What Is Inflation: Causes, And Effects On The Economy

What Is Inflation?

Inflation is a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.

Inflation is generally taken to be the rise of all or most prices, or (put the other way round) the fall of the general purchasing power of the monetary unit.

In many countries, high and sustainable economic growth and low inflation are two of the main objectives of macroeconomic policy. A widely accepted concept in macroeconomics is that low inflation is essential for economic growth.

What is your reaction when you find you have to pay twice as before to buy a kilo of pork? You may think it may be a temporary price adjustment by the manufacturer. But if the price increase happens in almost all commodities and lasts for a quite while you could have reasons to believe that inflation may have appeared.

Therefore, inflation has a very close connection to people’s common life by observing the price level.

Table of Contents:

Types of Inflation

The main types of inflation that are typically considered are demand-pull inflation and cost-push inflation.

Demand-Pull inflation describes inflation that occurs for the most basic of economic reasons, that is that prices for a good increase because demand for a product exceeds supply. For demand-pull inflation to occur full employment must be in place so that any increase in demand cannot be met simply by employing more resources to produce more of a product.

Demand-Pull inflation
Demand-Pull inflation

Cost-Push inflation occurs if there is a drop in output of a product usually due to an increase in costs, either through increased production costs or taxes or through some other kind of adverse shocks such as a supply shortage or a raw material. In this case, the economy will experience both higher prices and shortages of the product.

Cost-Push inflation
Cost-Push inflation

Measures Of Inflation

Inflation can be measured in a number of ways:

The first way is by using the Consumer Price Index (CPI). The CPI looks at the price changes of a “basket” of common consumer goods and services (i.e. food, clothing, gasoline). In the United States, this data is compiled by the Bureau of Labor Statistics (BLS) and released monthly.

As an example, the US city data for February ’07 shows that the CPI has increased by 0.5% over January and by 2.4% over February ’063. This measurement gives a good view of how the costs of goods and services are changing over time from the perspective of the consumer.

Another measure that is used is the Producer Price Indexes (PPI). The PPI is a set of indexes that measure the change in a selling price that a producer is able to get for a good or service. In the United States, this data is again collected and compiles by the BLS and published monthly.

The indexes are separated by commodity and industry sectors. Some of the commodities considered are finished goods, intermediate goods, crude goods, passenger cars, gasoline, and pharmaceuticals. Likewise, on the industry side, some industries considered are general warehousing and storage, electric power distribution, general medical and surgical hospitals, and offices of lawyers.

In the long run, the PPI and CPI will show similar rates of inflation. These indices however can give an inflated view of the rate of inflation. The CPI for instance assumes that the same quantity of product is bought by the consumer year over year this ignores the fact that as prices increase consumer preference may change, for example, if the price of beef increase dramatically the consumer may begin to buy poultry instead meaning that their food costs might not be as high.

For this reason, a third method is used to determine the rate of inflation. This third measure is the Gross National Product (GNP) deflator. The GNP deflator is a measure of the changes in prices of all final goods and services produced.

The advantage that the GNP deflator measurement has over CPI is that it considers all of the final goods and services in the economy while the CPI only considers the goods and services included in the “basket”. Also, the GNP deflator uses the current year proportions meaning that it takes into account changes in demand while the CPI uses fixed proportions year over year.

Causes Of Inflation

Inflation is caused when prices of production inputs increase. This can result from rapid wage increases or rising raw material prices for example. Ontario for example is planning on implementing a $15 minimum wage in 2019 (up from $11.25) which will force producers to raise prices and minimize the quantity of labor they seek. A near $4 rise in the minimum wage will leave more workers unemployed and will cause a spike in inflation within Canada once implemented.

Secondly, Inflation is caused when the aggregate demand in an economy exceeds aggregate supply, meaning consumers spend more than an economy can output. This process decreases the purchasing power of the currency being used because producers have to raise prices in order to meet demand.

