Let me begin this thread with a quote from Keynes: "Lenin is said to have declared that the best way to destroy the Capitalistic System was to debauch the currency... Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million can diagnose." Inflation can best be understood as a form of taxation— a much less conspicuous and insidious type of taxation. For a hypothetical example, let us simplistically suppose that the income tax is 10 percent (of any form of economic exchange between two individuals) and there is (for a particular year) a 100 percent rate of inflation— that is a doubling of the money supply without additional backing of the money with more reserve assets. This inflation (combined with the 10 percent income tax) is equivalent to a 60 percent income tax. Let us see why this is so. To make any form of economic exchange (to trade or earn money) one must obtain money to pay taxes. Even if one uses some other medium of exchange (such as gold), one must still pay taxes in the official government money (on the market value of the exchange). If the government increases the money supply (without increasing the net value of the all the money) the market price will increase. If the money supply doubles, prices will also double. Again, the real value of everything did not change, it is just that the money is worth half as much so it takes twice as much money to buy something. The government (or central bank), now that it has just printed all this new money, initially has half the money, which it can proceed to buy things with. Basically, half the output of the economy goes to the government, and it means there is less available for everyone else (as a net group at least). And then there is still that regular 10 percent income tax on top of that. The title is "Inflation Augments Taxation", and there is a reason for that. Because in the absence of taxation, inflation becomes essentially meaningless (at least for more than a very small degree of inflation). People would just switch over to some other medium of exchange that is not subject to inflation, or they would turn to some large private bank that issues its own mortgage-backed bank notes. So even a 100% rate of inflation is not really any burden on the economy if there is no taxation (at least not theoretically). Now in actuality, things are much more complex than this. There is the convenience of a single unified currency under direct government oversight, and it may likely be that the currency is somewhat overvalued (people do not realise how much the bank notes are actually worth). But to say that paper money is a completely "neutral" medium of exchange and has no inherent value is simply not true. Theoretically, the worth of money is directly dependant upon the level of taxation, and the reserve assets that back the money. I hope this explains the basic concept of how inflation is analogous to taxation, and quantifies the link between the two.
As you say, when inflation gets too high, people switch to another medium of exchange. An underground economy forms and people do not pay taxes. In hyperinflation, almost nobody pays taxes even if they use the inflated currency. I lived in South America in the 1980's when inflation hit over 1000%. Almost every transaction was done outside the system. Taxation and inflation were not linked. Its the same for taxes. When taxes get too high, people switch that highly taxed part of the income/transactions to another medium of exchange.
Just like excessive taxation, excessive inflation can impose a very difficult or even unbearable burden on the people. It can destroy the incentives for economic exchange. Whether high taxation or inflation, it inevitably drives people into an underground market, and the respect for the rule of law is disregarded. How much the government cracks down on this underground market can greatly affect things. The communist countries tend to be the most ruthless at this, but even they find it is impossible to completely erradicate the underground economy. I recently read a book about the early history of the russian revolution. Excessive inflation, to fund the war against the German Empire and Austria-Hungry, was one of the main reasons for the impoverishment of the urban masses, which ultimately fueled the communist revolution. Interestingly, those who were most self sufficient fared best. When the government destroys the economy, the farmers in the countryside had no incentive to send food to the cities. Perhaps this was one of the reasons that after the revolution the communists "exerted" so many demands on the peasant farmers.
Let me ask a question about the generic concept of "inflation". Person A buys orange juice at a convenience store in 2007. The list price is $3.00. Once per month, the store runs a two-for-one sale. Person A buys 4 containers of orange juice and waits for the next monthly sale. The “net price” is $1.50 for the final consumer. Today, in 2012, the list price of the orange juice is $3.30 in the convenience store. The convenience store offers sales every 3 months in 2012 and the discount is $0.50. The final consumer pays $2.80 for a container of orange juice. Ignoring seasonal and drought-induced fluctuations in price, what is the correct way to interpret the “true inflation”? A. Use a point or average value of orange juice price as a commodity in 2007 and in 2012. B. Use the store list price (i.e. 10 % inflation over 5 years). C. Use the final consumer price (i.e. 86 % inflation over 5 years).
The real rate of inflation can be a somewhat complex thing to determine, but has very important political implications. Realistically, an exact value is probably not possible to determine in many instances. Just because the price of orange juice changes does not necessarily mean it was because of inflation. But if the prices of everything (or many things) seem to be going up, at nearly the same rate, it is generally a sign of inflation. This leads to a debate over what the actual definition of inflation is. Most economists generally use inflation to describe purchasing power. But if prices of different things change in different ways, and some people buy more of certain things than other people, there is no single definition of inflation that could apply to everyone. So this definition is really rather subjective. My definition of inflation is the change in value of the unit of exchange medium, measured by work-hours it takes to buy basic things for a modest life. As much as we would like to be able to unambiguously quantify inflation, it just has to be accepted that to at least some degree it is a relative concept. That does not mean we should just ignore when a central bank is significantly causing inflation by diluting the backing of the currency. To answer your specific question, if we try to use orange juice to guage inflation, both the list price and sale price have to be taken into account, and what the actual intent of these sales likely is. There are several marketing reasons a store may choose to have a sale. But in the most simple scenario, ignoring all other potential factors, it would be the lowest price of orange juice (sale price) we would use.
