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For the concept in cosmology, see cosmic inflation.
Inflation rates around the world.
Annual inflation rates in the U.S., 1914-2007.

In mainstream economics, the word “inflation” refers to a general rise in prices measured against a standard level of purchasing power. Previously the term was used to refer to an increase in the money supply, which is now referred to as expansionary monetary policy or monetary inflation. Cash inflation is measured by comparing two sets of identical non-monetary items at two points in time, and computing the increase in nominal cost not reflected by an increase in quality. There are, therefore, many measures of inflation depending on the specific circumstances. The most well known are the CPI which measures the change in nominal consumer prices, and the GDP deflator, which measures inflation in new products and services created.

The prevailing view in mainstream economics is that inflation is caused by the interaction of the supply of money with output and interest rates. Mainstream economist views can be broadly divided into two camps: the "monetarists" who believe that monetary effects dominate all others in setting the rate of inflation, and the "Keynesians" who believe that the interaction of money, interest and output dominate over other effects. Keynesians also tend to add a capital goods (or asset) price inflation to the standard measure of consumption goods inflation. Other theories, such as those of the Austrian school of economics, believe that inflation is caused by an increase in the supply of money by central banking authorities while the Historical Cost Accounting Inflation viewpoint highligts the fact that the combination of inflation and the global stable measuring unit assumption as implemented under the 700 year old Historical Cost Accounting model currently destroys the real value of all companies´ Retained Income balances at the annual rate of inflation in low inflation economies. Companies are free to revoke the stable measuring unit assumption by implementing Real Value Accounting and stop Historical Cost Accounting inflation.

Related concepts include: deflation, a general falling level of prices; disinflation, the reduction of the rate of inflation; hyper-inflation, an out-of-control inflationary spiral; stagflation, a combination of inflation and poor economic growth; and reflation, which is an attempt to raise prices to counteract deflationary pressures.

In classical political economy, “inflation” referred to government policy itself: inflation meant increasing the money supply over and above that necessary to accommodate any increase in real GDP, while “deflation” meant decreasing it. Some economists in a few schools of economic thought, generally described as libertarian, classical liberal, or ultra-conservative, still retain this usage. In mainstream economic terms these would be referred to as expansionary and contractionary monetary policies.

Econometrics

Measuring inflation is a question of econometrics, finding objective ways of comparing nominal prices to real activity. In many places in economics, "real" variables need to be compared. For example, in order to calculate GDP, effective interest rate and improvements in productivity are the "real variables" used in the calculations. Each inflationary measure takes a "basket" of goods and services, then the prices of the items in the basket are compared to a previous time, then adjustments are made for the changes in the goods in the basket itself. For example, a month ago canned corn was sold in 10 oz. jars for $9, and this month it is sold for $10. Assuming the quality of the product does not change, (ie a different metal in the can, a new type of corn,) the resulting price change is attributed to inflation. Economists analyze the aforementioned factors when calculating inflation for a product. For example, if that same can of corn was sold in 9 oz. jars for $9, and this month is sold in 10 oz jars for $10, and there are no other economic factors, then an economist would analyze the product as undergoing no inflation.

Measures of inflation

Examples of common measures of inflation include:

  • consumer price indices (CPIs) which measure the price of a selection of goods purchased by a "typical consumer".
  • Cost-of-living indices (COLI) which often adjust fixed incomes and contractual incomes based on measures of goods and services price changes.
  • producer price indices (PPIs) which measure the price received by a producer. 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 resulting increase in the CPI. Producer price inflation measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" as consumer inflation, or it could be absorbed by profits, or offset by increasing productivity.
  • wholesale price indices, which measure the change in price of a selection of goods at wholesale, prior to retail mark ups and sales taxes. These are very similar to the Producer Price Indexes.
  • commodity price indices, which measure the change in price of a selection of commodities. In the present commodity price indexes are weighted by the relative importance of the components to the "all in" cost of an employee.
  • GDP Deflator measures price increases in all assets rather than some particular subset. The term "deflator" in this case means the percentage to reduce current prices to get the equivalent price in a previous period. The US Commerce Department publishes a deflator series for the US economy.
  • Capital goods price Index, although so far no attempt at building such an index has been tried, several economists have recently pointed the necessity to measure separately capital goods inflation (inflation in the price of stocks, buildings, lands, and other assets). Indeed a given increase in the supply of money can lead to a rise in inflation (consumption goods inflation) and or to a rise in capital goods price inflation. The growth in money supply has remained fairly constant through since the 1970's however consumption goods price inflation has been reduced because most of the inflation as happened in the capital goods prices.
  • Regional Inflation The Beaureau 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. This is equivalent to not adjusting the composition of baskets over time.

