What is Inflation?
When the level of currency of a country exceeds the level of production, inflation occur. Most of the inflation is caused by the increase of food prices. It might be due to less productivity in agriculture sector and so-called shortage of goods and services in the economy. In addition, fluctuating oil prices in world market could be also, due to rigid wage and price structure, another cause of rise in general price level of almost all other commodities. Rising import prices also considered one important factor affecting the inflation. Inflation effect the economy in different ways, it effects the investments of individuals and increase the ratio of unemployment.
Causes of Inflation:
So, what exactly causes inflation in an economy? There is not a single, agreed-upon answer, but there are a variety of theories, all of which play some role in inflation:
1. The Money Supply
Inflation is primarily caused by an increase in the money supply that overtakes economic growth. Ever since developed nations moved away from the gold standard during the past century, the value of money is determined by the amount of currency that is in circulation and the public’s perception of the value of that money. When the Federal Reserve decides to put more money into movement at a rate higher than the economy’s growth rate, the value of money can fall because of the changing public perception of the value of the underlying currency. As a result, this reduction will force prices to rise due to the fact that each unit of currency is now worth less.
One way of looking at the money supply effect on inflation is the same way collectors value items. The rarer a specific item is, the more valuable it must be. The same logic works for currency; the less currency there is in the money supply, the more valuable that currency will be. When a government decides to print new currency, they essentially weaken the value of the money already in circulation. A more macroeconomic way of looking at the adverse effects of an increased money supply is that there will be more dollars follow the same amount of goods in an economy, which will automatically lead to increased demand and therefore higher prices.
2. The National Debt
The reason of inflation in nation debt is that as a country’s debt increases, the government has two options: they can either raise taxes or print more money to pay off the debt.
A rise in taxes will cause businesses to react by raising their prices to equalize the increased corporate tax rate. On the other hand, should the government choose the final option, printing more money will lead directly to an increase in the money supply, which will in turn lead to the deflation of the currency and increased prices.
3. Demand-Pull Effect
The demand-pull effect states that as earnings increase within an economic system, people will have more money to spend on consumer goods. This increase in liquidity and demand for consumer goods results in an increase in demand for products. As a result of the increased demand, companies will raise prices to the level the consumer will bear in order to balance supply and demand.
An example would be a huge increase in consumer demand for a product or service that the public determines to be cheap. For instance, when hourly wages increase, many people may determine to undertake home improvement projects. This increased demand for home improvement goods and services will result in price increases by house-painters, electricians, and other general contractors in order to offset the increased demand. This will in turn drive up prices across the board.
4. Cost-Push Effect
Another factor in driving up prices of consumer goods and services is explained by an economic theory known as the cost-push effect. Essentially, this theory states that when companies are faced with increased input costs like raw goods and materials or wages, they will preserve their productivity by passing this increased cost of production onto the consumer in the form of higher prices.
A simple example would be an increase in milk prices, which would undoubtedly drive up the price of a cappuccino at your local Starbucks since each cup of coffee is now more expensive for Starbucks to make.
5. Exchange Rates
Inflation can be made worse by our increasing experience to foreign marketplaces. On a day-to-day basis, we as consumers may not care what the exchange rates between our foreign trade partners are, but in an increasingly global economy, exchange rates are one of the most important factors in determining our rate of inflation.
How does inflation effect the economy?
Inflation affects the economy in different ways both positive and negative. To understand the effects of economy we should highlight different points which can cause the inflation.
1. Effect on distribution of income and wealth
The mainly effect of inflation is on the group of individuals which are within the national economy and Some people gain by making big fortune and some others lose. We can get to know more about these different groups of peoples in detail:
Creditors and Debtors: During inflation creditors lose because they gain in effect less in economic consumption than if they had received the reimbursement during a period of low prices. Debtors, on other hand, as a group gain during inflation, since they reimburse their debts in currency that has lost its value.
