Table of Contents
- Causes of Inflation
- Types of inflation
- Effects of inflation
- A) Effects on distribution of income and wealth
- B) Effects on production
- C) Effects on income and employment
- D) Effects on business and trade
- E) Effects on the government finance
- F) Effects on growth
- How governments control inflation
Inflation is the persistent rise in the price of goods and services. This rise in price to the fall in the value of money. We can also view it as a situation whereby too much money pursues few goods in the same economy. This economic situation is within a given period of time. The general price level is a major determinant of inflation. That is when the cost of goods and services shoots up. The value of money depreciates within that period as a result. We cannot overemphasize its effects on the growth of an economy. It is important to note that uncontrolled inflation contributes greatly to widening the gap between the rich and the poor.
Inflation results in a rise in the cost of living. This economic situation erodes the purchasing power of an economy and also causes the opportunity cost of holding money to rise. When we talk about opportunity cost, it is the value of an alternative forgone. This means, one missing out when choosing an alternative in place of another. Hyper inflation is dangerous to an economy. Controlling it is tedious because it is an extreme form of inflation when the economy gets shattered. Excess growth in money supply brings about this form of inflation. Money supply in this case can be regulated to reduce the adverse effect.
When a currency loses its value, prices of goods and services continue to rise. Rising prices result in buying fewer amount of goods. The value of money today is not the same as that of our parents and grandparents. We will notice that the prices of goods and services today are higher than they were. What a specific amount of money could buy is less than what it can buy presently. The volume of goods a token can buy is certainly lesser. That is, money cannot buy the same volume it used to buy. In some cases, this factor discourages investment and savings. This usually happens as a result of uncertainties over inflation in the future.
There is a strong relationship between inflation and hoarding of goods which causes prices to rise. On the other hand, an increase in price causes most traders to create artificial scarcity of those goods. Inflation when controlled is favorable to an economy, that is a suppressed inflation. Most economists prefer a low and steady inflation rate. It reduces the adverse effects of the recession. A low and steady inflation rate can be maintained by helping the labor market to adjust promptly. The labor market then adjusts in cases whereby there is a decline in economic activities. The monetary authorities carry out the responsibility of keeping the rate of inflation low and stable. Mostly, these monetary authorities are the central banks that control monetary policies.
Causes of Inflation
Economists characterize inflation as a continuous increase in the price of goods and services. It has some relevant driving factors that are major determinants. An increase in the cost of production is one factor. Another is the increase in demand for these products and services. Inflation is caused by the following;
This occurs when the aggregate demand for goods and services shoots up. We refer to it as an excess demand over supply which results in higher prices. It is also certain that when the money supply increases, inflation can result. This is where we talk about too much money pursuing few goods. This is when the gap between the demand and supply for those goods and services becomes wide. In some cases, the monetary authorities increase the rate of the money supply to individuals. This results in higher demand for goods and services. This is because of the availability of money. The money’s purchasing power then declines.
Demand-pull inflation usually occurs when the growth of the economy is too fast. If demand shoots faster than production capacity, firms, in turn, respond by increasing the prices of their products. Shortage in supply is the factor that causes pressure on price.
Too much money pursuing few goods is a major characteristic of demand-pull inflation. In this situation, the economy has almost the full capacity to employ labor. The unemployment decreases and the rate of economic growth becomes faster than that of the long-run trend. As firms engage in more production, they employ more factors of production (labor). This results in higher employment and a lower rate of unemployment. The increased demand for labor leads to an upward shift in pressure on wages. When this pressure surfaces, it will result in wage-push inflation. This is when higher wages increase income thereby leading to a rapid increase in consumer spending.
Cost-push inflation results when there is an increase in the costs of production. When the cost of raw materials rises, then prices of finished goods rise. The demand for goods remains the same while the supply of goods decreases due to the high cost of production. Most firms transfer the high cost of production to the final consumer in form of higher prices of these finished goods. We can notice a sign of cost-push inflation when the prices of goods such as oil and metals shoot up because they are major inputs of production. There are various factors that can lead to cost-push inflation such as an increase in the cost of factors of production (land, labor, and capital) which are needed to produce goods.
Here is an example of cost-push inflation. When the price of maize shoots up, a company that produces poultry feeds will have to pay more to get the maize. Maize is certainly a major input in manufacturing feeds. After producing the feeds, this company sells them to poultry farmers at a higher price. As a result of the rise in the prices of these poultry feeds, poultry farmers will also have to increase the prices of their birds. The final consumers buy these birds at a higher price. Cost-push inflation results in a temporary rise in the inflation rate. The regulatory body can control this through monetary policy.