Hedonic adjustments to measuring inflation

Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods from the present are compared with goods from the past. This includes hedonic adjustments and “reweighing” as well as using chained measures of inflation. As with many economic numbers, inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost increases, versus changes in the economy. Inflation numbers are averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices. Finally, when looking at inflation, economic institutions sometimes only look at subsets or special indices. One common set is inflation ex-food and energy, which is often called “core inflation”.

The role of inflation in the economy

In the long run, inflation is generally believed to be a monetary phenomenon, while in the short and medium term, it is influenced by the relative elasticity of wages, prices and interest rates. [1] The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian schools. In monetarism, prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trendline. 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.

A great deal of economic literature concerns the question of what causes inflation and what effect it has. A small amount of inflation is often viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are "sticky downward" and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Efforts to attain complete price stability can also lead to deflation, which is generally viewed as a negative outcome because of the significant downward adjustments in wages and output that are associated with it.

Inflation is also viewed as a hidden risk pressure that provides an incentive for those with savings to invest them, rather than have the purchasing power of those savings erode through inflation. In investing, inflation risks often cause investors to take on more systematic risk, in order to gain returns that will stay ahead of expected inflation. Inflation is also used as an index for cost of living adjustments and as a peg for some bonds. In effect, inflation is the rate at which previous economic transactions are discounted economically.

Inflation also gives central banks room to maneuver, since their primary tool for controlling the money supply and velocity of money is by setting the lowest interest rate in an economy - the discount rate at which banks can borrow from the central bank. Since borrowing at negative interest is generally ineffective, a positive inflation rate gives central bankers "ammunition", as it is sometimes called, to stimulate the economy.

However, in general, inflation rates above the nominal amounts required to give monetary freedom, and investing incentive, are regarded as negative, particularly because in current economic theory, inflation begets further inflationary expectations.

  • Increasing uncertainty may discourage investment and saving.
  • Redistribution
    • It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and profits which may keep pace with inflation.
    • Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax.
  • International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade.
  • Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.)
  • Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
  • Relative Price Distortions: Firms do not generally synchronize adjustment in prices. If there is higher inflation, firms that do not adjust their prices will have much lower prices relative to firms that do adjust them. This will distort economic decisions, since relative prices will not be reflecting relative scarcity of different goods.
  • 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.
  • Inflation tax when a government can improve its net financial position by allowing inflation, then this represents a tax on certain holders of currency. Governments may decide to use this "stealth tax" in order to avoid hard fiscal decisions to cut expenditures, raise taxes, or confront government unions with greater efficiency.
  • Bracket Creep is related to the inflation tax. By allowing inflation to move upwards, certain sticky aspects of the tax code are met by more and more people. Commonly income tax brackets, where the next dollar of income is taxed at a higher rate than previous dollars. Governments that allow inflation to "bump" people over these thresholds are, in effect, allowing a tax increase because the same real purchasing power is being taxed at a higher rate.

As noted, some economists see moderate inflation as a benefit; some business executives see mild inflation as "greasing the wheels of commerce." A very few economists have advocated reducing inflation to zero as a monetary policy goal - particularly in the late 1990s at the end of a long disinflationary period, when the policy seemed within reach.

Causes of inflation

There are different schools of thought as to what causes inflation. Most can be divided into two broad areas: quality theories of inflation, and quantity theories of inflation. Many theories of inflation combine the two. The quality theory of inflation rests on the expectation of a buyer 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 equation of the money supply, its velocity, and exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.

Keynesian economic theory proposes that money are 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":

  • Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending, etc.
  • Cost-push inflation: presently termed "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 has been seen most graphically when governments have financed spending in a crisis by printing money excessively (from war or civil war conditions), often leading to hyperinflation where prices rise at extremely high rates (such as, doubling every month). Another cause can be a rapid decline in the demand for money as happened in Europe during the black plague.

