Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over some time. It is the constant rise in the general level of prices where a unit of currency buys less than it did in prior periods. Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation’s currency.
As prices rise, a single unit of currency loses value as it buys fewer goods and services. This loss of purchasing power impacts the general cost of living for the common public which ultimately leads to a deceleration in economic growth. The consensus view among economists is that sustained inflation occurs when a nation’s money supply growth outpaces economic growth.
To combat this, a country’s appropriate monetary authority, like the central bank, then takes the necessary measures to keep inflation within permissible limits and keep the economy running smoothly.
Inflation is measured in a variety of ways depending upon the types of goods and services considered and is the opposite of deflation which indicates a general decline occurring in prices for goods and services when the inflation rate falls below 0 per cent.
Important Points
Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.
Inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
The most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
Inflation can be viewed positively or negatively depending on the individual viewpoint.
Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets.
People holding cash may not like inflation, as it erodes the value of their cash holdings.
Ideally, an optimum level of inflation is required to promote spending to a certain extent instead of saving, thereby nurturing economic growth.
Causes of Inflation
Rising prices are the root of inflation, though this can be attributed to different factors. In the context of causes, inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
(i) Demand-Pull Effect
Demand-pull inflation occurs when the overall demand for goods and services in an economy increases more rapidly than the economy’s production capacity. It creates a demand-supply gap with higher demand and lower supply, which results in higher prices. For instance, when oil-producing nations decide to cut down on oil production, the supply diminishes. It leads to higher demand, which results in price rises and contributes to inflation.
Additionally, an increase in the money supply in an economy also leads to inflation. With more money available to individuals, positive consumer sentiment leads to higher spending. This increases demand and leads to price rises. Money supply can be increased by the monetary authorities either by printing and giving away more money to individuals, or by devaluing (reducing the value of) the currency. In all such cases of demand increase, the money loses its purchasing power.
(ii) Cost-Push Effect
Cost-push inflation is a result of the increase in the prices of production process inputs. Examples include an increase in labour costs to manufacture a good or offer a service or an increase in the cost of raw material. These developments lead to higher costs for the finished product or service and contribute to inflation.
(iii) Built-In Inflation
Built-in inflation is the third cause that links to adaptive expectations. As the price of goods and services rises, labour expects and demands more costs/wages to maintain their cost of living. Their increased wages result in higher costs of goods and services, and the spiral continues as one factor induces the other and vice-versa.
Theoretically, monetarism establishes the relation between inflation and the money supply of an economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and especially silver flowed into the Spanish and other European economies. Since the money supply had rapidly increased, prices spiked and the value of money fell, contributing to economic collapse.
Types of Inflation Indexes
Depending upon the selected set of goods and services used, multiple types of inflation values are calculated and tracked as inflation indexes. The most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
(a) The Consumer Price Index
The CPI is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as available for purchase by the individual citizens. Changes in the CPI are used to assess price changes associated with the cost of living, making it one of the most frequently used statistics for identifying periods of inflation or deflation. The U.S. Bureau of Labor Statistics reports the CPI every month and has calculated it as far back as 1913.
(b) The Wholesale Price Index
The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level. While WPI items vary from one country to other, they mostly include items at the producer or wholesale level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton grey goods, and cotton clothing. Although many countries and organizations use WPI, many other countries, including the U.S., use a similar variant called the producer price index (PPI).
(c) The Producer Price Index
The producer price index is a family of indexes that measures the average change in selling prices received by domestic producers of goods and services over time. The PPI measures price changes from the perspective of the seller and differs from the CPI which measures price changes from the perspective of the buyer.
In all such variants, the rise in the price of one component (say oil) may cancel out the price decline in another (say wheat) to a certain extent. Overall, each index represents the average weighted cost of inflation for the given constituents which may apply at the overall economy, sector or commodity level.
Remedies of Inflation
Inflation is generally controlled by the Central Bank and/or the government. The main policy used is monetary policy (changing interest rates). However, in theory, there are a variety of tools to control inflation including:
Monetary policy
Higher interest rates reduce demand in the economy, leading to lower economic growth and lower inflation.