Built-in inflation doesn’t just come up on its own. Either cost-push inflation or demand-pull inflation triggers it. This occurs when workers expect their employers to pay a higher amount of wages/salaries. This is due to an upward shift in the prices of goods and services. This demand for an increase in pay comes up in order for employees to meet up with the rise in prices. This is because they want to maintain their cost of living. As workers demand higher pay, the cost of production increases. This tends to raise the cost of living. In other words, when the cost of living shifts upward, workers begin to demand higher pay.
Types of inflation
We shall categorize the causes of inflation based on their speed which are as follows;
This is a mild or moderate inflation rate. The rise in the price level is persistent but at a mild rate. Consumers expect the price to keep moving upward which boosts the level of demand. They begin to beat higher for higher prices in the future as a result. this form of inflation drives the expansion of the economy. According to the federal reserve, when prices increase with less or equal to two percent, it is beneficial to economic growth.
It is a strong form of inflation that is harmful to the economy. Here, the economic growth becomes too fast. Consumers begin to buy more goods than they need in order to avoid buying at higher prices in the future. This increased rate of buying pushes demand upward such that suppliers are not able to meet up. This causes the prices of goods and services to go beyond the reach of the people. The percentage of the rise in price level ranges from three to ten percent.
Galloping inflation results when the government fails to check mild inflation or when it is uncontrollable. Money loses its value so fast that the income of businesses and employees cannot meet up with costs and prices. This situation discourages foreign investors and they begin to avoid the country. The economy becomes unstable which deprives it of having access to its needed capital. This causes the government leaders then lose their credibility. Inflation rises higher than ten percent which wreaks so much havoc on the economy. It is very important to avoid it at all costs.
Hyperinflation arises when prices shoot up more than fifty percent in a month. Wars and natural disasters trigger this occurrence. This happens because the government will have to print more money to pay for such happenings. By implication, nothing good can be said about such economic situations. Prices go out of control such that monetary authorities are not able to impose any regulatory check on them.
This is the simultaneous occurrence of inflation, economic stagnation, and/or recession. It remains unchecked for that period of time. In other words, that economy experiences stagnation alongside price inflation. A major characteristic of stagflation slow economic growth and a high unemployment rate. There also exists a decline in the gross domestic product (GDP). When the government increases the money supply and constrain supply at the same time, stagflation results. It is very difficult and expensive to eliminate once it starts. Monetary policymakers need to determine if raising the rate of interest will reduce stagflation or further spark unemployment.
Core inflation is the increase in the price of goods and services which does not include that of food and energy sectors. It is measured by the consumer price index (CPI). Economists do not include the prices of food and energy because they are bound to change unpredictably. The price changes are mostly in the negative form. This form of inflation is important because it is used to determine the impact which rising price has on a consumer income. It states the relationship between the prices of goods and services and the consumer income level.
Deflation is the inverse of inflation. It is the persistent decrease in the price level of goods and services leading to the rise in the real value of money. This occurs when the inflation rate goes below zero, that is, a negative inflation rate. Deflation is very dangerous because;
- It makes people spend less such that consumers tend to wait for their purchasing power to rise as prices fall. When this happens in an economy, the spending declines, and this can likely lead to recession.
- Debtors are not better off because their debts have more value in real terms when prices decrease.
- Real wages actually shoot up when there is deflation. By implication, employers pay workers more in terms of purchasing power. If the production does not correspond with the level of the real wage rate, it could lead to layoffs.
Effects of inflation
The following explains the effects of inflation;
A) Effects on distribution of income and wealth
Different groups of individuals within an economy do not feel the same impact of inflation. Some are better off while others are worse off.
Debtors and creditors
The redistribution of income in favor of debtors takes place such that creditors lose during inflation. This is because they receive their repayment when the currency’s purchasing power is weak. Debtors on the other hand received when the currency’s purchasing power was high. They repay their debts when the currency has lost its value.
Producers and workers
Inflation favors producers because they gain more profits from the sale of their products due to higher prices on their products. As a result of the rise in prices, producers usually earn more during inflationary periods. Unfortunately, workers lose as there exists a fall in their real wage as the rise in their money wage is usually not proportional to the increase in prices. The working class however gains because employment increases during inflation.
Fixed income earners
Fixed income earners such as salary earners, rent earners, pensioners, etc., suffer more as a result of inflation because the value of their earnings declines. Inflation, therefore, erodes the purchasing power of fixed-income earners. Their income is fixed per time but the value is not fixed.
The investors gain in equity shares because the dividends they get are at a higher rate. This is as a result of their larger corporate profits and the value of their shares appreciates. The bondholders on the other hand lose because their interest rate is fixed yet there is a fall in the real value.
