Tallinn Secondary School of Science
Types and effects of inflation in
macroeconomics
Extended essay
Karl Joosep Randveer
138.c, Science-Economics
Teacher: Geili Kütt
Tallinn 2021
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Abstract
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Introduction
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1 Inflation in macroeconomics
1.1 The definition of inflation
Inflation can be defined as a general rise in prices in the economy. It can be measured by
consumer prices, usually by monitoring the price movements of food, alcohol, clothing, energy,
household goods, health, transport, communications, education and entertainment (European
Central Bank website). Price monitoring intervals can vary, most commonly by looking at
inflation on a monthly or quarterly basis. The consequence of inflation is a reduction in the
purchasing power of money - an increased amount of money has entered into circulation,
causing supply and demand to become unbalanced. As a result, money (the currency involved
in inflation) loses its value. The process opposite to inflation is called deflation, where the rise
in prices freezes or even begins to fall and the amount of money in the economy does not
increase. (Kerem, et al. 1998: 136)
Inflationary goals
Inflation is of great importance to the economy - a prerequisite for a sustainable, profitable
economy is that prices rise, consumers' purchasing power increases and cash flows expand. In
order for inflation to remain at a positive level, i.e. above zero, central banks need to add
incentives to the economy that provide an opportunity to increase cash flow, and in turn, a path
for the company's development opportunities. In order to ensure economic growth, inflation is
raised by central banks mainly through the promotion of interest rate conditions in order to
secure better conditions for businesses. For an example, in the euro area countries, the European
Central Bank has set a target of keeping inflation rates at around 2%, which provides sufficient
price stability, sustainable economic growth but also control over the stability of the economy.
Maintaining an inflation rate of 2% is applied by most developed country central banks
(Investopedia team 2021).
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Controlling inflation is a very important and inevitable process. The national government and
the central bank participate in it. There are four different methods that are often used at the same
time to keep inflation under control:
• the implementation of monetary policy measures (eg raising interest rates and restricting the
supply of money in circulation);
• implementation of fiscal policy, ie fiscal policy measures (eg tax increases);
• measures aimed at increasing the growth potential of the economy (eg steps that increase the
supply of products and thus limit price increases);
• Limiting wage increases (eg limiting wage increases for civil servants).
All of the above techniques dampen economic activity in the short term, but help prevent
excessive inflation. (Pettinger 2021)
Monetary policy is closely linked to the measures taken by central banks to achieve the agreed
inflation target. When real inflation is higher than desired, monetary policy interest rates are
usually raised, and conversely, when inflation is lower than recommended, the central bank
usually lowers interest rates. If demand inflation has emerged in the economy due to too rapid
economic growth (see Chapter x), the central bank will prematurely limit its course by raising
interest rates. Unfavorable credit conditions prevent excessive economic growth, which in turn
prevents higher price increases. This technique is used by central banks when the actual value
of inflation exceeds the desired inflation threshold (Chart x). Most developed countries,
including those in the euro area, want inflation to remain at 2%. (Pettinger 2021)
Joonis x. Suurbritannia inflatsioonigraafik vahemikus 1989–2016.
Allikas: Economicshelp
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Potential effects of inflation on ecnomic performance
As explained before, inflation has both good and bad effects on the economy. The initial effect
of inflation on the economy and businesses is very positive - raising prices will allow companies
to earn more turnover, which in turn will ensure higher profits. Companies that produce
consumer goods (such as food producers) benefit the most from rising prices, as they are the
first to reach the price increase. This means that the price increase has not reached them by now
and the production costs have not started to increase. (Floyd 2021)
The increase in turnover ensures higher profits for companies, and thus more opportunities for
development and expansion. As a result, more jobs will be created, leading to higher demand
for a variety of consumer goods. All people involved in the company will benefit from the
increase in profits - shareholders will receive more dividends, wages will rise and more jobs
will be created. In addition, borrowers benefit from a fixed interest rate as the value of money
decreases over time (ibid.). The average consumer will suffer the most from inflation - the
savings left in the bank account will lose their value and the expenses will inevitably increase.
This has a negative impact on consumers' quality of life, as prices may rise faster than incomes
and consumption opportunities may decline in the short term.
The effect of inflation on buying power
Over time, the money in a bank account loses its value or purchasing power. If the consumer
does not earn any return on free money, the purchasing power of the money, ie the ability to
purchase goods, decreases. This means that the money with which it was possible to buy, for
example, two packs of milk at the beginning of the year will be able to pay for 1.7 packs of
milk in two years. For example, the value of one euro fell by around 5 cents between 2007 and
2009, meaning that the savings of € 5,000 in a bank account over the period required purchasing
power of 5,514€ by the end of 2009 to remain at the same level as in 2007 (Figure x). This
means that the purchasing power of these savings decreased by 514€ during the period. (Floyd
2021)
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Joonis x. Ühe euro ostujõud vahemikus 2000–2020.
