Inflation
Inflation is the rise in price levels in an economy over a given time period. This means
that a given amount of currency will buy lower number of goods as time passes as it loses its
value. For this reason controlling inflation is one of the main economic objectives of a
government. There are many ways to control inflation; however most of them work by either
increasing aggregate supply or decreasing aggregate demand. Both actions result in the
equilibrium moving down. The measures that are required to control the inflation depend on what
is thought to be causing it. A government's monetary policy can decrease aggregate demand by
increasing interest rates. This will discourage borrowing and increase savings, both of which
constrict consumption, thereby decreasing aggregate demand. Fiscal policies can also be used to
control inflation. If a government wants to decrease it then it will increase taxation and decrease
government spending.
This will result in consumers and firms having less to spend, therefore coupled with the
lower government spending this will cause leakages to increase and injections to decrease,
reducing aggregate demand. Subsidising the costs of firms will decrease production cost allowing
them to lower their prices, also reducing inflation. Supply side policies such as education and
training will increase the quality and quantity of labour available for firms, which will result in an
outward shift of the aggregate supply curve. This will move the equilibrium down, decreasing
price levels and therefore also decreasing inflation. Other ways to decrease inflation is to reduce
tariffs on imports, as this will lead to lower prices and therefore lower cost-push inflation.
Inflation targeting can lower the chances of both types of inflation by decreasing the expectations
of inflation. In conclusion short term measures to control inflation seek to decrease aggregate
demand, whereas long term solutions want to increase aggregate supply.
Inflation can be controlled by adopting following measures / methods:(A). Monetary measures: Monetary measures relate to the control in the supply and
circulation of money in the country.
1. Bank rate policy: In case of inflation, the bank rate is increased; the supply of money is
controlled.
2. Open market operation: During inflation, the central bank sells govt. securities and
price bonds in the open market in order to contract the supply of money.
3. Variable reserve ratio: In order to control inflation, the central bank increases the
reservation.
4. Credit Rationing: When there is inflationary pressure, the state bank adopts the policy
of credit rationing.
(B). Fiscal Measures: Measures in connection with public borrowing, public
expenditures and public revenues are called fiscal measures.
1. Public Borrowing: During inflation, increase the public borrowing, during deflation,
decrease in public borrowing.
2. Public Revenues: In order to control inflation, the increase in public revenues by the
Govt.
3. Public expenditures: Inflation is also controlled by decreasing the public expenditures
by the Govt.
(C). Realistic Measures:
1. Increase the supply of goods and services: When the supply of goods and services is
increased, the prices will come down.
2. Population planning: Control on population by adopting different measures of family
planning will reduce the demand and finally prices will be controlled.
3. Price control policy: The govt. should adopt strict price control policy against the
profiteers and hoarders.
4. Economic Planning: Effective economic planning is necessary to control the inflation
in the country.
Causes of Inflation
Inflation means there is a sustained increase in the price level. The main causes of
inflation are either excess aggregate demand (economic growth too fast) or cost push factors
(supply side factors)
1. Demand pull inflation
If the economy is at or close to full employment then an increase in Aggregate Demand
(AD) leads to an increase in the price level. As firms reach full capacity, they respond by putting
up prices, leading to inflation. Also, near full employment, workers can get higher wages which
increases their spending power.
AD INCREASE
AD can increase due to an increase in any of its
components C+I+G+X-M
We tend to get demand pull inflation, if economic
growth is above the long run trend rate of growth. The long
run trend rate of economic growth is the average sustainable
rate of growth and is determined by the growth in
productivity.
2. Cost Push Inflation
If there is an increase in the costs of firms, then firms will pass this on to consumers.
There will be a shift to the left in the Aggregate Supply (AS)
Cost push inflation can be caused by many factors
1. Rising wages
If trades unions can present a common front then they can bargain for higher wages.
Rising wages are a key cause of cost push inflation because wages are the most significant cost
for many firms. (higher wages may also contribute to rising demand)
2. Import prices
One third of all goods are imported in the UK. If there is a devaluation then import prices
will become more expensive leading to an increase in inflation. A devaluation / depreciation
means the Pound is worth less, therefore we have to pay more to buy the same imported goods.
CPI-INFLATION
In 2011/12, the UK experienced a rise in cost-push inflation, partly due to the
depreciation in the Pound against the Euro. (also due to higher taxes)
3. Raw Material Prices
The best example is the price of oil, if the oil price increase by 20% then this will have a
significant impact on most goods in the economy and this will lead to cost push inflation. E.g. in
early 2008, there was a spike in the price of oil to over $150 causing a temporary rise in inflation.
4.
Profit Push Inflation
When firms push up prices to get higher rates of inflation. This is more likely to occur
during strong economic growth.
5. Declining productivity
If firms become less productive and allow costs to rise, this invariably leads to higher
prices.
6. Higher taxes
If the government put up taxes, such as VAT and Excise duty, this will lead to higher
prices, and therefore CPI will increase. However, these tax rises are likely to be one-off increases.
There is even a measure of inflation (CPI-CT) which ignores the effect of temporary tax
rises/decreases.
CPI-CT
CPI-CT is less volatile because it ignores the effect of taxes. In 2010, some of the UK
CPI inflation was due to rising taxes.
What else could cause inflation?
Rising house prices
Rising house prices do not directly cause inflation, but they can cause a positive wealth
effect and encourage consumer led economic growth. This can indirectly cause demand pull
inflation
Printing more money
If the Central Bank prints more money, you would expect to see a rise in inflation. This is
because the money supply plays an important role in determining prices. If there is more money
chasing the same amount of goods, then prices will rise. Hyperinflation is usually caused by an
extreme increase in the money supply
However, in exceptional circumstances – such as liquidity trap / recession, it is possible to
increase the money supply without causing inflation. This is because in recession, an increase in
the money supply may just be saved, e.g. banks don’t increase lending but just keep more bank
reserves.
Inflation expectations
Once inflation sets in it is difficult to reduce it For example, higher prices will cause
workers to demand higher wages causing a wage price spiral. Therefore, expectations of inflation
is important. If people expect high inflation, it tends to be self-serving.
The attitude of the monetary authorities is important for example if there was an increase
in AD and the monetary authorities accommodated this by increasing the money supply then
there would be a rise in the price level
services to go up. It will make the country’s exports less competitive in the international
market and have a negative effect on the balance of trade.
Exchange rate: High rate of inflation will affect the external value of money or the
exchange rate of the country. Other countries will find the currency more expensive and hence
there will be less demand for it and the value of currency will fall.
WHO GAINS, WHO LOSES:
Gainers
Businessmen gains as the
prices of their products go up and so
does their profits.
Farmer’s cost of production
will not go up drastically in the short
run and thus will ain.
Shareholders will get better
returns as businesses will be making
more profits.
Governments that are in debt
will also find their burden reduced.
Debtors will gain as the real
value of money has gone down since
the time they took the loan.
Losers
Creditors lose as the principle
sum received is less in terms of real
income.
Wage earners will find their
real wages going down and thus lose.
Pensioners usually have a
fixed income and will lose.
Students, unemployed people
will lose.
Bondholders, those who have
purchases bonds from government
and companies will lose.