Inflation and Unemployment - Essay Example

INFLATION Inflation is defined as a gradual and persistent increase in the general price level in an economy over a given period of time. High inflation rate in an economy would mean that the situation of “Too much money chasing too few goods” is prevalent in the economy and that the money is losing is value faster over certain time than it would with lower inflation rates. This means that the number of goods and services a dollar would buy would reduce over time. That is, the value of the currency would fall. It is also argued that a desired rate of inflation is required in an economy for it to grow. As inflation is directly proportional with the aggregate demand in an economy and also the money supply, governments encourage a certain rate of inflation to prevail in an economy for gradual growth (Edwards, 1984). Prior to setting up of a business or preparing the annual financial budget for the economy, inflation is always taken into account. Measures are taken to control inflation so as to leave room for investment, global competitiveness and local demand in the economy. Therefore, attaining price stability through controlled inflation has always been one of the major concerns for all economies (Hart, 2010). Inflation is caused through various factors. It is however difficult to conclude as to what factor has precisely led to inflation and by how much. The forces of demand and supply and other factors concurrently result into inflation and the government has the tools of fiscal and monetary policy to control these factors simultaneously. The major causes of inflation can be because of a demand shocks, supply shocks, money supply and exchange rates, and future expectations (Mishkin, 1984): Demand-Pull Inflation: Inflation is directly proportional to the aggregate demand in an economy. This is because, when the economy is at its growth stage, there are more employment opportunities. As more people are able to work, households’ incomes rise giving them more purchasing power. This causes a rise in the aggregate demand. As the aggregate demand curve moves to the left, the producers also have to increase their supply to exploit this rise in demand. As they increase their production/extend their supply, their costs of production increase which results into an increase in the price level. This Demand-pull inflation can be so intense that it can also cause a Stagflation where an economy reaches at a stagnant growth with high unemployment and high inflation rates. (Martin, 1985). Cost-Push Inflation: In contrast with Demand-Pull Inflation, Cost-Push Inflation is when the increments in the costs for supplying commodities in the markets cause an increase in the general price level. These supply shocks are regardless the level aggregate demand in the economy. Cost-Push Inflation is mainly caused due to a possible rise in the taxes and duties, costs for employing factors of production, depletion of resources etc. In order to accommodate this increase in the costs of production, firms tend to reduce their supply because of cost constraints. As the supply curve moves to the left, an upward pressure is put on the prices and hence Cost-Push inflation is caused (Mishkin, 1984). Effects of the Money Supply: To give a boost to the Aggregate Demand in an economy, the government pumps in more money into the economy in the form of increased expenditure. In contrast to that, the Central Banks tend to increase the supply of money in response to the increased demand for money and to accommodate this rise in aggregate demand. This, then leads to the devaluation of the currency because of too much money circulation in the economy hereby causing Inflation. (Oxford University Press, 1996). Structural Inflation: Because of the seasonal demand of certain commodities, the prices would vary from one season to another. For example, the demand for warm clothes would be higher in winter, causing a demand-pull inflation of warm clothes in winter. Similarly, this can be attributed to different geographical locations of the same country. In colder parts of a country (Alaska in the United States for example), the demand for warmer clothes would remain high throughout the year causing Structural Inflation in the industry of warm clothes. Correspondingly, if an economy is experiencing a boom in a certain industry, it would experience Structural Inflation as the boom in one industry would gradually reflect into other industries as well due to the multiplier effect (Mishkin, 1984) Expected Inflation: Future expectations in the rate of inflation also play a role in causing Inflation. For example, if businesses plan to invest, they would take the time-value of money into consideration. These future expectations are made to take Inflation into account. If the inflation is expected to be at 15%, the prices in future would be set a little above 15% so as to increase the real income of the business. The workers would also demand wage rates higher than 15%. In the future, if the actual Inflation rate would have been less than 15%, the expected rate and adjustments made to it for protection against inflation would eventually result into a 15% inflation rate (Mishkin, 1984). As a desired level of Inflation is a requisite for economic growth, Inflation has certain costs and drawbacks too. It not only has an impact on the purchasing power of the households but also affects the economy as a whole. Some costs of high inflation to the economy are as follows: Inflation and Unemployment: Inflation is inevitable if a country wants to reduce the unemployment rate in its economy. This is because, as the government increases its expenditures to increase the aggregate demand and encourage economic activity, employment is created. However, as more and people become employed, the aggregate demand rises giving rise to Demand-Pull inflation. At this point, the employment level is high but because of inflation, firms start to cut back on production as the households lose purchasing power. Therefore, inflation inevitably gives way to unemployment (Peters, 1981).  