In a period of rapid economic growth, demand in the economy could be growing faster than its capacity to meet it. This leads to inflationary pressures as firms respond to shortages by putting up the price. We can term this demand-pull inflation. Therefore, reducing the growth of aggregate demand (AD) should reduce inflationary pressures.
The Central bank could increase interest rates. Higher rates make borrowing more expensive and saving more attractive. This should lead to lower growth in consumer spending and investment. See more on higher interest rates.
A higher interest rate should also lead to a higher exchange rate, which helps to reduce inflationary pressure by:
Making imports cheaper. (the lower price of imported goods)
Reducing demand for exports.
The increasing incentive for exporters to cut costs.
Fiscal Policy
A higher rate of income tax could reduce spending, demand and inflationary pressures.
The government can increase taxes (such as income tax and VAT) and cut spending. This improves the government’s budget situation and helps to reduce demand in the economy.
Both these policies reduce inflation by reducing the growth of aggregate demand. If economic growth is rapid, reducing the growth of AD can reduce inflationary pressures without causing a recession.
If a country had high inflation and negative growth, then reducing aggregate demand would be more unpalatable as reducing inflation would lead to lower output and higher unemployment. They could still reduce inflation, but, it would be much more damaging to the economy.
Control of the money supply
Monetarists argue there is a close link between the money supply and inflation, therefore controlling the money supply can control inflation.
The main way central banks control the money supply is by buying and selling government debt in the form of short-term government bonds. Economists call this ‘open market operations, because the central bank is selling bonds on the open market. Central banks usually own a big portion of their county’s debt. When they want to shrink the money supply, they can sell some of that debt to banks or investors. People hand over money to buy the debt, and money is taken out of the economy, as money that used to be floating from person to person disappears into the central bank. When the central bank wants to add more money to the economy it can buy debt, taking government debt out of the economy and replacing it with new money.
All this bond buying and selling affect the interest rate too. By shifting the supply and demand for debt, central banks can move the interest rate to affect how many people take new loans. Changing the interest rate allows central banks to also impact the money supply indirectly because each loan a bank makes actually creates money.
Central banks have other tools to indirectly control the money supply, like requiring banks to keep more money on hand (called reserve requirements), or changing the interest rate at which they lend money to private banks. In recent years central banks have also experimented with a new policy called quantitative easing—basically a turbocharged version of buying bonds.
Supply-side policies
Supply-side policies are government attempts to increase productivity and increase efficiency in the economy. If successful, they will shift aggregate supply (AS) to the right and enable higher economic growth in the long run.
There are two main types of supply-side policies.
Free-market Supply- Side policies involve policies to increase competitiveness and free-market efficiency. For example, privatisation, deregulation, lower income tax rates, and reduced power of trade unions.
Interventionist Supply- Side policies involve government intervention to overcome market failure. For example, higher government spending on transport, education and communication.
Benefits of Supply-Side Policies
In theory, supply-side policies should increase productivity and shift long-run aggregate supply (LRAS) to the right.
(a) Lower Inflation
Shifting AS to the right will cause a lower price level. By making the economy more efficient, supply-side policies will help reduce cost-push inflation. For example, if privatisation leads to more efficiency it can lead to lower prices.
(b) Lower Unemployment
Supply-side policies can contribute to reducing structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment. See Supply-side policies for reducing unemployment.
(c) Improved economic growth
Supply-side policies will increase the sustainable rate of economic growth by increasing LRAS; this enables a higher rate of economic growth without causing inflation.
(d) Improved trade and Balance of Payments
By making firms more productive and competitive, they will be able to export more. This is important in light of the increased competition from an increasingly globalised marketplace. See also: Economic Importance of Supply-Side Policies.
Limitations of supply-side policies
Productivity growth depends largely on private enterprises and trends in technological innovation. There is a limit to which the government can accelerate the growth of technological change and improvements in working practices.
Supply-side policies can be counter-productive. For example, flexible labour markets may reduce costs for businesses – but if they cause job insecurity, workers may become demotivated and labour productivity stagnates. Since 2009, the UK has seen a fall in structural unemployment due to more flexible labour markets – but productivity growth is almost stagnant.
In a recession, supply-side policies cannot tackle the fundamental problem which is the lack of aggregate demand.
All supply-side policies take a long time to have an effect. Some policies, such as education spending may not influence the economy for 20-30 years.
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