The Causes of Inflation and Deflation - Essay Example

?Introduction Every economy wants price stability and to reach this goal, the rate of inflation and deflation should be equilibrium. Inflation and deflation are the two economic catastrophes that affect price stability and economic growth. General price level of goods and services that are moving in an increasing manner is called inflation and its opposite side is deflation wherein the movement of prices is downward. The increase and decrease of prices are not ordinary because as the movement becomes more persistent, the more it delivers significant number of negative consequences. However, the movement of prices is characterized not just to one but to all commodities. For instance, oil products in global market are becoming scarce and volatile because of the continuing crisis in the Middle East, the primary suppliers of oil products. In lieu of this, oil prices rose to its highest point in just a very short period of time while demand is getting faster. Conversely, if this oil producing countries return in their normal business term, then the production of oil products will increase, thereby bringing a stability of price. This environment is one of the current examples of inflation and deflation that is happening in reality. The main thrust of this paper is to discuss the causes of inflation and deflation, and how these affect corporate decision-making. To have a better understanding on this anomaly, it is a requirement to study the complex movements of prices and their effects through current situations and events. Inflation and Its Causes Inflation is described by Mukherjee (2002, p.26) “as a process in which the price level is rising and money is losing its value.” As you can see in figure 1, if the aggregate demand (AD) is increasing faster than the rate of the aggregate supply (AS), the general price level also increases, and this phenomenon is known as inflation. Nowadays, many countries are suffering from higher rates of inflation and sometimes government had to compromise by paying the cost of the reduced productivity. However, many economists have argued that pouring too much money into the economy as a solution would only lead to a more serious inflation (McNeese, 2000, p.22). The main causes of this phenomenon include: Too much demand in the economy. If the demand is high and the available supply cannot meet the demand, general price level would eventually move upward, thereby bringing in inflation or particularly known as demand-pull inflation. This is a situation wherein the rate of demand is faster than the rate of supply leading to a shortage of supply which means that “an increase in demand will affect prices more than output because firms may not be able to recruit staff more easily or produce more...” (Gillespie, 2007, p.381). Cost-push, monetary, and supply shock inflation. This type of inflation occurred when the supply of money in the circulation is high, causing the purchasing power of people to increase and eventually lead to a demand-pull inflation. On the other hand, cost-push inflation happened when the level of productivity among workers is increasing, labour expenses are also increased and the rate will be added up to the general price level (Grant & Vidler, 2003, p.132). Lastly, supply shock is more or less interrelated with demand-pull inflation; however, this time the supply is generally scarce. For example, the steady increase in prices of oil products in the world market brought by subsequent events particularly in Libya have also contributed to the increase of prices in almost all of the basic commodities. Deflation and Its Causes “Deflation is a sustained decrease in the average price level of the entire economy” (Saunders & Gilliard, 2000, p.32). The steady and continuous fall of prices sound interesting to those who are not fully aware of deflation, but this term is not good for the monetary economy because falling prices would adversely affect income that eventually to bankruptcy. As sale, profit and investment fall together, producers are forced to cut down their labor cost that would increase the rate of unemployment, decrease overall productivity, and disequilibrium in the economy (Belke & Polleit, 2009, p.434). According to some economists, deflation is the biggest problem in the modern economy because once the threat of deflationary spiral occurred, there is no turning back. The deflationary spiral (see figure 2) showed that deflation is initiated by a falling of demand that would lead to a decrease in prices, purchasing power of the people, and lower productivity. If productivity and economic growth are reduced, profits could not anymore sustained the operating expenses of businesses, thereby reducing wages or lay-off workers that would lead further to a decrease in prices. The main causes of deflation include: Capitalism/Escalation in the demand for money. The increase in competition, innovation, and efficiency are largely brought by capitalism. If competition in particular would escalate then supply of commodities will boost up, and if supply is much higher than demand, prices need to be lowered down in order to have demand-supply equilibrium. Credit-based/Decrease in the money supply. Low velocity of money mostly occurred if the economy is based on credit and if there is a decline in the supply of money, demand also goes down. Thus, the threat of deflationary spiral will follow owing to the development of a phenomenon called deflation. Increase in supply of commodities. If the supply of commodities would increase up to the extent that it exceeded the degree of demand, then prices need to be lowered down to have equilibrium. In this case, the excess supply will pull the general price level into a very low rate, thereby bringing in deflation. Consequences of Inflation and Deflation A. Negative consequences of inflation 1. Loss of purchasing power. If the rate of inflation is higher (prices are high), it is expected that the rate of purchasing power of the people will decline. This is because inflation and individual income are interrelated. Say for example, the current rate of inflation in UK consumer price index (CPI) has reached to 3% and this rate is expected to increase in the next two years (see figure 3). Thus, because inflation is an upward movement of prices, the scenario means that prices of commodities in UK will rise by 3 percent. There are companies who give their employees a rise on their income to compensate with rate of inflation; however, 2.2% increased of average earnings in UK is relatively small compared to the 3% expected future inflation rate (see figure 4). If average income would not be changed as to the rate of inflation, purchasing power of income will lose. 2. Effect on saving. Generally, people put their money in the bank because of the imposed annual interest but because of increase