Inflation Its Causes And Its Cure Economics Essay

Inflation in its general sense can be defined as a general rise in the price level, resulting in a reduction in the real value for money. If we were to take a basket of goods and attach a monetary value to it at a specific time period, and we look at that same basket of goods some time later where you will have to pay more to obtain that basket. We can see how the price for the same basket of goods has increased which means that the money lost its value (purchasing power).

In a modern economy, containing inflation is one of the major targets of macroeconomic policy. If all inflations were balanced, inflation would impose no major economic burden. But real- world fluctuations are seldom fully balanced or anticipated. When inflations are unbalanced, relative prices, tax rates, and real interest rates get affected. Individuals go to the bank more often, taxes may increase, and measured income may become distorted. Also, when inflations are unanticipated, they lead to mistaken investments and random income redistributions. And when society is determined to take steps to lower inflation, the real cost of such steps in terms of lower output and employment can be painful.

-Types of Inflation

1. Monetary inflation- is simply the artificial expansion of the money supply, and is historically the primary engine of inflation. It pleasantly enables demand to increase before any increase is produced in supply.

2. Price inflation- is the market’s natural unpleasant “deflationary” reaction to monetary inflation. By reducing the purchasing power of all currency in circulation, and by reducing the purchasing power of credit based on assets, rising prices powerfully if somewhat belatedly counteract the pleasant artificial increase in purchasing power that is the purpose of monetary inflation. Price inflation tends to reduce demand and increase supply.

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3. Real inflation”-is the rate at which inflationary causes would impact price levels if all inflationary causes were considered and the time gap were eliminated. Since precise measurement is impossible, this is essentially an evaluative process, producing a figure or range of figures that constitute fairly inexact estimates.

-Causes for inflation

Inflation is a process, not a thing. The real problem is thus to define those factors that cause inflation – those factors that are “inflationary.”

That which increases demand without immediate relationship to supply, and that which reduces supply without immediate relationship to demand, is “inflationary.”

 Also, that which prevents or inhibits the growth of supply to meet increased demand, and that which prevents or inhibits the reduction of demand to conform to a supply reduction, is “inflationary.” Such government policies as expansion of the money supply, restraints on international or domestic commerce, and controls on prices, profits, rents or interest, all fit this definition.

COST PUSH – when there is an increase in the cost of production due to an increase in the prices of certain raw materials e.g. oil. This causes the prices of finished products to increase.

DEMAND PULL – if demand for goods and services increased (due to factors such as increase population, preference, taste, external factors, etc.) and aggregate supply cannot match that demand in the short run. This results in an increase in prices due to shortages that may arise in that economy.

GOVERNMENT FACTORS – an increase in the money supply or reduction in taxes will cause consumption to increase which will eventually cause the same effects as explained in the demand pull.

-Short Run Philips curve

The original Phillips curve idea was subjected to criticism from the monetarist school among them the American economist Milton Friedman. Friedman accepted that the short run Phillips curve existed – but that in the long run, the Phillips Curve was vertical and that there was no trade off between unemployment and inflation. The curve was drawn based on the assumption of a given inflation rate. If there is an increase in inflation caused by a large monetary expansion this would lead to a higher inflationary expectation thus causing an upward shift in the short run Phillips curve.

The Phillips Curve describes the relationship between inflation and unemployment. According to Freidman “the higher the rate of unemployment, the lower the rate of inflation”.

Short Run Phillips Curve (SRPC)*

Diagram of The Phillips curve

-Effects of an acceleration in nominal GDP growth

Suppose your annual salary went from $20,000 a year to $40,000 a year. Does that mean you are better off? Can buy twice as many goods?

If there is zero inflation, if prices stay the same, then the answer is “Yes”. With a doubling of income you can buy twice as many goods.

However, suppose the inflation rate was 40%. That means goods and services would be rising in price by 40%. Therefore, even though your nominal income has increased by 100%, it doesn’t mean you can buy 100% more goods. Your effective purchasing power has increased by 100 – 40 = you are effectively 60% better off.

If prices doubled and your income doubled. Your real income (effective purchasing power) would be exactly the same.

This same principle can be applied to National Income.

In the case of Zimbabwe, inflation has reached 100,000%. Therefore the Nominal value of output is rising very fast because the prices of goods are increasing. From a statistical point of view, it looks like nominal GDP is rising very fast. But, the reality is that living standards are falling because inflation is greater than the increase in nominal GDP

-Expectations and the inflation cycle

Friedman introduced the idea of “adaptive expectations “- if people see and experience higher inflation in their everyday lives, they come to expect a higher average rate of inflation in future time periods. And they (or the trades unions who represent them) may then incorporate these changing expectations into their pay bargaining. Wages often follow prices. A burst of price inflation can trigger higher pay claims, rising labour costs and ultimately higher prices for the goods and services we need and want to buy. This is explained easier by the diagram below.

Trade unions expect inflation to rise so they bargain for higher wages.

WAGES INCREASE

RISE IN INFLATION INCREASED SPENDING

INCREASE DEMAND

Diagram of the Inflation Cycle

-Recession as a cure for inflation

FIG 1

OUTPUT

b

a

YEARS

DIAGRAM ILLUSTRATING RECESSIONARY AND INFLATIONARY GAPS

Fiscal policy is one of two major tools used by the government to stabilize an economy. We know that whenever an economy is above its potential trend line the government through its control of taxes and government spending will try to bring the economy as close to its potential as possible. At point “a” the economy experiences high rates of inflation and over utilization of resources – which would eventually be followed by a sharp recession. This would entail additional goods and services being made available (assuming that supply does not change with the same rate as demand). As such the prices would eventually fall due to reduced shortages which were achieved through a means of reduced consumption in that economy. At any point below the trend line (e.g. at point b), governments would try to boost spending since it is at this point the unemployment rate is high and resources are therefore left unemployed. Boosting spending therefore would mean that governments would be cutting taxes and increasing government expenditure; thus running the economy into a budget deficit.

-The response of inflation and real GDP to supply shocks

In the general Aggregate supply and demand model. Using “P” to represent general pricing(inflation) and “Q” to represent output, where Aggregate demand is equal to output equal to Nominal GDP ( AD= Q= Nominal GDP).

An adverse shock in the aggregate supply curve will lead to a rise in price and a decrease in demand which means Nominal GDP falls and as a result Real GDP falls also because of a higher inflation rate. Real GDP= Nominal GDP ÷ Inflation(deflator).

In the event of a Beneficial quite the opposite will take place where price will fall, demand will increase, which means Nominal GDP will increase, and as a result Real GDP increases.

P AS1 AS AS2

(General prices) Adverse

Supply Shock Beneficial

P1 Supply Shock

P

P2

AD

0

Q1 Q Q2

Q(Output)

Diagram of general Aggregate supply and demand model