Business people, speculators, and traders
They generate more profit from the persistent rise in price thus causing them to gain.
Farmers also gain due to the rise in the prices of agricultural products and it is usually higher than the rise in prices of other goods. Inflation arising from the increase in the price of agricultural products is Agflation
It is clear that inflation affects the pattern in which income and wealth are being distributed across the country, thereby causing the rich to be richer and the poor to be poorer.
B) Effects on production
The rise in price tends to stimulate the production of goods (consumer goods and capital goods). Producers gain more increase in profit which motivates them to produce more by maximizing every resource available at their disposal. After full employment of resources, the production cannot increase because those resources needed for the production have already been employed fully. Producers and farmers put in efforts to increase their stocks in anticipation of further rise in prices, in this case, hoarding increases. Sometimes, these positive effects of inflation are not found because sometimes production remains at the same position despite the constant rise in prices.
C) Effects on income and employment
The employment rate increases under the impact of the increase in production but the real income of the people does not equally increase because of the decrease in the purchasing power of money. Inflation though increases the money income of jurisdiction due to higher spending and increase in production.
D) Effects on business and trade
The rate of internal trade increases during an inflationary period as a result of higher incomes, production, and spending. Export trade is bound to suffer as a result of higher prices of domestic goods. Business firms expand their businesses in order to make higher profits. It is said that prices grow in a geometric progression while wages grow in an arithmetic progression. Wages do not increase at the same pace as prices which causes hardship to workers thereby creating more inequality.
E) Effects on the government finance
During inflation, the government generates more revenue from taxes, import duties, export duties, excise duties, etc., as they need to spend more for administrative and other purposes. The rising price however reduces the burden of public debt because a fixed amount is to be paid on installment per time.
F) Effects on growth
Galloping inflation and hyperinflation disrupt the growth of an economy as it causes an upward shift in the cost of development projects. Mild inflation, therefore, promotes the growth of an economy. Even though it is inevitable and better still desirable in the economy of developing countries, a high inflation rate declines the growth by causing the rate of capital formation to slow down thereby creating a sense of uncertainty.
How governments control inflation
Governments use different methods to control inflation. Some have positive impacts while others have negative/damaging effects. The mechanisms used to reduce inflation are as follows;
Wage price regulation
Governments use wage-price regulation to reduce inflation. The adverse effect is that it can lead to recession and job loss. It is also known as income policy and most governments avoid this program. It is government mandatory minimum or maximum prices set for specific goods and services.
Contractionary monetary policy
contractionary monetary policy is another tool that is used in fighting inflation. Here the government reduces money supply across the economy. This is done by reducing bond prices and increasing interest rates. Contractionary monetary policy helps to reduce spending and increase savings. Reducing spending brings down the rate of inflation and rapid economic growth. It also implies less available credit which reduces spending.
There are three major tools used in carrying out contractionary monetary policy;
a) Increase interest rates through the central bank
The central bank increases the cost of short term credit (debt). This is carried out by increasing short term interest rates. It has effects on consumers and businesses. Commercial banks increase the interest rate they charge their customers/clients. This also applies to the commercial banks. The central bank increases the interest rates they charge commercial banks.
b) Reserve requirements
There is a minimum amount of reserves which the central bank mandates commercial banks to hold with them. The central bank increases reserve requirements in this case. This aims at reducing money supply in the economy. The more money the central bank requires the commercial banks to hold back, the less they lend to customers. Borrowing less reduces spending.
c) Open market operations
The central bank sells and purchases government-issued securities. They sell large amounts of government securities to reduce money circulation. The occurrences of inflation may have negative effects to an economy. These negative effects are usually when the price of basic necessities such as food rise. Inflation also weakens a currency’s exchange rate. Higher prices as earlier stated drops down the value of a currency in an economy. This is why that currency’s exchange rate becomes weaker.
Inflation can occur in almost any product or service. It happens also when an economy grows due to increased spending. Inflation sometimes discourages savings. This is always because the money one saves today will have less value tomorrow. A shift in demand and supply for/of products are relevant factors that determine inflation. These are mostly situations whereby consumers are willing to pay more amount for few products. The expectation of further inflation brings concern once the inflation spreads wide. Inflation has the capacity to interfere with the ability to retire. Companies usually benefit from the positive impact of inflation when they charge more prices on their products and services. These companies charge higher prices as a result of high demand for the products and services.
Chyou is a published author who focuses on the field of international business. After an established career facilitating mergers and acquisitions for medium to large corporations, Chyou turned to writing to help students better understand international business concepts.