Inflation in the United States - Essay Example

Module Inflation in the United s Inflation is one of the most widely discussed topics in macroeconomics in the US economy. This is because consumers are concerned about the increasing costs of goods and services. In addition, the cost of production is constantly rising owing to the rising cost of raw materials (Balakrishnan and Ouliaris 3). Companies in turn increase the prices of goods and services to maintain their profit margins. On the other hand, the employees expect higher wages to keep up with the high cost of living. All these are known to be the effects of inflation and if no action is taken, the economy is likely to be adversely affected. Inflation affects the lives of all citizens in the US economy yet not everyone has the same purchasing power and income. It is therefore important for us to understand the causes of inflation, its effects and some actions taken by the government to regulate it. There has been a wide range of literature on the causes of inflation in history. There are different schools of thought on the causes of inflation. They are commonly divided into quantity theories of inflation and quality theories of inflation (Cate 96). The quantity theory of inflation is based on the quantity of money equation. On the other hand, the quality theory of is based on the sellers expectations to exchange currency at a later date. Presently, the quantity of the theory money theory is widely accepted as the inflation model in the long- run. This paper shall explore the causes of inflation based on three major theories, the Keynesian view, the rational expectations theory and the monetarist theory. The Keynesian view asserts that changes in money supply in the economy do not directly affect the prices of goods and services, inflation results from economic pressures that are manifested in the increases prices of goods and services. According to Robert J. Gordon’s triangle model, there are three main types of inflation: demand- pull inflation, monetary expansion and cost-push inflation (Cate 141). Demand- pull inflation is the most common and it describes a situation where the demand of goods increases over and above the supply. Sellers increase the prices of goods, as they know that they have the liberty to do so. There are numerous circumstances resulting to demand pull inflation the most important being an expanding economy. This type of inflation could lead to economic growth as long as it is within the right limits. Since people expect increasing inflation rates, they make increasing purchases to avoid price increases in future. Cost-push inflation is caused by a drop in the aggregate supply. This may have been as a result of an increase in the prices of inputs and natural disasters. Finally, built in inflation is caused by adaptive spirals that are relate to shifts in prices or wages. An important concept in this theory is the relationship between unemployment and inflation that is commonly referred to as the Phillips curve (Cate 141). This concept suggests that there is a tradeoff between the stability of prices and employment. This model was used to describe the status of the US economy in the 1960s however; it failed to explain the connection between economic stagnation and increasing inflation. It can be stated that the Philips curve explains the demand- pull aspect of the triangle model. The rational expectations theory states that economic actors act rationally to maximize their well being in future. They do not act solely depending on opportunity cots and pressures. This view states that future expectations and strategies play a key role in inflation (Gillman 67). A key assumption in this theory is that economic actors will act to keep up with rising inflation rates. This means that the central bank must play a key role in ensuring that they regulate the insurance rates. The monetarist view is based on the fact that the major factor affecting deflation or inflation is the velocity of money. In other words, inflation is affected by how quick the supply of money increases or decreases (Gillman 121). Fiscal policy and other attempts by the government are not effective in controlling inflation. The theory is based on the equation of exchange: MV=PY where; M is the quantity of money V is the velocity of money P is the price level Q final expenditures (real value) This theory assumes that velocity of money is not influenced by the monetary policy in the long- run. Additionally, the output is affected by the productive capacity of an economy. The basic assumption is that the price level of goods changes the quantity of money. These are the major causes of inflation in the US economy. However, there are additional causes of inflation including the presence of a national debt, national disasters and a weak US dollar. Inflation has serious impacts on the economy. For example, an increase in the prices of goods results to a decline in the purchasing power of the U.S dollar; hence leading to an increase in the cost of living (Thrall and Cramer 3). The impact of inflation is not evenly distributed across the economy there are benefits to some people and hidden costs to others. Owners of physical property such as assets and stock profit when their costs go up on the other hand, those who pay more money do not benefit (Gillman 121). Unpredictable inflation rates are detrimental to the entire economy. They lead to increased inefficiencies in the economy making it difficult for individuals and companies to plan for the future. Inflation leads to reduced productivity as companies are forced to divert resources in order to pay more attention to profits or losses resulting from the inflation. Inflation also has a negative impact on investments and savings as it creates uncertainty about the future hence individuals are skeptical about savings and investing. Inflation also results to an increase in the tax rates in the economy (Thrall and Cramer 3). Other negative impacts of inflation include hyperinflation, increased shoe leather costs, hoarding and menu costs. There are positive effects associated with moderate level of inflation in an economy. To start with, inflation leads to labor market adjustments since it allows the real wages to fall, enabling the labor markets to reach towards the equilibrium. Moderate rates of inflation encourage consumption within the economy and keep the capital flowing into a growing economy (Gillman 121). Moderate inflation rates can also lead to an increase in the interest rates and this may have a positive impact on the investment rates available in the economy. There are different ways of controlling inflation rates within an economy. Stimulating economic growth in an economy regulates the inflation rates. Monetary policy is the basic tool that is used in regulating the inflation rates. Central bank including the United States Federal reserve has a huge impact on inflation rates as it sets the interest rates in the economy. Keynesians argue that reducing the aggregate demand during expansions and increasing them during recessions can stabilize the inflation rates. This can be done by using fiscal and monetary policies. The government should maintain fixed exchange rates that can establish stability of the country’s currency (Gillman 121). A cost of living allowance should be established that should be adjusted based on the cost of living. Governments should control wages and the prices of goods during an inflation to regulate the cost of living. In summary, the above discussion explains the concept of inflation in the US economy. It states the causes of inflation based on the Keynesian, monetarist and rational expectations theory. It is clear that there are positive and negative impacts of inflation; however, the disadvantages outweigh the advantages. Finally, the government plays a key role in controlling the inflation rates in an economy through the Central Bank. Inflation is a macroeconomic problem that is here to stay and the US economy should learn how to regulate the inflation rates in the country. Works Cited Balakrishnan, Ravi & Ouliaris, Sam. U. S. Inflation Dynamics: What Drives Them Over Different Frequencies. International Monetary Fund, 2006. Print. Cate, Thomas. Keynes' General Theory: Seventy-Five Years Later. Edward Elgar Publishing, 2012. Print. Gillman, Max. Inflation Theory in Economics: Welfare, Velocity, Growth and Business Cycles. Routledge, 2013. Print. Thrall, A. Trevor & Cramer, Jane K. American Foreign Policy and the Politics of Fear: Threat Inflation since 9/11. Routledge, 2009. Print. Read More