in inflation, savings are devalued, and people are more reluctant to save their money in the bank (Lea, 2006, p.290). This phenomenon is happening in UK as savers are losing their money in real terms, and the cutting of interest rates among all British banks have encouraged people not to save (see figure 5). The real rate of interest will be devalued in the sense that the rate of inflation is much higher compared to the annual interest in the bank. 3. Effect on interest rates. Recently, the interest rate in UK is in between 1.75% to 2% and this rate has been consistent for so many years not until crisis had entered the country. Based on the forecast, this rate will continue to increase for another 1% of nominal interest rate or a total of 3% in the mid of 2011 brought by subsequent events (see figure 6). Effect on international competitiveness. UK is the second country in the world that is suffering from high inflation rate brought by high commodity prices (see figure 7). The prices in UK are too high that is why exported commodities could not anymore penetrate in their trading partners; instead imported commodities are more valued (Lipsey & Harbury, 1992, p.493). Compared to UK’s major competitor countries like U.S., Eurozone, and Japan (see figure 8) UK has the highest inflation that is why the international competitiveness of the country had collapsed (Anderton, 2006, p.646). Inflation uncertainty. Some analysts have said that inflation in UK would not last long and just temporary; however, others have suggested that the rate of inflation would tend to rise over the coming years. This different gap of analysis and inflation forecasts had made the situation worst for UK as a proof that they cannot provide complete picture for their status. According to Lloyds (2010), “The UK is a relatively open economy that is highly sensitive to external price shocks emanating from currency or commodity price movements...contribute significantly to changes in the inflation outlook over the coming years.” The latest inflation projection for UK is 2.6% (2011) and this would eventually be lowered down to 2% in 2012 (see figure 9). B. Negative Consequences of Deflation Unemployment. For instance, the unemployment rate in UK is rising from 2007-2009 (see figure 10), and this means that deflation in the country remained to be a big threat to the economy than inflation. The fact that demand is relatively low, businesses will have to lay off workers or else they will suffer the consequences of having high operating costs but with lower revenue growth. Lower spending. If commodity prices are falling, it would be hard for people to spend because they would actually wait for the time that commodities will further fall in prices. This is a negative implication that would create financial stagnation because if consumer spending is weak, the economy cannot grow. The consumer spending growth in UK since 1985 to 2008 as presented in figure 11 is rising in the first few years; however, the average growth is becoming slower since the 20th century. Inflation / Deflation Affect Corporate Decision-making Generally, both inflation and deflation should be considered in any corporate decision-making. In a world of managerial investment, money is always involved that is why the stability of prices and any price changes are always considered. Every business assumed that there is always a general movement of price level within the economy, either in upward (inflation) or downward (deflation) motion. The best time to decide is when the environment achieved price stability and equilibrium in the monetary economy because “although relative price movements will still have an impact on production, consumption, saving and investment, the rate of inflation and deflation would be so low that it would no longer be an important factor in economic decision making” (Mbuya, 2008, p.226). Every corporate decision-making with regard to investment needs to have a projection of inputs and outputs that the project might incurred; however; with inflation, the projection might encountered some changes that must be taken into consideration (Lumby & Jones, 2003, p.125). There are instances that the expected future inflation rates are different from the real rates, thus a problem would arise. For example, a firm need to decide on how to allocate their resources, but the management is unsure in the effectiveness of the allocation considering that inflation is high and volatile. They have to consider the expected rate of inflation so that if prices would tend to rise steadily and rate of savings are lowered, then they may demand of higher nominal rate of return on their investments before they will proceed with capitalism. On the other hand, if they continue with their planned investment projects they need to consider the movements of prices especially if there is a deflation because their capital investments would be damaged leading to debt deflation, defaults, and bankruptcies. Conclusion Inflation and deflation are just a matter of relationship between the movements of supply and demand that passed on prices. If the supply of money in a certain country will goes up, it is expected that the supply commodities will go down. Also, if the demand for money will goes down, the demand for commodities will go up. The movements of general level of commodity either upwards (inflation) or downwards (deflation) are economic threats that have negative implications on economic growth. However, most economists consider that inflation would do less damage to the economy compared to deflation that generates liquidity trap in the economy. The debate between inflation and deflation is still ongoing and for the past two decades, price stability has been difficult to achieve. References Anderton, A., 2006. Economics. 3rd ed. New Delhi, India: Dorling Kindersley Pvt. Ltd. Belke, A. & Polleit, T., 2009. Monetary economics in globalised financial markets. New York, NY: Springer. Blackden, R., 2009. Britain’s path to recovery will be long and protracted, Deloitte warns. The Telegraph, [internet] 27 Jul. 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Appendix Figure 1: The Inflation Source: (Pettinger, 2008) Figure 2: The Deflationary Spiral Source: (Jensen, 2009) Figure 3: UK Inflation CPI Forecast 2010 Source: (Walayat, 2010) Figure 4: UK Average Weekly Earnings Source: Davies, 2011 Figure 5: UK Savings Accounts - Real Return Interest Rates Source: (Walayat, 2010) Figure 6: UK Interest Rate Forecast 2010 - 2011 Source: (Walayat, 2010) Figure 7: United Kingdom’s Inflation brought by Commodity Prices Source: (Nelson, 2011 ) Figure 8: CPI Inflation: UK vs Other Major Economies Source: Lloyds, 2010 Figure 9: UK Inflation Forecast Source: (Lloyds, 2010) Figure 10: UK Unemployment Rate Source: (Blackden, 2009) Figure 11: UK Consumer Spending Growth Source: (Lloyds Banking Group, n.d.) Read More