Inflation

Introduction

Inflation is a very common term in economics. It is also pretty popular among public domains. Governments do everything to keep inflation at a low level as it impacts their credibility. However, sometimes, it is impossible to control inflation by resorting to external measures. That is why inflation is a matter of concern for both the general public and the governments.

What is Inflation?

When the purchasing power of a certain currency declines over time, it is referred to as inflation. The decline in purchasing power is indirectly measured by the increase in average prices of a basket of certain goods and services over a particular period of time. The price rise of selected goods means that a unit amount of currency buys less of the good over the given time period which is expressed in percentage terms.

Inflation is usually broadly measured by noting the average increase of prices of goods and services used by households generally in a country. However, it can also be narrowly measured for selected goods and services. Consumer cost of living depends on various factors and the share of each product’s price is included in it. When the consumer cost of living goes up, the prices of goods and services used by a household also go up.

The cost of products used by households constitutes the consumer price index (CPI). The average change in CPI is what gives the measure of inflation. This is expressed in percentage terms. Therefore, inflation can also be defined as the average increase in percentage terms of the consumer price index.

Core consumer inflation usually ignores the government-set prices and reflects the price rise of more volatile priced products. The core inflation usually notes down the prices of commonly used products that are extremely necessary for living, such as food and energy. Core inflation usually depends on seasonal factors and temporary supply conditions. An index that covers the process broadly, such as a GDP deflator is required to count the average inflation broadly, say, for a country and not individual households.

In general, the CPI basket is maintained at a constant level. However, it is sometimes tweaked to reflect the removal of non-used items. The GDP deflator on the other hand changes every year as it covers the prices of all the items produced in an economy. The GDP deflator is therefore more current, but since the GDP deflator considers non-consumer items, such as military consumption, it does not reflect the cost of living effectively.

Causes of Inflation

Some of the key causes of Inflation are as mentioned below.

Price Rise of Items

Inefficient monetary policies set by the government often lead to long-lasting sessions of high inflation. When money is supplied in an economy excessively, the purchasing power of a unit amount of money goes down. This leads to the price rise of items. So, there should be a coordination between the money supply and the size of the economy. It is known as the Quantity Theory of Money. The coordination can effectively downsize inflation when managed efficiently.

Supply Shocks

Another reason for inflation that is more or less out of the control of the governments is supply shocks that occur due to natural disasters when the supply of products is stopped due to the inability of transportation thereby creating a supply gap. Raise production costs, such as those of the oil can also increase inflation due to disruption in supply. Such inflation is known as cost-push inflation which is generally related to the supply side of the economies.

Demand Shocks

Another type of inflation that is related to the demand side is known as demand-pull inflation. Demand shocks, such as rallies in the stock markets and increased government spending or the central bank’s policy to lower interest rates can boost the economy, but when this effect is overwhelming, it can lead to demand-pull inflation. This happens because the demand exceeds the supply in the economy.

Therefore, the policymakers should balance the supply and demand as and when needed to stop too much of both supplies and demands in an economy to keep inflation within limits.

Expectations of Price Rise

Expectations of price rise can also induce inflation in an economy. When people expect a price rise, they tend to expect an increase in wages and the prices of contractual adjustments (such as an increase in rent which takes place automatically). These expectations of an increase in a future expenditure increase the price of the general basket of goods which is inflation. This is also known as built-in inflation.

Benefits of Inflation

Although long episodes of high inflation are considered harmful to an economy, a little rise in prices is welcomed by economists.

There are quite a few factors for which low levels of inflation are supported by economists. Some of these factors are as follows:

Inflation raises the prices of assets

Inflation raises the prices of assets, such as properties and stocked commodities. So, the owners of assets would welcome a little inflation as it will increase the prices of their assets in accordance with the rate of inflation.

Therefore, the owner of such assets can sell the assets at higher prices due to inflation which helps asset-owners profit from their properties and stocked commodities.

Speculate When Inflation Increases

Businesses and individuals start to speculate when inflation increases. Therefore, when they invest their money in a project, they check the risk involved in the project by checking the returns which must be more than the inflation rate. When inflation rises, more money buys fewer products. So, individuals and businesses tend to spend their money following the time value. The increased investment and expenditure boost the economy.

This can, however, backfire when the inflation is very high which will devalue the money erasing most of its purchasing power.

Conclusion

Inflation can make or break economies. Depending on the nature of inflation, an economy can shine or lose its competitiveness. When the inflation is moderate, it is considered good for the economy. As lower levels of inflation promote investment, it is considered good for the economy. However, lax monetary policies that lead to higher levels of inflation are harmful to economies. Overtly effective inflation erases the power of money meaning that people become poorer as their savings have less purchasing power.

Moreover, high inflation leads to exorbitant prices of commodities which become less accessible and affordable for the general citizens. Therefore, inflation must be checked constantly and kept under control for the betterment of citizens of an economy.

FAQs

1. What is hyperinflation?

Ans. Hyperinflation refers to inflation that is too much exorbitant and totally out of control of the government. In hyperinflation, the inflation may reach a value of 1,000 percent or more. For example, Zimbabwe’s inflation of 500 billion percent in 2008 is the worst case of inflation ever faced by an economy.

2. What is the opposite of inflation? Is it more desirable than inflation?

Ans. The opposite of inflation is called deflation which refers to diminishing prices of goods and services. Deflation may seem interesting but according to economists, it is not desirable for the economy either. Deflation leads to delays in purchases and leads to fewer investments in an economy which leads to fewer economic activities.

3. Which type of inflation is most desirable for an economy?

Ans. Stable, low, and predictable inflation is considered good for economies. In such inflations, the value of money remains intact while economic activities also remain at peaks.