A common reason for this type of inflation stems from when a country’s central bank rapidly increases the supply of money within an economy. The increase in money within an economy will subsequently increase demand for goods and services. Because firms will not be able to respond to this rise in demand as quickly as need be, they must raise prices in order to counteract the greater need for consumption, thus, decreasing the purchasing power of each unit of currency.

This injection of money into the economy by Central banks is referred to as monetary policy. Although, for example, printing money could be one measure to increase the money supply in an economy, this is usually only used in desperate measures.

There are three main ways the Fed can influence the money supply:

Modifying reserve requirements: the Central bank dictates the amount of funds banks are allowed to hold at any given time. By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy.

Changing interest rates: The Fed has the power to lower or raise the discount rate that banks pay on short-term loans from the Fed. By doing so, the Fed is able to effectively increase (or decrease) the liquidity of money. It is important to keep interest rates stable, however, as prolonged decreases in the discount rate will fuel inflation as banks will borrow much higher amounts.

Open market operations: This is where the Fed buys and sells government securities and/or bonds in the open market. If the Fed wants to increase the money supply, it buys government bonds, which supplies the securities dealers who sell the bonds with cash, increasing the overall supply of money in an economy.

Level Of Inflation

1 – Negative inflation, aka deflation. This is a disaster. It undermines confidence, creates a self-reinforced deflation spiral, and gives rise to major economic depression.

2 – Low inflation (0–1.5%) is mostly a symptom of some kind of problem in the economy that is keeping it from achieving its full potential. Usually, it is a crisis in demand or a problem of oversupply. It can come associated with high unemployment and low wages.

3 – Desirable inflation (around 2%). This is the sweet spot, where you want your economy to go. It means that the economy is close to its full potential, but it is not overheating. GDP is probably growing, and people are having a normal time finding jobs.

4 – Moderate inflation (from 3–5%). This is probably a symptom of an economic adjustment. It can mean that the economy is overheating and unemployment may be getting too low, it can mean that wages are catching up with previous increases in productivity, it can mean that in a common currency, such as the Euro, the more productive countries are reaping the benefits of their higher productivity, while allowing for other countries to catch-up.

5 – Double-digit inflation. This is a common symptom of a problem with the economy. It can be caused by a number of factors, but mostly it can mean that the economy is growing too fast too quickly. It can mean that the country is undergoing a competitive devaluation of its currency, it can mean that there is some political turmoil, it can mean that the economy needs some structural reforms. Each individual case would have to be studied, as it is very different to have 20% inflation with low unemployment (overheated economy) or to have 20% inflation with high unemployment (stagflation).

6 – Hyperinflation. This is a really nasty one, on par with number 1. This is a symptom of a serious supply-side problem. Basically, the economy is not producing enough wealth for the expenditures, and the government is making up for the deficit by printing more money as if there was no tomorrow. As it does that, the currency loses most of its value, confidence is eroded, and companies start raising prices for the goods that are in short supply. After a while, it also feeds on itself, as the expectation of inflation leads to even more inflation, and it is also very hard to come out of without severe austerity.

How Does Inflation Affect The Economy?

Inflation affects the economy in many ways, the effects are discussed below:

Business competitiveness: If one country has a much higher rate of inflation than others for a considerable period of time, this will make its exports less price competitive in world markets. Eventually, this may show through in reduced export orders, lower profits, and fewer jobs, and also in a worsening of a country’s trade balance. A fall in exports can trigger negative multiplier and accelerator effects on national income and employment.

Income redistribution: One risk of higher inflation is that it has a regressive effect on lower-income families and older people in society. This happens when prices for food and domestic utilities such as water and heating rises at a rapid rate.

Falling real incomes: With millions of people facing a cut in their wages or at best a pay freeze, rising inflation leads to a fall in real incomes.

Negative real interest rates: If interest rates on savings accounts are lower than the rate of inflation, then people who rely on interest from their savings will be poorer. Real interest rates for millions of savers in the UK and many other countries have been negative for at least four years.

Cost of borrowing: High inflation may also lead to higher borrowing costs for businesses and people needing loans and mortgages as financial markets protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt. There is also pressure on the government to increase the value of the state pension and unemployment benefits and other welfare payments as the cost of living climbs higher.