Inflation and the Exchange Rate: Because of inflation, too much money gets circulated in the economy. With the increase in demand of the currency, its value would fall. Hence, the purchasing power of the currency itself would fall. That is, ever increasing cash would have to be paid to buy the same amount of goods and services. Moreover, it affects the economy’s balance of payments as now; more cash would have to be paid for the same amount of imports (Peters, 1981). Redistribution of Income: Inflation takes away the income from those with lesser bargaining power to the assets which yield higher value in return. That is, people with fixed incomes are most likely to suffer as the value of money which they pay on rent, consumables etc would go directly to the owners of these assets. It further creates a disparity of income amongst all the Social Economic Classes (Peters, 1981). Investment Constraints: Inflation leads to increases in the costs of production. Moreover, during the time of inflation, the aggregate demand tends to fall and hence the purchasing power of the households. Because of this, investors become uncertain as to whether their businesses would generate enough yield and return (Peters, 1981). Global Competitiveness: Inflation in one country means higher prices of commodities. This may lead to a fall in demand of its good in the foreign markets and hence, the economy would lose out on the benefits of international trade (Peters, 1981). Inflation is most commonly measured through the Consumer Price Index and Product Price Index method in the UK. Consumer Price Index (Retail Price Index): This measures the increase in general price level of the current year from a base year. The base value of 100 is allocated to the price level in the base year. Selected consumer goods that are most commonly used by the selected households are monitored over time. Their prices in the base year are recorded and the increase is then calculated as a percentage and is added to the base year value of 100. The Index value of the year after that would be the sum of the current year percentage increase, and the previous year’s added Index Value (Lucas, 1981). Product Price Index: The PPI measures the rise in the price received by suppliers and producers over time. The method of calculation is the same as the CPI but the choice of goods are not from the consumers’ perspective but are from the producers’ perspective. The rise in the price level of those goods is recorded in the index (Lucas, 1981). The CPI and PPI method have some limitations too. Though they are the considered to be the most common ones but they do fail to overcome the following shortcomings: The CPI method only considers the spending patterns of a few selected households. It would be safe to infer that spending patterns differ from one household to another depending upon the demographics of the population and therefore cannot be generalized. The CPI method therefore may provide a misleading picture (Sengupta et al, 1998). The CPI only takes into account the consumables and other household goods. It does not consider non-household consumers. There may be certain goods which are not consumed by the households on a daily basis but are used by non-household users such as businesses and organizations (Sengupta et al, 1998). The CPI calculation incorporates those products as well whose prices may differ from one part of the country to another. The Housing sector for example is the best example of this drawback. People have different mortgage plans and rent agreements. Generalizing here again would deem this method to be not an authoritative one (Sengupta et al 1998). Besides these issues, the CPI does not incorporate the technological changes that might have led to an improvement in the quality of the goods that households consume. This quality could be reflected by a rise in prices however it cannot amount to inflation. (Sengupta et al, 1998). Inflation when controlled would result into a steady economic growth in an economy. The following factors explain why Inflation can also be beneficial for an economy: Without Inflation, an economy cannot grow and achieve sustained growth. However, this does not imply that growth is directly proportional with Inflation. As more money is injected into the economy to increase the aggregate demand, it causes inflation. However, without this inflation, the aggregate demand would remain unchanged. As government try to control the inflation through monetary and fiscal policy, the aggregate demand, which is one of the reasons of growth in an economy, can either be increased to result into growth via controlled inflation (Mishkin et al. 2007). High expectations in Inflation would push the investors to invest in the current fiscal year rather than wait for inflation to damage the value of their capital. As firms would invest the money, the value of which they’d rather lose over time, this would compliment a growth in the economy (Mishkin et al. 2007). Through controlled inflation, the redistribution of income and price variability can be controlled. Governments tend to control the money supply and interest rates in order to regulate spending in an economy. If this is controlled, the income disparity resulting from the otherwise high inflation can be prevented (Mishkin et al. 2007). Deflation is known as the general price index reductions in an economy. This might be viewed as a favorable situation for an economy however; it has major setbacks on the contrary. Deflation is considered to be favorable as long as it leads to lower costs of production. However, price reductions caused by decrease in aggregate demand and supply surpluses is harmful as this would maneuver the economy towards a recession. Not only if affects the profit margins of firms and businesses because of lower demand, but it also leads to further unemployment in the economy as firm would cut back on their production; leading to a fall in the purchasing power of the population. Simultaneously as the money circulation in the economy reduces, the value of the currency rises. This in contrast, increases the risks of the defaults in debts as the value of money would rise, the debtors would owe more in-terms of the value. With increase in defaults, potential investors would lose confidence in investing and hence, the economy would go down the slumps of depression (Brooks et al. 2002). Inflation therefore is a responsive issue which needs to be taken into consideration prior to deciding on the level of aggregate demand to be generated in the economy which would result in sustained growth and keep the inflation under control. References EDWARDS, G. T. (1984). How economic growth and inflation happen. New York, St. Martins Press. HART, J. (2010). How inflation works. New York, NY, Rosen Pub MISHKIN, F. S. (1984). The causes of inflation. Cambridge, Mass. (1050 Massachusetts Avenue, Cambridge 02138), National Bureau of Economic Research. MARTIN, L. W. (1985). Stagflation: A Condition Created by Accelerated Demand-Pull Inflation. American Journal of Economics and Sociology. 44, 497-501. OXFORD UNIVERSITY PRESS (1996). Inflation and money supply growth. World Development Report. 36. PETERS, D. J. (1981). Inflation: its costs and causes. Thesis (B.A.)--Tulane University, 1981 LUCAS, T. S. (1981). Understanding inflation accounting. [Stamford, Conn.], Financial Accounting Standards Board. SENGUPTA, S., & ENDOW, T. (1998). Inflation and Its Measures: Some Recent Issues. Economic and Political Weekly. 33, 599. MISHKIN, F. S., & SCHMIDT-HEBBEL, K. (2007). Does inflation targeting make a difference? NBER working paper series, 12876. Cambridge, Mass, National Bureau of Economic Research. BROOKS, D. H., & QUISING, P. F. (2002). Dangers of deflation. ERD policy brief, no. 12. Manila, Asian Development Bank. Read More