An Assignment on Inflation

Inflation
Bijoy Mondal 3/2/2013

Introduction:

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account within the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.

Definition:

The term "inflation" originally referred to increases in the amount of money in circulation. Today economists use the term "inflation" to refer to a rise of the price level. An increase in the money supply may be called monetary inflation, to distinguish it from rising prices, which may also for clarity be called 'price inflation'. Some definition is to be given below to better understand inflation----

According to Federal Reserve Bulletin, 1919

“Inflation is the process of making addition to currencies not based on a commensurate increase in the production of goods”

According to investorwords.com, 2013

“The overall general upward price movement of goods and services in an economy (often caused by an increase in the supply of money) usually as measured by the consumer price index and the producer price index.  

Causes of Inflation:

There are mainly three causes of inflation. They are demand pull inflation, cost pull inflation and over expansion of money supply.

• Demand Pull Inflation: The first cause is called demand-pull inflation. This occurs when demand for a goods or service rises, but supply stays the same. Buyers become willing to pay more to satisfy their demand. Demand-pull inflation can be accompanied by irrational exuberance.

•  Cost Push Inflation: The second cause is cost-push inflation. It starts when the supply of goods or services is restricted for some reason, while demand stays the same. When the supply of labor is not enough to meet demand, it can create wage inflation. In the past, inflation in prices generally led to wage inflation, so that companies could retain good workers. However, competition from technological alternatives (such as robotics) and lower-income countries means that wages haven't kept up with prices. Higher prices combined with stagnant wages means your standard of living has decreased. It's another reason for income inequality in the U.S.

• Over Expansion of Money: The third cause is over expansion of the money supply. That's when a glut of capital in the market chases too few opportunities. It's often a result of expansive fiscal or monetary policy, creating too much liquidity in the form of dollars or credit. 

Some other cause that are also responsible for the inflation:

1.  Increase in money supply. 
2.  Increase in disposable incomes. 
3. Increase in foreign demand and hence ex­ports. 
4. Increase in salaries, wages or dearness al­lowance and 
5.  Increase in population.

Some views about the causes of increasing inflation—

Keynesian view:

Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices. There are three major types of inflation:

a)      Demand-pull inflation: It is caused by increases in aggregate demand due to increased private and government spending.

b)      Cost-push inflation: It is caused by a drop in aggregate supply.

c)      Built-in inflation:  It is induced by adaptive expectations and is often linked to the price/wage spiral.

Monetarist view:

Monetarists believe the most significant factor influencing inflation or deflation is how fast the money supply grows or shrinks. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation.

Types of Inflation:

It's important to understand the difference between the many different types of inflation.

• Hyperinflation: If inflation is more than 50% a month, that's known as hyperinflation. This hasn't happened in the U.S. since the Civil War, but occurred in Germany before the 2^nd World War, and in Zimbabwe in the 2000s.

• Stagflation: Stagflation is when inflation occurs despite slow economic growth. The last time this happened in the U.S. was in the 1970s.When inflation affects different parts of the economy, it's known as asset inflation because it affects just one asset. This occurred with stock portfolios when the Dow reached its peak of 14,164.43 on October 9, 2007.

• Asset Inflation: Asset inflation also occurs each spring with oil prices. That's because commodities traders anticipate that demand for gas, and oil, will go up during the summer vacation driving season. If traders become concerned that the oil supply may be cut off, as during the Iran threat to close the Straits of Hormuz in 2012, traders will up the price of oil futures contracts. As a result, gas prices have spiked significantly in the springs of 2011 and 2012. These volatile gas prices can drive up the price of food, which is usually transported long distances.

Measurement of inflation:

Inflation is measured by the Bureau of Labor Statistics (BLS) using the Consumer Price Index (CPI). The Index is based on a survey of 23,000 businesses, and records the prices of 80,000 consumer items each month. The CPI will tell you the general rate of inflation. Check out the current inflation rate. Inflation is also measured by the Personal Consumption Expenditures price index, or PCE price index. This includes more business goods and services than the CPI. For instance, it includes health care services paid for by health insurance, whereas the CPI only includes medical bills paid for directly by consumers.

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

•  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. 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.

• Commodity price indices: It 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: it said that food and oil prices can change quickly due to changes in supply and demand conditions; 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. Central banks rely on it to better measure the inflationary impact of current monetary policy. 
•  GDP Deflate: it is a method of measure of the price of all the goods and services included in gross domestic product (GDP). The US Commerce Department publishes a deflate 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: it is an undue increase in the prices of real or financial assets. 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.

History:

Annual inflation rates in the United States from 1666 to 2004.

Increases in the quantity of money or in the overall money supply have occurred in many different societies throughout history, changing with different forms of money used. For example, when gold was used as currency, the government could collect gold coins, melt them down, mix them with other metals such as silver, copper or lead, and reissue them at the same nominal value. This practice would increase the money supply but at the same time the relative value of each coin would be lowered. As the relative value of the coins becomes lower, consumers would need to give more coins in exchange for the same goods and services as before. These goods and services would experience a price increase as the value of each coin is reduced. Historically, infusions of gold or silver into an economy also led to inflation. From the second half of the 15th century to the first half of the 17th, Western Europe experienced a major inflationary cycle referred to as the "price revolution", with prices on average rising perhaps six fold over 150 years. This was largely caused by the sudden influx of gold and silver from the New World into Habsburg Spain. The silver spread throughout a previously cash-starved Europe and caused widespread inflation. Demographic factors also contributed to upward pressure on prices, with European population growth after depopulation caused by the Black Death pandemic. By the nineteenth century, economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the production costs of the good, a change in the price of money and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency.