Risks of wage inflation: High inflation can lead to an increase in pay claims as people look to protect their real incomes. This can lead to a rise in unit labor costs and lower profits for businesses.

The Effect Of Inflation On Individual

  1. Wage-earners: may gain or lose depending upon the speed with which their wages adjust to rising prices. If their unions are strong, they may get their wages linked to the cost of living index. In this way, they may be able to protect themselves from the bad effects of inflation. But the problem is that there is often a time lag between the raising of wages by employees and the rise in prices. So workers lose because by the time wages are raised, the cost of a living index may have increased further. But where the unions have entered into contractual wages for a fixed period, the workers lose when prices continue to rise during the period of contract. On the whole, the wage earners are in the same position as the white-collar persons.
  1. Salaried Persons: salaried workers such as clerks, teachers, and other white-collar persons lose when there is inflation. The reason is that their salaries are slow to adjust when prices are rising.
  2. Businessmen: of all types, such as producers, traders, and real estate holders gain during periods of rising prices. Take producers first. When prices are rising, the value of their inventories (goods in stock) rises in the same proportion. So they profit more when they sell their stored commodities. The same is the case with traders in the short run. But producers profit more in another way. Their costs do not rise to the extent of the rise in the prices of their goods. This is because prices of raw materials and other inputs and wages do not rise immediately to the level of the price rise. The holders of real estate are also profit during inflation because the prices of landed property increase much faster than the general price level.
  1. Agriculturists are of three types, landlords, peasant proprietors, and landless agricultural workers. Landlords lose during rising prices because they get fixed rents. But peasant proprietors who own and cultivate their farms gain. Prices of farm products increased more than the cost of production. For prices of inputs and land, revenue does not rise to the same extent as the rise in the prices of farm products. On the other hand, the landless agricultural workers are hit hard by rising prices. Their wages are not raised by the farm owners, because trade unionism is absent among them. But the prices of consumer goods rise rapidly. So landless agricultural workers are losers.
  1. Debtor and Creditors: during periods of rising prices, debtors gain and creditors lose. When prices rise, the value of money falls. Though debtors return the same amount of money, they pay less in terms of goods and services. This is because the value of money is less than when they borrowed the money. Thus the burden of the debt is reduced and debtors gain. On the other hand, creditors lose. Although they get back the same amount of money that they lent, they receive less in real terms because the value of money falls. Thus inflation brings about a redistribution of real wealth in favor of debtors at the cost of creditors.
  1. Government: as a debtor gains at the expense of households who are its principal creditors. This is because interest rates on government bonds are fixed and are not raised to offset the expected rise in prices. The government, in turn, levies fewer taxes to service and retire its debt. With inflation, even the real value of taxes is reduced. Thus redistribution of wealth in favor of the government accrues as a benefit to the tax-payers. Since the tax-payers of the government are high-income groups, they are also the creditors of the government because it is they who hold government bonds. As creditors, the real value of their assets declines and as tax-payers, the real value of their liabilities also declines during inflation.
  1. Fixed Income Group: the recipients of transfer payments such as pensions, unemployment insurance, social security, etc., and recipients of interest and rent live on fixed incomes. Pensioners get fixed pensions. Similarly, the rentier class consisting of interest and rent receivers get fixed payments. The same is the case with the holders of fixed interest-bearing securities, debentures, and deposits. All such persons lose because they receive fixed payments, while the value of money continues to fall with rising prices.
  2. Among these groups, the recipients of transfer payments belong to the lower-income group and the rentier class to the upper-income group. Inflation redistributes income from these two groups toward the middle-income group comprising traders and businessmen.
  1. Equity Holders or Investors: persons who hold shares or stocks of companies gain during inflation. For when prices are rising, business activities expand which increases the profits of companies. As profits increase, dividends on equities also increase at a faster rate than prices. But those who invest in debentures, securities, bonds, etc. which carry a fixed interest rate lose during inflation because they receive a fixed sum while the purchasing power is falling.

In conclusion the effects of Inflation on economic is enormous.