Principles of Economics: Inflation - Article Example

Inflation According to Frisch (9), inflation is the continuous increase in prices or the continuous decrease in the purchasing power of money. In general the increase in prices of the product and services should persist for given period of time. However, in economics inflation has broader meaning (Frisch 9). It is used to show the correlation between the general supply of money in the economy and level of productivity in goods and services over a given period. Therefore increase in price does not mean there is inflation and a condition where prices are not increasing may also fall under the category of inflation. Inflation has different components, phases and forms. For example, deflation and inflation are often defined in relation to the amount of general supply of money viz a viz the economys ability to generate goods and services This article will aim at discussing the causes, effects, impacts and importance of inflation in an economy Causes of Inflation There are various causes of inflation which have been put forward by various economists. The first type of inflation is the Cost Push Inflation. This type of inflation occurs when firms respond to the increase in production costs, by increasing prices in order to retain their profit margins. When general costs increase the firms have few options on how to absorb the costs from within, this situation forces the organization to pass on this cost to the consumers. The rise in prices may be triggered by several factors, these factors being an increase in the cost of imported raw materials. This may occur in countries which heavily rely on exports of such products. On the other hand, this may also occur by a fall in the rate of the pound in the international currency exchange a market which raises the UK price of imported products. An illustration of cost push inflation occurred when British gas and alternative energy suppliers decided to increase the prices of gas and electricity. This strategy made energy producing firms to charge different prices for the domestic and foreign markets during the period between years 2005 and 2006. The other cause associated with cost-push inflation is due to the increase in labor costs. When labor costs increase, the effects of this measure on the company production is passed over to consumers.  This cause is significant in those firms and organizations which are labor-intensive. Some industries may opt against passing this high cost to the consumer since they might be able to cover cost in other ways but in the long run they may be forced to increase prices of their products. The wage inflation often moves closely with price inflation; this is caused the inability of the firm to absorb high operation cost in the long run The third cause of cost-push inflation is induced by higher indirect taxes charged by the state. For example, inflation sets in when a high excise duty is imposed on alcohol and cigarettes, when the government increases petroleum levy or there is a general increase of the value added tax, broadening of the VAT base. These taxes are charged on producers who, depending on the price elasticity of demand and supply for their commodities, can decide to pass on the tax burden to clients. For example, if the state was to decide to levy a new tax on jet fuel, then this would cause cost-push inflation. The government may decide to increase it revenue by widening the tax base and in the process cause a much more serious inflation problem. The other major cause of inflation is the demand-pull. This occurs in situation where the economy is operating in full employment. A full employment situation arises when all the available resources are being utilized to capacity. Demand-pull inflation occurs when the aggregate demand exceeds the aggregate demand in an economy. The scenario causes a deficiency in the market. In other words, it occurs when there is so much money being used to buy few commodities. Demand pull inflation involves an increase in the gross domestic product as the level of unemployment falls and as the economy move along Phillips curve. Unless the economy is operating at full employment, this problem should not persist for long since producers would step up their production to maximize their revenue by selling at high prices. An increase in production would reverse the situation and prices would stabilize once again Demand pull inflation is usually influenced by depreciation of the exchange rate. This causes an increase in import prices while export prices decrease. This situation stimulates the producers to increase production. In effect it causes consumers to buy fewer imports while the foreigners purchases more - aggregate demand increases. Assuming that the country is operating at full employment the increased foreign demand pulls the prices upwards causing the economy to experience inflation (Seager 10). On the other hand, a deliberate action by the government to decrease direct or indirect taxation in order to ease the tax burden on the people is a potential cause of demand-pull inflation. Decreasing tax causes the consumers’ real income to increase. As a result, their purchasing power is enhanced. Therefore with the same amount of money, a customer is able to buy a large volume of goods. Incase the economy is at full employment, induced demand would forces prices to increase.  