The money supply is also thought to play a major role in determining levels of more 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. Of course, today, not many economists believe in this 'hocus pocus' approach: the notion that central banks control the money supply has been virtually abandoned today. Today, most economists argue that central banks have little control: 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 advocates of Taylor Rules.

A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggested that price stability was a trade-off against employment. Therefore some level of inflation could be considered desirable in order to minimize unemployment. The Philips 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 Keynesian concept 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 Prime Minister Margaret Thatcher in the UK may 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 in the British economy. 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.

Problems of inflation

If inflation is high in an economy there are three main problems it can cause:

  1. People on a fixed income (e.g. pensioners, students) will be worse off in real terms due to higher prices and equal income as before; this will lead to a reduction in the purchasing power of their income.
  2. Rising inflation can encourage trade unions to demand higher wages. This can cause a wage spiral. Also if strikes occur in an important industry which has a comparative advantage the nation may see a decrease in productivity and suffer.
  3. If inflation is relatively higher in one country, and that country maintains fixed exchange rates with other countries, then the country's exports will become more expensive for other countries to purchase, creating a deficit on its current account.

Monetarism

One of the most influential schools of economic thinking rests on a quantity theory of money, namely monetarism. The school of thought was the output of 1970s stagflation. Monetarists assert that empirical study of monetary history shows that "inflation is always and everywhere a monetary phenomenon." Modern mainstream central bank practice until recently adhered closely to this concept.

These economists derive this belief from what is known as the Quantity Theory of Money. The Quantity Theory of Money, simply stated, is that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:

where is the general price level of consumers' goods, is the aggregate demand for consumers' goods and is the aggregate supply of consumers' goods. The idea behind this formula is that the general price level of consumers' goods will rise only if the aggregate supply of consumers' goods goes down relative to the aggregate demand for consumers' goods, or if the aggregate demand increases relative to the aggregate supply of consumers' goods. Based on the idea that total spending is based primarily on the total amount of money in existence, the economists calculate aggregate demand for consumers' goods based on the total quantity of money. Therefore, they posit that as the quantity of money increases, total spending increases and the aggregate demand for consumers' goods increases as well. For this reason the economists who believe in the Quantity Theory of Money also believe that the only cause for rising prices in a growing economy (this means aggregate supply of consumers' goods is increasing), is an increase of the total quantity of money in existence, which is caused by monetary policies, generally of central banks where there is a monopoly on currency issue and the lack of a commodity peg to currency. The central bank of the United States is the Federal Reserve; the central bank backing the euro is the European Central Bank.

No-one denies that inflation is associated with an excessive supply of money, but opinions differ as to whether the excessive money supply is the causal factor.

Rational expectations

Rational expectations theory, sometimes known as “ratex” or as “rashex”, is a view of macroeconomics that states that economic actors look rationally into the future and try and maximize their general sense of future states of well-being, and do not simply respond to the immediate opportunity cost and pressures of the present. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.

One core assertion of rational expectations theory is that actors will seek to “head off” central bank decisions, by acting preemptively and in ways that may themselves fulfill the predictions that drive them. 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 which would be very damaging to the economy, and possibly require government bailouts.

In this view central banks might be at an advantage renouncing some flexibility of monetary policy, in order to persuade economic actors that the bank will not allow it.

Other theories

Austrian School

Austrian School economics falls within the general tradition of the quantity theory of money, but is notable for providing a theory of the process whereby, upon an increase of the money supply, a new equilibrium is pursued. More specifically, possessors of the additional money are held to react to their new purchasing power by changing their buying habits in a way that generally increases demand for goods and for services. Austrian School economists do not believe that production will simply rise to meet all this new demand, so that prices increase and the new purchasing power erodes. The Austrian School emphasizes that this process is not instantaneous, and that the changes in demand are not distributed uniformly, so that the process does not ultimately lead to an equilibrium identical to the old except for some proportionate increase in prices; that “nominal” values thus have real effects. Austrian economists tend to view fiat increases in the money supply as particularly pernicious in their real effects. This view typically leads to the support for a commodity standard of a very strict variety where all notes are convertible on demand to some commodity or basket of commodities. (The more popular of the Austrian economists tend to favor a gold standard.)

