Bijoy Mondal 3/2/2013
1.1. 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.
1.2. 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 in 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 the Federal Reserve Bulletin, 1919
“Inflation
is the process of making additions 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) is usually measured by the
consumer price index and the producer price index.
1.3. Causes of Inflation
There are mainly
three causes of inflation. They are demand pull inflation, cost pull
inflation, and over-expansion of the money supply.
- Demand Pull Inflation: The first cause is called demand-pull inflation.
This occurs when demand for a good 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 mean 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 causes 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.
1.4. Theoretical Perspective
1.4.1. 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:
·
Demand-pull
inflation: It is caused by
increases in aggregate demand due to increased private and government spending.
·
Cost-push
inflation: It is caused by a
drop in aggregate supply.
·
Built-in
inflation: It is
induced by adaptive expectations and is often linked to
the price/wage spiral.
1.4.2. 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.
1.5. Types of Inflation
It's important to
understand the difference between the many 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 2nd 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 drive up the price of oil futures contracts. As a
result, gas prices have spiked significantly in the spring of
2011 and 2012. These volatile gas prices can drive up the price of
food, which is usually transported long distances.
1.6. 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 measure 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. The 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: They 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 Deflator: It is a method of measuring the price of
all the goods and services included in gross domestic product (GDP). The US
Commerce Department publishes a deflator 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 by 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 the real standard of living due to 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.
1.7. 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 century, Western Europe experienced a major
inflationary cycle referred to as the "price revolution", with prices
on average rising perhaps sixfold 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 did 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.
1.8. 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.
1.8.1. 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.
1.8.2. Negative:
High inflation rates are
regarded as harmful to the 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 on trade from an increased instability in
currency exchange prices caused by unpredictable inflation. Some negative
effects of inflation are 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 restrains wage
inflation. In the 20th century, similar concepts in Keynesian economics included
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 are 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 cause 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.
1.8.3. 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 bond 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.
o 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 those 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.
o 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.
1.9. 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 of
around 2% to 3% per annum. 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 latter 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 that 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.
1.10. Conclusion:
From the above
description, my point of view is that inflation is too harmful for any country's
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
for 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 in a country, everybody should take the necessary steps. Especially,
the government of a country plays a vital role in the reduction of inflation.
References
Abel, A. B., & Bernanke, B. S. (2005). Macroeconomics (5th ed.). Pearson Addison-Wesley.
Barro, R. J. (1997). Macroeconomics. MIT Press.
Blanchard, O. (2000). Macroeconomics (2nd ed.). Prentice Hall.
Burda, M. C., & Wyplosz, C. (1997). Macroeconomics: A European text.
Oxford University Press.
Hall, R. E., & Taylor, J. B. (1993). Macroeconomics. W. W. Norton
& Company.
InvestorWords. (n.d.).
Mankiw, N. G. (2002). Macroeconomics (5th ed.). Worth Publishers.
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