A decrease in taxes causes both aggregate demand and the real gross domestic product to be higher than the potential gross domestic product. Demand-pull inflation is also caused by an increase in the level of money supply in a country. When the country mints more than its potential GDP, prices increase. A stable amount of more supply is required to avoid causing an imbalance between the money market. This type of inflation was experienced in Zimbabwe when President Mugabe ordered the central bank to mint more money to facilitate his campaign. According to the monetarist economists, the core of inflation is the supply of currencies in excess of the economic production potential. The rising consumer confidence accompanied by an increase in household prices leads to an increase in total household demand for goods and services, characterized by a general increase in prices. Demand pull inflation is also caused by a rapid economic growth. When an economy experiences growth within a short duration of time, consumers’ welfare improves which promotes consumer confidence. As consumer confidence improves, the demand for goods and services increase which causes aggregate demand to increase. The consumer prices are pushed up by the increasing demand. Incase this growth persists at high rate, the economy will experience inflation. Some economists argue that international debts also cause inflation. All nations borrow money from well wishers including the International Monetary Fund (IMF). When this money accumulates without being serviced, a country may opt to print money to clear the debt. Since these debts are paid at an interest, the country is likely to increase taxes to collect enough revenues to clear the debt. As the taxes increase, producers will pass on the tax burden to the consumers by increasing prices. The presences of international debts have left many countries with the problem of dealing with high inflation. Costs of inflation Inflation causes a lot of harm to the economy. Such effects are known as economic costs. These costs impact the marginal costs of generating money. Just like all other products, the economic costs of inflation entail the proper "price" of money, which in this case, is the nominal interest rate. This "price" of money shows the return which need be pre-determined to retain money (dollars), instead of other assets that earn interest. The main costs of inflation are as discussed below: The first cost of inflation is evident on how it affects global competitiveness. Inflation stimulates foreign competing since inflation affects the strength of currencies. For instance, a country that is experiencing inflation has a weaker currency compared to the other currencies. This makes it impossible for it to compete globally since imports are expensive while her exports are cheap in the international markets. The more a countries exports are, the lesser the level of competition, which consequently decreases the countrys exports. Such a condition can however be reversed if there is a drop in the exchange rate. Consider the following example, if the UK has higher inflation compared to other countries, it will lose price competitiveness in the global market. This increase in relative inflation causes a decrease in market share in the world share of UK exports and increase in import penetration. Finally, this will cause the UK economy to experience stagnation coupled with low level of employment thereby the contraction of the country’s GDP. Inflation cost is reflected by the uncertainty of the economic trends which becomes uncertain. With high inflation, the population of a given country becomes indecisive regarding the ways of spending their money, and what to use their money for. Under such conditions, the nations commercial organizations grow indifferent and unwilling to make investments as they worry about their future profits. The unpredictable nature of the economy affects the general productivity of a country and investors’ confidence is greatly affected by inflation. The business cycle in this respect becomes irregular and uncertain (Dowd 12). According to William Phillips (1958), inflation portrays a negative relationship with employment. William argues that an inverse relationship exists between employment and inflation. When the level inflation decreases, the unemployment rate increases and vise versa. Although inflation is considered undesirable, economist are forced to choose between the two evils, whether to have a low level of inflation or to have high inflation rates and low level of unemployment. However, under some severe levels of inflation it has been witnessed that inflation and unemployment moves in the same direction causing a situation known as stagflation. Milton Friedman (1970) argues that stagflation is a long term effect of inflation. He reasons that in the long run, firms will feel the pressure of inflation and they will contract employment hence there will be high unemployment rate accompanied by high level of inflation (Solow, Taylor & Friedman 32). Computation of Inflation There are two main ways of calculating inflation; by using the Consumer Price Index (CPI) or alternatively, the Gross domestic Product (GDP). The details of how these methods are used are shown below. The consumer price index is the most commonly used method in many countries including the US. CPI is the simplest and the most convenient way of computing inflation by calculating the percentage change in the CPI from one year to the other. The CPI is computed using a constant basket of goods and services. The percentage change in the CPI shows how much more or less expensive the constant basket of goods and services in term of CPI is from one year to the next. The percentage change percentage change obtained reveals the percentage change in prices or the change in inflation. The CPI allows one to have a base year which one will use to compare with the other years. Consider the table 1 below: Table 1: Rise in price of bananas in years Years Price of Bananas (USD) Quantity of bananas Price of backrubs Quantity of backrubs Year 1 1.00 5 $6.00 5 Year 2 1.00 5 $6.00 7 Year 3 2.00 10 $6.00 9 Over time, the CPI varies as the prices associated with the commodities in the constant basket of goods changes. From the above table, the CPI increased from 100 to 141 to 182 from year 1 to 2 to year3 respectively. The percent change in the inflation from the base year to the other year is computed by subtracting 100 from the CPI. For instance, the percent change in the inflation from year 1 to year 2 is 141 - 100 = 41%. The percent change in the inflation from year 1 to year 3 is 182 - 100 = 82%. In so doing, changes in the cost of living can be calculated across time. The other method of determining the inflation rate is by use of GDP deflator. The GDP deflator is computed by dividing the nominal gross domestic product by the real one. For example, using the table above, the inflation index can be calculated. Let’s assume year is the base year. To determine the inflation rate we will first determine the nominal GPD and real GDP for the three years. Nominal GDP in year 3 is (10 X $2) + (9 X $6) = $74 and real GDP in