency, or quantity theory, and banking schools in Britain during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.

[edit] Anti-classical or backing theory

Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory". The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency.[38] Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions.

[edit] Controlling inflation

A variety of methods have been used in attempts to control inflation.

[edit] Monetary policy
Main article: Monetary policy
Please help improve this article or section by expanding it. Further information might be found on the talk page. (September 2008)
The U.S. effective federal funds rate charted over fifty years.

Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum.

There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.

Monetarists emphasize increasing interest rates (slowing the rise in the money supply, monetary policy) to fight inflation. Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand as well as by using monetary policy. Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a return to the gold standard. All of these policies are achieved in practice through a process of open market operations.

[edit] Fixed exchange rates
Main article: Fixed exchange rate

Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.

Under the Bretton Woods agreement, most countries around the world had currencies that were fixed to the US dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attacks. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e.g. Argentina (1991-2002), Bolivia, Brazil, and Chile).

[edit] Gold standard
Main article: Gold standard
Under a gold standard, paper notes are convertible into pre-set, fixed quantities of gold.

The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver.

Gold was a common form of representative money due to its rarity, durability, divisibility, fungibility, and ease of identification.[39] Representative money and the gold standard were used to protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression. However, they were not without their problems and critics, and so were partially abandoned via the international adoption of the Bretton Woods System. Under this system all other major currencies were tied at fixed rates to the dollar, which itself was tied to gold at the rate of $35 per ounce. That system eventually collapsed in 1971, which caused most countries to switch to fiat money, backed only by the laws of the country. Austrian economists strongly favor a return to a 100 percent gold standard.

Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output.[40] Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining,[41][42] which some believe contributed to the Great Depression.[43][44][42]

[edit] Wage and price controls
Main article: Incomes policies

Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands.

In general wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.

Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed (see creative destruction).

[edit] Cost-of-living allowance
For more details on this topic, see Cost of living.

The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as social security) are tied to a cost-of-living index, typically to the consumer price index.[45] A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually.[45] They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.

Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally-determined indexes. Many economists and compensation analysts consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized world, average wages have increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity and worker bargaining power rather than simply living costs, and (2) most cost-of-living indexes are not forward-looking, but instead compare current or historical data.