Understanding Inflation: Causes, Effects, and Economic Impact

Posted on Jan 4, 2025 in Economy

Inflation

Inflation refers to a situation in the economy where there is a general and sustained increase in prices, measured in terms of indices.

Price stability is crucial for governments to achieve all their macroeconomic objectives, so the control of inflation has been their main priority in the past 20 years.

A few important points:

An increase in a small number of prices does not constitute inflation. The key thing is for the increase to be measured across a wide range of items that affect the spending of consumers.
The rate of increase is recorded on an annual basis, and is likely to be variable.
A low and steady rate of inflation may not be a bad thing for the economy. This puts pressure on businesses to be competitive.

Inflation Levels:

<5 Very mild inflation which can actually aid
5-9 Mild inflation, which must be kept under control to avoid future difficulties.
10-19 Inflationary pressures build up with increased wage demands and high interest rates; savings begin to be affected. Strict policies essential if problem is to be resolved.
20-50 Serious inflation. Economic relationships in real danger of breaking down. Confidence in money is seriously eroded.
50 and above Signs of hyperinflation. Depending on severity, domestic economic structures collapse and currency becomes worthless on foreign exchange markets and also internally.

Main causes of inflation

A good starting point is monetary inflation, as periods of inflation coincide with increases in the money supply.

Increase in money supply, increase rate of inflation

Note that this will only occur if the rate of growth of the money supply is greater than the increase in the level of output in the economy, so forcing up prices.

The demand curve for money is like any other demand curve – people want to hold a larger quantity of money when the value falls as they need more money to buy their particular purchases.
The supply curve for money is vertical since it is fixed by the central bank.
At the initial equilibrium (X), the demand for money and supply of money are balanced – the value of money is at (V) and the price level at (p).
An increase in the supply of money (e.g. by printing more notes) shifts the supply of money from S1 to S2.
The outcome is that there is a new equilibrium position at (Y) where the value of money has halved and the price level has doubled.

Causes of inflation:

Cost-push inflation

A phenomenon in which the general price levels rise (inflation) due to increases in the cost of wages and raw materials.

Cost-push inflation develops because the higher costs of production factors decreases in aggregate supply (the amount of total production) in the economy. Because there are fewer goods being produced (supply weakens) and demand for these goods remains consistent, the prices of finished goods increase (inflation).

E.g. Most developing economies rely heavily on imported oil. Sometimes oil supplies can be restricted. As demand is largely unaffected, prices are forced to rise, causing cost-push inflation. Developing economies will have to suffer higher raw material costs, higher prices for imported consumer goods, etc.

Demand-pull inflation

It occurs when there is an increase in the total demand for goods and services in an economy.

This increase in demand ‘pulls’ prices upwards if the economy does not have spare capacity to meet these increased needs.

E.g. In developed economies; an increase in consumer spending (often government induced) at a time of low unemployment has pulled up the price level.

Consequences of Inflation

The effects of inflation depend on:

The rate at which it is rising
Whether the rate if accelerating or stable
Whether the rate is the one which had been expected
How the rate compares with that in other countries

The inflation rate

The higher the % at which the inflation rate rises, the more problems will be caused because money will be losing its purchasing power at a more rapid rate. A very high rate of inflation is known as hyperinflation. When this occurs, results are the following:

NEGATIVE

People and companies may lose considerably purchasing power if they keep money lying idle and not earning interest.
People will lose confidence in money and may even go back to barter for their day-to-day needs.
Political instability. (People become dissatisfied with the government’s failure to control the high rise in prices and may look to parties offering radical solutions to the problem.) Economists refer to this as shoe leather costs
Menu costs: Costs involved in changing prices. E.g. catalogues, price tags, bar codes and advertisements have to be changed.
Inflationary noise: Can result in consumers and producers taking wrong decisions and therefore, resulting in a misallocation of resources. E.g. producers seeing the price of their good rising may increase output when this higher price is actually the result of inflation rather than increased demand.

POSITIVE (low, stable rate of inflation e.g. 2%)

If rise in general price level is caused by increasing aggregate demand, firms can feel optimistic about the future.
Firms can also benefit if prices rise by more than costs (profits will increase)
Inflation may also stimulate consumption (because real interest rates may be low or even negative as the nominal rate of interest does not tend to rise in line with inflation)
Inflation may also help firms which need to reduce costs to survive. Generally the major costs are wages. With zero inflation, firms may have to cut their labour force. At a time of recession and low inflation, job losses are inevitable. However inflation would allow them to reduce the real costs of labour by keeping money wages constant or not raising them in line with inflation.

Accelerating versus stable inflation

Accelerating will cause:

Workers to press for higher wages.
Firms to rise prices to cover expected higher costs.
Consumer to purchase goods now before prices rise further
Discourage firms from undertaking investment.

If inflation is stable it will be easier to predict the future inflation and hence easier to plan and protect people from harmful effects.

Anticipated versus unanticipated inflation

Anticipated: When the rise in the general price level is the one, or close to the one expected. If firms, workers, consumers and the government have correctly predicted the inflation rate, then they can take measures to avoid harmful effects.

Unanticipated: When inflation either was not expected or is higher than had been expected. This can result in a fall in consumption and investment, as people are uncertain about future inflation.

International Price competitiveness

Inflation may make a country’s goods less price competitive, which will result in balance of payments problems.

Consumers may turn away from buying the country’s goods and services, which may cause a deficit in the trade in goods and the trade in services sections to increase.

In a floating exchange rate:

Fall in demand for a country’s goods and services and reduction in investments from abroad
Reduce the exchange rate
Lower export prices
Restore price competitiveness

However, if the country’s inflation rate is below that of its main competitors, its goods and services will become more price competitive, and if they were originally cheaper than their rivals , even with a higher inflation rate they may still be at lower price.

Balance of payments problems

In principle, the overall deficits and surpluses for any economy should balance. The same can be applied on a global scale, where a surplus on the balance of payments for one country if offset by a deficit elsewhere.

Equilibrium in this context: a situation where manageable deficits are cancelled out by modest surpluses over a period of time.

E.g. where the imports of goods and services exceeds exports but where this is offset by an inflow of foreign direct investment.

E.g.2. Where the exports of goods and services exceed imports but where there is substantial investment abroad by companies and residents.

Disequilibrium: when over a particular period, a country is recording persistent deficits of surpluses in its balance of payments.

It can arise where

The imports of goods and services exceed exports and the financial account is in deficit
The exports of goods and services exceed imports and the financial account is in deficit
There is a large surplus on the current account which generates an overall balance of payments surplus

Consequences of Balance of payments disequilibrium

There are consequences of the disequilibrium in the balance of payments for:

For a domestic economy:

In developing countries: Need for corrective action, as these countries still depend heavily on agriculture
In developed countries: As most developed countries depend on imported goods. Unemployment is a huge consequence.
A second domestic consequence is that because of low business confidence, foreign investors are not willing to invest in the country due to the risks involved.
For consumers there´s another consequence, which is that there are likely to be fewer stock of certain exotic imported products and there will be many more domestically produced goods. Moreover, imports will have high taxes imposed to reduce their consumption and encourage domestic consumption.

For the external economy:

If there is disequilibrium it is likely that the government will impose protectionist methods to prevent an excess of imports and correct the disequilibrium.

The causes and consequences of fluctuations in foreign exchange rates

When international rather than domestic trade takes place, there is a noticeable difference. If a UK resident buys a product made by factors of production in the UK, then only one currency is used