Inflation

 Inflation

What is inflation?

Inflation is a general increase in price levels over a period of time. It results in continuously decreasing purchasing power in the economy. When general price levels rise, each unit of currency buys fewer and fewer amount of goods. Thus, inflation actually reflects the decrease in purchasing power of currency over time – or a loss of real value of the medium of exchange that is currency. It is a continuing rise in price level, not a one-time increase in price of a particular commodity.

 What are the types of inflation?

There are four main types of inflation as categorized by their speed. There are also specific types of wage and asset inflation. These types are –

1.  Creeping Inflation: - It is when prices rise 3% a year or less. It may not be immediately noticeable but if the creeping rate of inflation continues, it might end up becoming a problem. When prices increase at this rate, it tends to make consumers expect a continuous rise in prices. This leads to an increase in demand, benefitting economic growth and driving economic expansion.
2. Walking Inflation: - It is strong or destructive inflation where prices rise between 3% and 10% each year. It hurts the economy as economic growth is heated up too fast. Demand rises meteorically and as a result, suppliers cannot keep up. More importantly, neither can wages. Thus, common goods and services are priced beyond the range of most people. This kind of inflation is a warning sign to the government to control it before it turns into galloping inflation.
3. Galloping inflation: - It is a form of inflation in which prices rise more than 10% every year. The currency of the country will lose value in the global economy so fast that business and employee incomes cannot keep up with the prices. Foreign investors begin to avoid the country, depriving it of necessary capital. This leads to the general instability of the economy, government and the country as a whole. It must be prevented at all costs.
4. Hyperinflation: - It is a rare and extreme form of inflation in which prices rise more than 50% a month. In this case, the inflation is completely out of control and no measures can be taken to stop it. Most cases occur when governments print money in order to pay for wars. An example of this happened in Venezuela in 2018 where prices were predicted to have risen 13,000% in 2018 by the IMF.
5. Stagflation: - This occurs when there is price inflation, but economic growth is stagnant. It causes economic instability due to the rise in unemployment, severe inflation, and lack of economic growth. It is also known as recession-inflation. It was first recognised during the 1970’s when many developed economies experienced rapid inflation and high unemployment as a result of an oil shock.
6. Deflation: - It is the opposite of inflation. It is a general decline in prices for goods and services and it is typically associated with contraction in the supply of money and credit in the economy. During deflation, the purchasing power or real value of currency rises over time. By definition, monetary deflation can only be caused by a decrease in the supply of currency or financial instruments (stocks or bonds) that are redeemable through money.
7. Wage inflation: - It is a situation also known as wage-push inflation in which a general rise in cost of goods and services is a result of and is preceded by a rise in wages. Higher wages are one element of cost-push inflation. They can then drive up the cost of production. There are three causes of this type of inflation -  When there is a shortage of workers, when labour unions negotiate ever-higher wages and when workers effectively control their pay.
8. Asset inflation: - Asset price inflation or an asset bubble occurs due to the rise in prices of one asset class as opposed to ordinary goods and services. Examples of these assets include financial instruments such as bonds, securities and their derivatives, real estate, oil and gold. This type of inflation is often overlooked by inflation-watchers when the rate is low. The rise in oil prices each spring and the subprime mortgage crisis in the U.S.A(and the subsequent global financial crisis) are examples of asset price inflation.

What are the causes of inflation?

The main causes of inflation are: -

Demand-pull inflation: - It is inflation that results from an initial increase in aggregate demand. If the economy is at or near full employment, this results in an increase in price level. In a demand-pull inflation spiral, aggregate demand keeps increasing and price level increases indefinitely. Although any of the factors that affect aggregate demand (AD = Consumption + Investment + Government Expenses + (Exports – Imports) can start the demand-pull inflation process, only an ongoing increase in the supply of money can sustain it.

Cost-push inflation: - It is inflation that is caused by an initial increase in costs of a business, which passes on the costs to the consumer. The initial increase in costs causes a decrease in the aggregate supply. If aggregate demand increases as a result, cost-push inflation occurs. This form of inflation can be caused by many factors –

                                i.            Rising wages

                              ii.            Increase in import prices

                            iii.            Increase in raw material prices

                            iv.            Profit-push inflation

                              v.            Declining productivity

                            vi.            Higher taxes

c)      Printing money/Devaluation: - If the central bank of a country prints more money, a rise in inflation is expected. If the money supply increases and the supply of goods and services remains the same, then prices will rise. Hyperinflation is usually caused by an extreme increase in money supply.

d)      Inflation expectations: - Once inflation sets in, it is difficult to reduce it. For example, increasing exports leads to increasing aggregate demand which causes increases in price level and this continues. This causes a export-price spiral. Thus, expectations of inflation are important as when people expect high inflation rates – it often turns into a self-fulfilling prophecy.

 

What are the consequences of inflation?