Marxist theory

In Marxist economics, value is based on the labor required to extract a given commodity versus the demand for that commodity by those with money. The fluctuations of price in money terms are inconsequential compared to the rise and fall of the labor cost of a commodity, since this determines the true cost of a good or service. In this, Marxist economics is related to other "classical" economic theories that argue that monetary inflation is caused solely by printing notes in excess of the basic quantity of gold. However, Marx argues that the real kind of inflation is in the cost of production measured in labor. Because of the classical labor theory of value, the only factor that is important is whether more or less labor is required to produce a given commodity at the rate it is demanded.

Supply-side economics

Supply-side economics asserts that inflation is always caused by either an increase in the supply of money or a decrease in the demand for balances of money. The value of money is seen as being purely subject to these two factors. Thus the inflation experienced during the Black Plague in medieval Europe is seen as being caused by a decrease in the demand for money (the money stock used was gold coin and it was relatively fixed), whilst the inflation of the 1970s is regarded as initially caused by an increased supply of money that occurred following the US exit from the Bretton Woods gold standard. Supply-side economics asserts that the money supply can grow without causing inflation as long as the demand for balances of money also grows.

Historical Cost Accounting Inflation

Inflation has two components under the current Historical Cost Accounting paradigm: Cash Inflation and Historical Cost Accounting inflation.


I. CASH INFLATION


Cash inflation is the economic process that results in the destruction of the real value of monetary items over time as indicated by the change in the Consumer Price Index in low inflationary economies.

There are three distinct economic items in the economy:


1. Monetary items

2. Variable real value non-monetary items

3. Constant real value non-monetary items.


1. Monetary Items

Monetary items are functional currency units held and accounted monetary values only of the functional currency.

Non-monetary items are all items that are not monetary items. Non-monetary items are subdivided into two classes: variable real value non-monetary items and constant real value non-monetary items.

2. Variable real value non-monetary items.

Variable real value non-monetary items include items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.

Under Real Value Accounting variable real value non-monetary items are valued in terms of International Accounting Standards and International Financial Reporting Standards as issued by the International Accounting Standards Board with the exception of the stable measuring unit assumption, the whole of International Accounting Standard IAS 29: Financial Reporting in Hyperinflationary Economies and the definition of monetary items in IAS 21 The Effects of Changes in Foreign Exchange Rates.

Examples of variable real value non-monetary items are property, plant, equipment, land, buildings, raw material, work-in-progress, finished goods, stock, marketable securities, foreign currency and vehicles.


The functional currency is the monetary unit of account of the principle economic environment in which an economic entity operates.

The functional currency is money in a national economy. An item can only be money when it fulfills all three functions of money in a national economy:

a.) Medium of exchange

b.) Store of value

c.) Unit of account

Foreign exchange is not money in a national economy since it is not the unit of account. Foreign exchange is a variable real value non-monetary item valued at market value in foreign exchange markets.

The essential feature of a monetary item is that it is a functional currency unit or a functional currency value that only pertains to the functional currency. Actual monetary units cannot be updated and actual accounted monetary values are not updated in current financial accounts and statements.

Monetary values have the exact same attributes as money held with the single exception that they are accounted monetary values and not actual bank notes or bank coins. A monetary item never has a microeconomic non-monetary base during its entire economic life in our modern economies where our functional currencies have no intrinsic value. A monetary item cannot be the accounted value of a non-monetary item in any way or form in an economy with fiat money.

Money’s real value is continuously being destroyed by cash inflation in a cash inflationary economy. Cash inflation cannot be stopped by a change in the accounting model, for example, from the Historical Cost Accounting model to the Real Vale Accounting model. Real Value Accounting only stops Historical Cost Accounting inflation in all non-monetary items.

The real value of a non monetary item treated incorrectly like a monetary item under the Historical Cost Accounting model, on the other hand, is being destroyed, not by cash inflation, but by Historical Cost Accounting inflation which can be stopped at any time by adopting the Real Value Accounting model.

Examples of money held are bank notes and bank coins.

