Economics

The Harvey files 1: inflation

July 11, 2007
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Shorthand thinking means that inflation is now simply identified as an increase in prices. This is a dangerous misconception, as higher prices on their own are in fact deflationary. This point was recognised by some commentators when oil prices soared last year: the effect was correctly compared to a tax levied by the oil producers which depressed demand in general.

Higher prices are in fact a symptom of inflation, in the same way as a high temperature is a symptom of fever, not the fever itself. Inflation is fuelled by a rise in incomes and spending—not by higher prices, which are an attempt by the economic body to bring excessive demand back into balance with inadequate supply. Inflation is therefore appropriately tackled by letting prices rise without extra spending power. The weapon of choice—rising interest rates—is defective because it results in higher incomes as well as having some restraining impact on demand: many benefits, including pensions, are directly linked to inflation, as are many pay agreements. So relying on interest rates to squeeze inflation prolongs the process of regaining control and achieves eventual equilibrium only at the cost of pushing prices to higher levels than are necessary.

You don’t cure a fever by plunging the thermometer into cold water.