Allikas: Statista 2021
1.2 Types of inflation
Demand inflation
When the demand for consumer goods exceeds the supply, demand inflation arises, which leads
to higher commodity prices. The price increase can be explained by the lack of raw materials
due to the increase in demand: supply at the previous price level is no longer sufficient,
producers react by raising prices, after which the price increase reaches the sellers and then to
the consumers. This type of inflation is one of the most common for inflation. (Chen)
There are several factors behind demand inflation, mainly the growing economy and the
increase in the money supply. The growing economy has a significant impact on people's
psychology and sense of money - the amount of free money is increasing and the demand for
consumer goods is growing. As a result, new buyers enter the market, increasing the amount of
money circulating in the market. (Masterclass)
Cost inflation
Cost inflation is caused by rising production costs: higher wages, expensive raw materials and
unexpectedly rising transport costs affect the final price of any consumer goods. Cost inflation
occurs in all markets, but usually not at the same time. For example, there may be sharp cost
inflation in oil markets, but food prices remain stable. This type of inflation is often the result
of crises, such as supply difficulties due to difficult political circumstances, production
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difficulties due to natural disasters (destruction of raw materials or damage to production
equipment). (Trevisiami 2021)
In addition to unexpected events, cost inflation can also be directly affected by the country's
domestic policy and economic situation: changes in tax policy, raising minimum wages,
sanctions (either for the producing country or the country from which the raw materials are
ordered), real estate and investing capital. Raising taxes will significantly change production
costs - paying them is essential for the company to function. In order for the production process
to work, the tax is paid at all stages related to the payment: import of raw materials, payment
of wages to employees, sale and export. In addition to taxes, the lion's share of the costs of the
production process is the payment of wages, time and the number of employees. Raising the
minimum wage will lead to an increase in production costs nationwide. (Trevisiami 2021)
Inflation due to inertia
Inflation due to inertia usually starts with other types of inflation, which reduces the purchasing
power of money held by consumers. As the purchasing power of money declines due to
persistent inflation, workers will demand higher wages in order to maintain a normal standard
of living. As raising wages is a high cost for the company - in addition to paying wages to the
employee, tax liabilities also increase - production costs, which in turn cause companies to raise
the prices of their products, which will soon be followed by a new round of wage demands. As
a result, an inflationary spiral is forming, which is depleting the income of consumers as well
as businesses. Inert inflation arises from cost or demand inflation - precisely because these types
of inflation affect the consumer the most. (Ebanx Homepage)
Inflation due to money supply
The more money people have in their hands, the more they are willing to spend, which in turn
encourages price increases due to higher demand. The money supply (monetary aggregate) is
an indicator that provides an overview of all the most liquid instruments in the market. For
example, in addition to currency, the money supply also includes bonds and other similar
instruments that can be easily monetised. Keeping the money supply under control ensures
stable growth in the economy. For example, in the case of a larger money supply, interest rates
usually fall, which in turn creates more investment opportunities in the market, but the money
also reaches consumers, which strongly stimulates the whole market.
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Central banks need to keep their monetary aggregates under control so that money supply does
not increase too quickly and does not create dangerous inflation for the markets. The European
Central Bank divides money on the market into three main groups: M1, M2 and M3, where M1
is the sum of currency in circulation and overnight deposits, M2 is the sum of M1 and two-year
deposits redeemable at notice of up to three months, and M3 money market fund shares / units.
and the amount of debt securities with a maturity of up to two years (European Central Bank
website). The data are mainly monitored by the European Central Bank through banking
transactions: this gives the clearest picture of the money in circulation. As the monetary
aggregate grows, more money enters the circulation of consumers. When the supply of money
in circulation exceeds demand, consumers have more free money to spend on shopping.
1.3 Inflationary spiral
There are four main types of inflation in macroeconomics (see Chapter x): demand inflation,
cost inflation, inflation due to inertia and money supply. When inflation occurs, all types work
together - the activation of one type of inflation leads to another until the domino effect of the
spiral arrives: as a result of a good economic situation, consumer confidence increases, demand
for products increases and prices rise. In order to keep up with the price increase, consumers
will demand an increase in wages. With the inflationary spiral, demand inflation, cost inflation
and inflation due to inertia are beginning to amplify each other, and the so-called reproduce.
The following scenario gives a brief overview of the inflation spiral: the growth of inflation is
significantly influenced by the economic situation. As the global economy improves,
consumers' confidence in spending will increase: more people will save, there will be more
opportunities to spend, and domestic demand for consumer goods will increase - demand
inflation will begin. Due to the increase in demand, it is necessary to increase production in
order to meet consumer demands, but the price of the raw material needed for this purpose has
also risen, as consumer demand for the product has increased the producer's demand for raw
materials in order to increase supply. As a result, cost inflation begins - rising production costs
due to rising raw material prices force producers to raise the market price of a product to keep
pace with a growing economy.
In order to keep up with rising prices, consumers need money to spend. As inflation continues,
consumers will see price increases, confidence in spending will remain high and corporate cash
flows will increase due to the increase in confidence. Consumers are starting to turn to
employers with proposals to increase wages - the price increase has started to catch the eye of
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consumers, and due to the good economic situation, companies can also increase wages. Inertial
inflation is beginning to emerge: the value of wages in the economy is rising and spending in
the economy is continuing, giving room for price increases.
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2 The use of technical analysis patterns in cryptocurrency
markets
2.1 Alapealkiri 2 (omauurimuslik osa)
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Conclusion
Kokkuvõte on kahe lehekülje pikkune, seal sõnastatakse eesmärgi täitmine ja antakse
vastus sissejuhatuses uurimisküsimusele või –küsimustele. Samuti tõdetakse, kas hüpotees
leidis kinnitust või mitte. Esitatakse kõige olulisemad järeldused, milleni töö käigus jõuti.
Kirjeldatakse tekkinud ja edaspidist uurimist vajavaid probleeme, kuid uusi andmeid enam
ei esitata. Kokkuvõttes ei viidata kirjandusallikaile, ei esitata enam uusi andmeid, järeldusi
ning ei püstitata uusi probleeme.
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Bibilography
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