Examples of monetary values are bank account balances, money loans owed or made, notes payable and notes receivable. Depreciating or hyper depreciating monetary items have fixed nominal values but changing real values as their real values are slowly being destroyed by cash inflation and very rapidly being destroyed by cash hyperinflation, respectively.

Cash inflation can be reduced by reducing the rate of inflation through sound monetary, economic, political, social and other policies. This will reduce the rate of destruction in the real value of money. Two percent consecutive annual inflation destroys 51% of the real value of all monetary items over 35 years.

Cash inflation can be partially reversed by cash deflation, but, this is not recommended.


II. HISTORICAL COST ACCOUNTING INFLATION


Historical Cost Accounting inflation is the Historical Cost Accounting practice whereby accountants world wide destroy the real value of constant real value non-monetary items (eg. retained income - a shareholder value) not fully or never updated over time due to the use of the Historical Cost Accounting model or any other accounting model which does not allow the continuous updating of constant real value non-monetary items in an economy subject to low cash inflation.

3. Constant real value non-monetary items.

Constant real value non-monetary items are economic items with constant real values as a result of the double entry accounting model introduced in about the year 1300 in Venice, Italy.

Since money is legal tender in a national economy, all economic items, including constant real value non-monetary items, are accounted using money as the monetary unit of account. Unfortunately cash inflation continuously destroys the real value of money over time. Stable money never existed in the past over any sustained period of time and does not exist today.

Stable money or price stability is defined as a year-on-year increase in the Consumer Price Index of 0%.

A high degree of price stability is defined as a year-on-year increase in the Consumer Price Index of above zero and up to 2%.

2% consecutive annual inflation destroys 51% of the real value of all monetary items over 35 years – all else except inflation being equal. 2% consecutive annual inflation also destroys 51% of the real value of all constant real value non-monetary items never updated, for example, the real value of retained income in all companies´ balance sheets, over 35 years´ time – all else except inflation being equal.

Under Real Value Accounting constant real value non-monetary items are continuously updated at the current (today´s) rate of inflation in low inflationary economies always to current (today´s) real value at the date of the transaction or payment or the date of presentation (not preparation unless prepared and presented on the same day) of financial reports.

Real Value Accounting financial results and reports are prepared in terms of the rate of inflation at the balance sheet date in low inflation economies as defined above. During the current financial year only non-monetary items are updated at the current (today´s) rate of inflation every time the statements are accessed or presented till the current year end date. You cannot update monetary items during the current financial year.

After the year-end financial statements have been prepared at the year-end rate of inflation, all items - monetary and non-monetary items - are updated at the current (today´s) inflation rate (even years afterwards) every time the statements are accessed or presented to show the real value of all items, including monetary items, at the balance sheet date in terms of current (today´s) real value, that is, updated to the current (today´s) rate of inflation (even years afterwards). All values in these financial reports change with every month´s new CPI value. Computerised updating and presentation is the best form of implementation.

Constant real value non-monetary items include, for example: issued share capital, retained income, provisions, reserves, share premiums, retained losses, net monetary loss, net monetary gain, all items in shareholders equity, trade debtors, trade creditors, other debtors, other creditors, salaries, wages, fees, royalties, rent, interest paid in the Profit and Loss Account, interest received in the Profit and Loss Account, dividends, taxes, VAT, all Profit and Loss Account income/sales/revenue and all Profit and Loss Account costs and expenses, salaries payable, wages payable, rent payable, fees payable, royalties payable, interest payable, interest receivable, dividends payable, taxes payable, VAT payable, contstant real value non-monetary items stated at cost, salaries receivable, wages receivable, rent receivable, fees receivable, royalties receivable, dividends receivable taxes receivable, VAT receivable.

In most countries, primary financial statements are prepared on the Historical Cost basis of accounting without regard either to changes in the general level of prices or to increases in specific prices of assets held, except to the extent that property, plant and equipment and investments may be revalued.

The International Accounting Standards Board only identifies two instead of the three distinct economic items, namely, monetary and non-monetary items. The difference between variable and constant real value non-monetary items is ignored by the IASB as a result of the implementation of the stable measuring unit assumption - the cornerstone of the Historical Cost Accounting model - whereby it is accepted in low cash inflationary economies that the functional currency's internal real value is constantly being destroyed by cash inflation - but, this destruction of real value is regarded as of not sufficient importance to adjust the real values of constant real value non-monetary items in the financial statements. They are valued at Historical Cost which results in the destruction of their real values at the rate of inflation year after year when they are not fully or never updated.