Inflation has different consequences depending on whether it is anticipated or unanticipated. The major possible consequences of inflation are: -

a)      Inflation reduces real income and increases investment. As prices rise, the same amount of money cannot buy as much. People thus have less incentive to save as saving less money means having more money available for investment.

b)      There is a large amount of business uncertainty. High rates of and volatile inflation are not good for business confidence as they cannot be sure of what their costs and prices will be. This will result in negative implications on the economic growth of the economy.

c)      There will be a regressive effect on lower-income families and older people in society. Thus, inflation will result in income redistribution in such a way that income inequality is increased.

d)      The interest rates for borrowings may be increased to attempt to control inflation. This will result in an increase in the cost of borrowings and will have a negative impact on both consumption and investment. The government will also be pressured to increase pension amounts, unemployment benefits and other welfare payments as the cost of living is increasing.

e)      There is social unrest in the society as workers demand higher wage rates in order to deal with higher costs of living. Households are in general discomfort as the purchasing power falls.

f)       High inflation can lead to an increase in wage rates as workers try to maintain their standard of living by protecting their real income. This may lead to higher unit costs and a fall in business profits.

g)      If interest rates on savings accounts are lower than the rate of inflation, then people who rely on interest from their savings will become poorer as the real value of their money will fall.

h)      If a country has a higher rate of inflation than other countries for a prolonged period of time, the export industry will be hit hard. The cost of production will rise and the exports will become less price competitive in world markets. This will result in reduced export orders, lower profits, reduced jobs and a worsening of a country’s balance of payments.

The major winners in an inflation scenario are: -

·         Workers with strong wage bargaining power like in unions (wages increase)

·         Debtors if interest rates on loans are below inflation rates (real value of debt falls)

·         Producers if prices of goods and services rise faster than costs (profits increase)

·         Wealthy groups when there is prolonged asset inflation

The major losers in an inflation scenario are: -

·         Retired people on fixed incomes (real value of pensions and interest falls)

·         Lenders if interest rates on loans are below inflation rates (real value of debt falls)

·         Savers if interest rates on savings are below inflation rates (purchasing power falls)

·         Workers in low-paid jobs with little to no bargaining power

·         Exporting firms – they may lose sales and profits as they become less competitive

 

What policies can be used to reduce inflation?

The main policies that can be used to reduce inflation are as follows: -

a)      Monetary policy: - It is the main policy used to reduce the rate of inflation by changing the interest rates. Higher interest rates lead to reduced demand in the economy leading to lower economic growth and lower inflation. As part of monetary policy, many countries also have a target inflation rate. By keeping a credible and reachable inflation target, it helps to lower inflation expectations and thus makes it easier to control inflation. A higher interest rate also leads to a higher exchange rate which helps reduce inflation by –

                                i.            Making imports cheaper

                              ii.            Reducing demand for exports

                            iii.            Increasing incentive for exporters to cut costs

b)      Supply-side policies: - They aim to increase long-term competitiveness and productivity. For example, more flexible labour markets may help reduce inflationary pressure. However, they cannot be used to reduce sudden increases in inflation rate, they are very much long-term policies. They also have no guarantee of working.

c)      Fiscal policies: - They involve the government changing tax rates and spending levels to influence the level of Aggregate Demand (AD). Increasing taxes and reducing government spending helps to reduce AD and thus lower inflation rates. This is a demand-side policy. It can only be used in a limited way as it is disliked by the public.

d)      Wage controls: - If inflation is being caused by wage inflation, then moderating wage growth helps to control inflation. Lower wage growth helps to reduce cost-push inflation and moderate demand-pull inflation. However, this policy is difficult to enforce widely especially in areas where the workers’ unions are strong.

e)      Targeting money supply (Monetarism): - In this policy, inflation is sought to be controlled by controlling the money supply. Monetarists believe there is a strong link between the money supply and inflation. It has been proved today that this link is less strong than expected and inflation controlled through this way might be accompanied by recession. Policies to be stressed in this field of thought are –

                                i.            Higher interest rates (Tightening monetary policy)

                              ii.            Reducing budget deficit (Deflationary fiscal policy)

                            iii.            Control of money being created by the government

It is difficult to control two types of inflation –

a)      Hyperinflation: - In a period of hyperinflation, most conventional strategies tend to fail. People will have lost confidence in the currency and inflation expectations are hard to change. So in order to save the economy it may be necessary to either introduce a new currency or use another currency.

b)      Cost-push inflation: - It is extremely hard to control this form of inflation without it leading to lower growth. It is often best to let temporary inflation factors come to an end.

 

How do we measure inflation?

Inflation is generally measured by a central government authority. Depending on which set of goods and services is selected, multiple types of inflation values are calculated and tracked as inflation indexes. The most common are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). The indexes are: -

a)      The Consumer Price Index: - It is a measure that examines the weighted average of prices of a set of goods and services which fulfil primary consumer needs such as transportation, food and medical care. It is calculated by taking price changes of each item in the set and averaging them based on their relative weight. Changes in the CPI can be used to assess the changes in the cost of living.

b)      The Wholesale Price Index: - It is another popular measure of inflation that tracks the changes in the prices of good in the stages of production before the retail level. They mostly include items at the producer or wholesale level like cotton, rice and so on.

c)      The Producer Price Index (PPI): - Although many countries and organisations use the WPI, the U.S.A. and many others use the PPI instead. It is a family of indexes that track the average change in selling prices received by domestic producers of goods and serviced during a period of time. The PPI measures price changes from the perspective of the seller unlike the WPI which does so from the perspective of the buyer.

As a result, using these indexes, Change in Inflation = [(Final Index Value)/(Initial Index Value)].