year 3 using period 1 as the base year is (10 X $1) + (9 X $6) = $64. The proportion of nominal GDP to real GDP is ($74 / $64) - 1 = 16%. This shows that the price rose by 16% from year one, the base year to year three. The same process is used for the other years (Anonymous 1). The two methods have their shortcomings when it comes to measuring the inflation rate. The CPI cannot be used in measuring all the population groups; the trend reflected by the rural population is different from the one shown by the urban population. The CPI cannot be used to produce official estimates for the inflation rates for subgroups of the population such as the elderly. It can also not be used to measure the living standard between two places. Both methods depict some inconsistencies and therefore their interpretation should be done carefully. On the other hand, the GDP deflator has its limitations in determining the inflation index. The there is no criteria for determining the base, thus the results obtained cannot be used to give precise information. This method fails to recognize the time value of money as the value of money changes from one year to another. Generally GPD deflator is a complex way of determining the inflation index and thus it can not be used applied to some new products which are not produced in the base year (Carbough 221). Although inflation is usually associated with negative effects it has several positive effects to an economy. Marcus Taylor (2005) argues that mild inflation slightly increases prices of the commodities. This effect stimulates productivity as producers strive to maximize profits from the prevailing market prices. Secondly inflation promotes business growth, investors prefer to reinvest their profits rather than save it in the bank to avoid loosing money value. This is because during inflation investment in assets increases. Since inflation reduces the money value, debts value decreases and it often advisable to sort them during inflation. The value of assets which were initially bought at low prices increases drastically and they fetch high prices during the inflation period. Finally the values of fixed assets could increase, making some firms more financially stable. Traditionally, higher prices an increase often leads to higher investment, thus fixed assets in theory should rise in value. Deflation is the lowering of prices of products. This process has its consequences just as inflation itself. Lowering prices results to shrinking of profits margins and may cause business to collapse and results in high levels of unemployment. The resulting high unemployment rate reduces the purchasing power consequently affecting negatively the production of companies. As the vicious cycle continues, the whole economy may cripple down due to a decrease in production incentives. When asset price bubbles explode, or when credit availability is controlled, demand may remain downcast for an extended period. According to Solow, decreases in prices cause uncertainty crises and fuels demand for cash. Several reasons drive the increase in the demand for cash. First, the uncertainties crisis affects the Keynes precautionary motive for money. An extreme situation causes banks to panic and looks for ways of getting cash, the demand for liquid cash surges at the expenses bank deposits and, in turn, decreases the money multiplier. The proportion of money supply to bank reserves supplied by the central bank to commercial banks decreases. The central bank increases pressure to supply petty cash and this may cause it to print more money. Failure by the fed to distinguish the deflationary impact of a sharp rise in the demand for cash in 1932 caused the crumple of the money multiplier; this led to the infamous economical melt down that followed in 1930s (Hoag and Hoag 388-399). The problem of deflation will continue to escalate as the demand for money intensifies. A deflationary spiral creates an accelerating decrease in prices. The decreasing prices mean that money earns interests and as a result the purchasing power is enhanced. The money ability to buy goods and services increases hence deflation reduces nominal (market) interest rates the same way inflation drives it. The actual return on cash rises as inflation decreases boosting money demand, this further cause’s additional pressure deflation. The reality that deflationary real returns on cash are not taxed further exacerbates deflationary pressure by increasing the demand for cash (Douglas & Quising 10). Conclusion The problem of inflation has caused prices to increase to increase rapidly. The countries experience different levels of inflation and therefore experiences different impacts. There are several causes of inflation and the policy makers of each country need to be vigilant to maintain a low level of inflation. This will ensure that the country is able to maintain a relative low level of unemployment since an increase in unemployment leads to low purchasing power. Low level of inflation stimulates production as producers are motivated to take advantage of price increases. On the other hand, the government should strive to minimize borrowing as this may lead to inflationary trends. Works Cited Anonymous. Measuring the Economy 2.Sparks Notes. Retrieved on: 28 October 2010. Retrieved from:http://www.sparknotes.com/economics/macro/measuring2/section1.html. Online Carbough, Robert. Contemporary economics: an applications approach. Ohio: Thompson publishers.2006. Print. Douglas, Brooks and Quising, Philipinas. Dangers of Deflation. Manila: ADB publishers, 2002. Print. Dowd, Kelvin and Frisch, H. Theories of inflation. New York. Cambridge: University Press, 1994. Print. Hoag, John and Hoag, Arleen. Introductory Economics. London: World Scientific Publishing Co, 2006. Print. Paul, Samuelson. "Thoughts about the Phillips Curve". Massachusetts: Chanthan Publishers. 2003. Print. Seager, Hutton. High Inflation: Causes and Consequences. New Jersey: Pricenton University Press. 1922. Print. Solow, Robert. Taylor, James. Friedman, Milton. Inflation, Unemployment, and Monetary Policy. Massachusetts: MIT Press, 2009. Print. Taylor, Marcus. The four benefits of inflation. retrieved from: http://ezinearticles.com/?The-Four-Economic-Benefits-of-Inflation&id=2102601. 2005. Web. Read More