The IASB´s definition of non-monetary items include variable real value non-monetary items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.

They also include Historical Cost items based on the stable measuring unit assumption.

One of the basic principles in accounting is the Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency.

This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.

Valuing these items at Historical Cost results in their real values being destroyed at the rate of inflation every single year when they are not fully or never updated, exactly the same as in monetary items or cash.

Although it is broadly known in low inflation economies that the destruction of the internal real value of the monetary unit of account is a very important matter and that inflation thus destroys the real value of all variable real value non-monetary items when they are not valued at fair value, market value, present value, net realizable value or recoverable value, for the purpose of valuing constant real value non-monetary items, the change in the real value of money is not regarded as sufficiently important to update their values in the financial statements.

However, when companies operate in an economy with hyperinflation (perhaps only Zimbabwe at the moment with 4 530% inflation), then it is International Accounting Standard practice to update everything in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies. Companies in hyperinflationary economies have to update variable AND constant real value non-monetary items.

But, ONLY as long as their annual inflation rate has been 26% for three years in a row adding up to 100% - the rate required for the implementation of IAS 29.

Once they are not in hyperinflation anymore, for example, 20% consecutive annual inflation for an indefinite period of time, then they are forbidden to update constant real value non-monetary items under the rules of Historical Cost Accounting. Then they must destroy their real value again – at 20% per annum – or at the many different levels of low inflation prevailing in the world today.

The stable measuring unit assumption is revoked under the Real Value Acounting model.

Historical Cost Accounting Inflation is stopped with the implementation of the Real Value Accounting model.

The Historical Cost Accounting model automatically becomes the Real Value Accounting model only at 0% cash inflation. Real Value Accounting results in 0% Historical Cost Accounting inflation or 0% destruction of real value in all non-monetary items under any level of cash inflation - all else except cash inflation being equal.

Under the Real Value Accounting model inflation only has one component, namely, a monetary component, that is, cash inflation. Real Value Accounting stops Historical Cost Accounting inflation.

Issues of classical political economy

While economic theory before the "marginal revolution" is no longer the basis for current economic theory, many of the institutions, concepts, and terms used in economics come from the "classical" period of political economy, including monetary policy, quantity and quality theories of economics, central banking, velocity of money, price levels and division of the economy into production and consumption. For this reason debates about present economics often reference problems of classical political economy, particularly the classical gold standard of 1871-1913, and the currency versus banking debates of that period.

Currency and Banking Schools

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, or RBD. Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. The RBD argues 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 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

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 [1] argues that the value of money is determined by the assets and liabilities of the issuing agency. 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.

Controlling inflation

There are a number of methods that have been suggested to stop 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 (that is, using monetary policy). High interest rates (and slow growth of the money supply) are the traditional way that central banks fight inflation, using unemployment and the decline of production to prevent price increases.

However, central banks view the means of controlling the inflation differently. 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 (reducing 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.

Another method attempted is simply instituting 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. In general wage and price controls are regarded as a drastic measure, and 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. Many developed nations set prices extensively, including for basic commodities as gasoline. The usual economic analysis is that that which is under priced is overconsumed, and that the distortions that occur will force adjustments in supply. For example, if the official price of bread is too low, there will be too little bread at official prices.

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, assuming that the economy will adjust, abandoning 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)

See also

Notes

  1. ^ Federal Reserve Board's semiannual Monetary Policy Report to the Congress; Roundtable; Introductory statement by Jean-Claude Trichet on 1 July 2004

References

  • George Reisman, Capitalism: A Treatise on Economics (Ottawa : Jameson Books, 1990), 503-506 & Chapter 19 ISBN 0-915463-73-3
  • Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, New York, Harper Collins, 1995.
  • Baumol, William J. and Alan S. Blinder, Macroeconomics: Principles and Policy, Tenth edition. Thomson South-Western, 2006. ISBN 0-324-22114-2
  • Whittington, G., "Inflation Accounting: An introduction to the debate", Cambridge, Cambridge University Press, 1983.
  • Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.

Statistical Sources

Austrian

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