Factors That Contribute to the Inflation Level - Essay Example

INFLATION Institute INFLATION Inflation is defined as the increase in the general price levels in an economy over a period of time, there are a lot of factors that contribute to the inflation level in an economy, one of the many reasons is the interest rates that are prevalent in the economy. What happens is that if the interest rates are high, then the people would like to save more and spend less of their disposable incomes. This would lead to lower aggregate demand levels and might result in deflation, on the other hand if the interest rates are lowered then people spend more of their disposable incomes because the opportunity cost of saving is higher and they would rather spend. The CPI level according to the report in question at the given time is 1.1% and is expected to shoot up to 2%, the government’s aim is to keep the CPI level between 1-2%, that is why the bank of England in its latest meeting has decided not to tamper with the interest rate at this point of time because they run the risk of going above or below the inflation level target that they have set themselves. It is necessary to maintain the CPI level in this range only because a lot of financial calculations are based on the interest rate level and it is imperative that it is kept within this range or else the whole economy could be damaged quite considerably and the repercussions would have to be faced for a very long time. (Flemming (1976)). The other factors in consideration were: Demand: The demand level was going up as the world economy over all showed signs of positive growth but still had some considerable amount of recovery to make to get back to the pre financial crisis level, households were still hesitant in spending lavishly as the economy has not fully recovered from the initial shock. Due to this decrease in consumption the companies have also decreased their level of spending on capital by almost 10%, this is one of the reasons why the interest rates cannot be increased in the economy right now as this would lead to further reduction in capital expenditures by the company and have even more adverse effects on the economy and would also contribute to further slumping and more unemployment. GDP: The gross domestic product is basically the total produce of the economy in monetary value terms, the report suggests that in the 3Q of this year the GDP fell by around 0.4%, there is a need to push the economy out of the recession and the a decreasing GDP is not a good sign for the economy at all. The interest rates were kept constant to promote capital expenditure and they were expected to reach 200 billion pounds through capital financing for companies through the bank. The committee also found that the economy is recovering and in august they had expected a much more substantial fall in the GDP growth rate than 0.4% which goes to show that the banks policies were working in favor of the economy. Inflation: The inflation rate for the same period of time last year was 5.2% but it has fallen quite considerably and is now 1.1% largely due to a lack of demand in the economy because of the financial crisis that the economy is facing, this could be owing to the fact that the wages have seen a downward trend in the economy because the pounds exchange value has gone down considerably and producers face considerably higher prices on the imported items. Lowering the interest rate is not in favor of the economy as this would push down the pound sterling value even further in the exchange market and would result in deepening of crisis at home. There are certain factors that account for Inflation in economy; namely Demand-Pull Inflation, Cost-Push Inflation, Expectations-Induced Inflation and the Money Supply Inflationary Pressures. Demand-Pull Inflation: It is primarily caused because of a rise in the level of aggregate demand in an economy. As certain factors like people’s incomes, changes in tastes and preferences etc or increase in the level of government expenditure at a Macro level, lead to a rise in the demand, the aggregate demand curve of an economy would shift to the right causing the firms to extend their supply to meet this excess demand. As costs rise from this extension in the supply, prices rise and hence this leads to inflation caused by a rise in the demand thus called Demand-Pull Inflation. (Hall 1982). Cost-Push Inflation: When firms’ costs of production rise irrespective of the changes in Aggregate Demand, it becomes expensive for the firms to maintain the level of production at a particular price and therefore, the Supply curve shifts to the left, creating a supply shock in the economy. As the firms would now be less willing to supply at given level of prices because of higher costs of production (caused by implementation of taxes, non-availability of factors of production etc), the supply curve would shift to the left and hence causing the prices to rise leading to Cost-Push Inflation. (Hall 1982). Structural (Demand-Shift) Inflation: Demand shifts in certain industries may cause inflation because of rising demand or rising wage rates. An example to denote this Structural inflation is of the UK boom of the 1980s where the South was experiencing an excess demand because of rapid growth and the north was gaining on Structural Unemployment because of a decline in their industries. (Hall 1982). Expectational Inflation: Workers and employers negotiate on the wages keeping the expected rate of inflation in mind. For example, if the expected inflation rate is set to be 10%, the workers would demand a wage rate increase more than 10% so as to raise their Real Income; whereas, the employers would also raise the price of their commodity by 10%. Even if the actual expected Inflation would be below 10%, peoples’ expectations would rather lead to an Inflation of 10%. (Sinclair (2010) and Hall (1982)). Money Supply Inflationary Pressure: If the central bank plans to inject more money into the economy, the situation of Too much money, chasing too few goods would arise. The Central Bank may do so in order to increase the level of economic activity by investing more into the economy. (Hall 1982). To calculate changes in the real value of money over time, Inflation has to be measured in order to gauge the weight of the currency. The most common measure to calculate Inflation is the Consumer Price Index method also known as the Retail Price Index. The Product Price Index is also