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 banknotes outstripped the quantity of metal available for their redemption. At that time, the term inflation referred to the devaluation of the currency, the price of goods was not rise.This relationship between the over-supply of banknotes 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 what effect a currency devaluation  has on the price of goods.

Effects:

Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include an increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Positive effects include ensuring that central banks can adjust real interest rates and encouraging investment in non-monetary capital projects.

General:

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. The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money.

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.

Negative:

High 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. With high inflation, purchasing power is redistributed from those on fixed nominal income. This redistribution of purchasing power will also occur between international trading partners and fixed exchange rates are imposed. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation. Some negative effects about inflation is to be given below:

1. Unemployment: A connection between inflation and unemployment has been drawn since the emergence of large scale unemployment in the 19th century, and connections continue to be drawn today. In Marxian economics, the unemployed serve as a reserve army of labor, which restrain wage inflation. In the 20th century, similar concepts in Keynesian economics include the NAIRU (Non-Accelerating Inflation Rate of Unemployment) and the Phillips curve. 
2. Cost-push inflation: High inflation can prompt employees to demand rapid wage increases, to keep up with consumer prices. In the cost-push theory of inflation, rising wages in turn can help fuel inflation. 
3.  Hoarding: People buy durable and non-perishable commodities and other goods as stores of wealth, to avoid the losses expected from the declining purchasing power of money, creating shortages of the hoarded goods. 
4. Social unrest and revolts: Inflation can lead to massive revolutions. For example, inflation and in particular food inflation is considered as one of the main reasons that caused the 2010–2011 Tunisian revolution and the 2011 Egyptian revolution.
5.  Hyperinflation: If inflation gets totally out of control, it can grossly interfere with the normal workings of the economy, hurting its ability to supply goods. Hyperinflation can lead to the abandonment of the use of the country's currency, leading to the inefficiencies of barter.
6.  Allocate efficiency: A change in the supply or demand for a good will normally causes its relative price to change, signaling to buyers and sellers that they should re-allocate resources in response to the new market conditions. 
7.  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.
8.  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. 
9. 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.

Positive:

1. Labor-market adjustments: Nominal wages are slow to adjust downwards. This can lead to prolonged    disequilibrium and high unemployment in the labor market. Since inflation allows real wages to fall even if nominal wages are kept constant, moderate inflation enables labor markets to reach equilibrium faster.
2. Room to maneuver: The primary tools for controlling the money supply are the ability to set the discount rate and open market operations, which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. 
3. Instability with Deflation: Economist S.C.Tsaing noted that once substantial deflation is expected, two important effects will appear; both a result of money holding substituting for lending.
   • Continually falling prices: The first was that continually falling prices and the resulting incentive to hoard money will cause instability resulting from the likely increasing fear, while money hoards grow in value and people realize that a movement to trade that money hoards for real goods and assets will quickly drive those prices up. Thus, a regime of long-term deflation is likely to be interrupted by periodic spikes of rapid inflation and consequent real economic disruptions. Moderate and stable inflation would avoid such a seesawing of price movements.
   •  Financial Market Inefficiency with Deflation: The second effect noted by Tsaing is that when savers have substituted money holding for lending on financial markets, the role of those markets in channeling savings into investment is undermined. With nominal interest rates driven to zero, or near zero, from the competition with a high return money asset, there would be no price mechanism in whatever is left of those markets. With financial markets effectively euthanized, the remaining goods and physical asset prices would move in perverse directions.

Control Inflation:

A variety of methods and policies have been used to control inflation. Those are given below:

• Stimulating economic growth: If economic growth matches the growth of the money supply, inflation should not occur when all else is equal. A large variety of factors can affect the rate of both. For example, investment in market production, infrastructure, education and preventative health care can all grow an economy in greater amounts than the investment spending. 
• Monetary policy: Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping their inter-bank lending rates at low levels; normally to a target rate around 2% to 3% per annual. A low positive inflation is usually targeted, as deflationary conditions are seen as dangerous for the health of the economy. Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy. 
• Fixed exchange rates: 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. 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). 
• 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.  For example, A U.S. silver certificate could be redeemed for an actual piece of silver. The gold standard was 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. The Bretton Woods system broke down in 1971, causing most countries to switch to fiat money– money backed only by the laws of the country. 
• Wage and price controls: Another method attempted in the past has been wage and price controls. 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 Income Accord in Australia and the Wassenaar Agreement in the Netherlands. 
• Cost-of-living allowance: The real purchasing-power of fixed payments is eroded by inflation. In many countries, employment contracts, pension benefits and government entitlements are tied to a cost-of-living index, typically to the consumer price index. A cost-of-living allowance adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually in low inflation economies.. 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.

Conclusion: From the above description my point of view is that inflation is too much harmful for any countries economic growth. It also affects our daily life. It decreases the purchasing power of money and everyone is the victim of inflation. There are many reasons of inflation of a country such as - demand pull inflation, cost push inflation, over expansion of money, increase in money supply, increase in foreign demand and hence ex­ports, increase in salaries, wages or dearness al­lowance; and increase in population. To reduce inflation from a country everybody should take the necessary steps. Especially the government of a country plays vital roles for the reduction of inflation.

References

Abel, Andrew; Bernanke, Ben (2005). Macroeconomics (5th ed.).

 Barro, Robert J. (1997). Macroeconomics. Cambridge

 Mankiw, N. Gregory (2002). Macroeconomics (5th ed.).

 Blanchard, Olivier (2000). Macroeconomics (2nd ed.).

 Hall, Robert E.; Taylor, John B. (1993). Macroeconomics. New York.

 Burda, Michael C.; Wyplosz, Charles (1997). Macroeconomics: a European text. Oxford

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