Fixed income-earners: This group like the salaried people, rent-earners, landlords, pensioners, etc., suffer greatly because the value of their earnings diminish during inflation.
Wage Earners: Wage earners may gain or lose depending upon the speed with which their wages adjust to rising prices.
Investors, Bondholders and others: The investors in equity shares gain as they get shares at higher rates because of larger corporate profits and as they find the value of their shareholdings appreciated. But the bondholders lose as they get a fixed interest the real value of which has already fallen. Other groups like traders, speculators, businesspeople and black-marketers, they gain because they make more profits from the constant rise in prices.
Farmers: Farmers also gain because the rise in the prices of agricultural products is usually higher than the increase in the prices of other goods.
2. Effects on Production
The rising prices arouse the production of all goods both of consumption and of capital goods. As producers get more and more profit, they try to produce more and more by utilizing all the available resources at their disposal.
But, after the stage of full employment the production cannot increase as all the resources are fully employed. Moreover, the producers and the farmers would increase their stock in the expectation of a further rise in prices. As a result, hoarding and cornering of commodities will increase. But such favorable effects of inflation upon production are not always found. Sometimes, production may come to a halt position despite rising prices.
3. Effects on Income and Employment
Inflation tends to increase the collective money income (i.e., national income) of the community as a whole on account of larger spending and greater production. Similarly, the size of employment increases under the impact of increased production. But the real income of the people fails to increase respectively due to a fall in the purchasing power of money.
4. Effects on Business and Trade
A rise in inflation is likely to mean a rise in the cost of raw materials. Also, workers are likely to demand higher wages to cope with the higher cost of living. This rise in prices can also cause greater instability and uncertainty. With organizations uncertain about future costs, they may hold back from making investment decisions. Organizations generally prefer a low and stable inflation rate. Also, with an inflation rate, organizations may expect rising interest rates, which will increase cost of borrowing another reason to hold back on investment.
With higher inflation, organizations may face menu costs (the cost of changing and updating prices). However, with modern technology this cost has reduced in importance as it is easier for firms to update prices automatically.
The total volume of internal trade tends to increase during inflation due to higher incomes, greater production and larger spending. But the export trade is likely to suffer on account of a rise in the prices of national goods.
5. Effects on the Government Finance
During inflation, the government revenue increases as it gets more revenue from income tax, sales tax, excise duties, etc. Similarly, public expenditure increases as the government is required to spend more and more for administrative and other purposes. But the rising prices reduce the real burden of public debt because a fix sum has to be paid in instalment per period. With inflation, even the real value of taxes is reduced. Thus, redistribution of wealth in favor of the government accrues as a benefit to the tax-payers. Since the tax-payers of the government are high-income groups, they are also the creditors of the government because it is, they who hold government bonds. As creditors, the real value of their assets declines and as tax-payers, the real value of their liabilities also declines during inflation. The extent to which they will be gainers or losers on the whole is a very complicated calculation.
6. Effects on Economic Growth
The effect on economic growth is uncertain. Sometimes inflation is caused by a rapid rate of economic growth. However, if growth is above the long-run trend rate this may not be sustainable especially if interest rates rise. Although a minor dose of inflation is inevitable and desirable in a developing economy, a high rate of inflation tends to lower the growth rate by slowing down the rate of capital formation and creating uncertainty.
Conclusion:
Inflation is a rise in the general level of prices of goods and services in the economy over a period of time. When the general price level rises, each unit of the currency buys fewer goods and services. Different economist understands and define the concept of inflation in different ways. But in generally inflation refers to a situation of continuously rising prices of commodities and factors of production. Inflation play a vital role for the development of economy. The inflation rate must be at moderate level. For developing countries 3% to 4% raise of inflation could be acceptable but in developed countries it must be 1-2% only. When the inflation rate is highly it decrease the purchasing power of the people and cost of the product would be costlier. Presently, monetary policy is geared towards maintenance of price stability. Also, and given the exchange rate policy is maintained, it is important to refine monetary formulation in this regard.
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