used to measure the average change in the selling price of certain commodities. Retail Price index (RPI) or Consumer Price Index (CPI): RPI measures the changes in the price level of a selected consumer goods over a period of time. A basket of the most common consumer goods is selected and the base year value for their prices is set to 100. The price increase in these goods is then recorded in the next year and the percentage averaged increase is then added to the Price Index of 100. (Crone et al (2008)). Product Price Index (PPI) In the PPI method, the average increase in the selling price of the products received by the producers is recorded and averaged over year with 100 as the index of the base year. Price changes are viewed from the sellers’ perspective in the PPI method. (Crone et al (2008)). These measurements would give us a picture of the Inflation prevailing in the economy however these methods also have some limitations. CPI takes into account the Housing facilities as well. This might lead to some inaccuracy as the Housing Category accounts to variations in rent, types of mortgages etc. The costs of these houses may be different in different parts of the country for example; the patterns of mortgages taken out on houses and the rent paid for accommodation would differ depending on the population of the city etc. (Crone et al (2008)). Every household may have different spending patterns and preferences as compared to others. The CPI method generalizes the consumption patterns and does not take income parities into account. Moreover, this method would give a misleading figure as a certain good consumed by a selected household, might not by and large be consumed by the rest of the households as well. (Crone et al (2008)). The changes in the quality of the commodities consumed by the households are also not accounted for in contrast with increases in prices. Also, technological advances that might have led to the improvement of the quality with respect to prices are also not considered in the CPI method. (Crone et al (2008)). The CPI method assumes that only the consumer households make the expenditure. It does not take into account the non-household consumers who are also a part of the economy. The PPI tends to focus on the producers/non-household point of view but then again, the household expenditure and prices are not taken into account. (Crone et al (2008)). Inflation is considered as bad for an economy. But without inflation, an economy cannot grow. It is directly proportional with the employment level of an economy. However, too much inflation tends to damage an economy. Below are the points which explain why Inflation might prove to be good for an economy: High Inflation rates would lower the value of debts in an economy. A high Inflation rate could be used to reduce the value of the debts, an economy owes other countries and hence, it can be used to lower the debt values. (Foster (1972)). Investors tend to invest in times of Controlled Inflation. This is because if they don’t invest or roll the money, the money would lose its value over time. Therefore, controlled inflation leads to growth in an economy. Moreover, if the money is kept in the banks, it would lose its net value due to inflation as the interest rates do not exceed the rate of inflation. (Foster (1972)). Central banks use Inflation Targeting to improve the financial position of an economy. Reduced arbitrary redistribution of income and reduced relative price variability are also one of the resultants of Targeted Inflation. Moreover, these low inflation rates result into long-term growth. (Foster (1972)). Deflation is when the economy experiences reductions in its Price Indexes and experience falling prices. Technological advancements, reduction in raw material prices, increased capacity and reduced demand, policy changes (like deregulation), and enhanced productivity are the key factors that lead to Deflation. The reduction in the general price level is good for the overall economy when technological advancements, policy changes or any other factors reduce the costs incurred in a business and hence does not create hurdles for the businesses as far as it is profitable. However, reductions in prices due to excess supply in the market, reductions in consumer spending or a decrease in aggregate demand; affects the profit margins of businesses negatively, leading to losses and closures. Furthermore, Deflation leads to unemployment as the economy gets steered towards a depression. These losses of jobs result into a further decrease in the aggregate demand as people start to lose their purchasing power due to unemployment. This further puts a downward pressure on the prices. Deflation puts a downward pressure on the prices and economic activity in an economy but simultaneously, increases the value of the currency. As the circulation of money is reduced, the value of the currency rises. In such a situation, the debtors are most liable to default as the cost to debtors increase as they would now be paying more in terms of the value of what they owe. The financial sector therefore would have to struggle with a higher rate of default and nonperformance of loans. All these factors combine to thrash the confidence of investors willing to invest in any business. With expectations in further price decreases, no credibility of the debtors and no returns, the investors would back down further threatening a rise to the unemployment and hence navigating the economy towards a depression. (Brooks et al (2002)). Inflation therefore, has to be present in an economy for it to grow however, it needs to be controlled and closely monitored and has to be addressed to while designing a monetary or fiscal policy for a country or preparing a financial budgeting policy for an organization or a country. References SINCLAIR, P. J. N. (2010). Inflation expectations. London, Routledge HALL, R. E. (1982). Inflation, causes and effects. Chicago, University of Chicago Press FOSTER, E. (1972). Cost and benefits of inflation. [Minneapolis], Research Dept., Federal Reserve Bank of Minneapolis. FLEMMING, J. S. (1976). Inflation. London, Oxford University Press CRONE, T. M., KHETTRY, N. N. K., MESTER, L. J., & NOVAK, J. A. (2008). Core measures of inflation as predictors of total inflation. Philadelphia, PA., Federal Reserve Bank of Philadelphia. BROOKS, D. H., & QUISING, P. F. (2002). Dangers of deflation. ERD policy brief, no. 12. Manila, Asian Development Bank. Read More