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In economics, inflation is a rise in the general level of prices of goods and services
in an economy over a period of time. When the price level rises, each unit of
currency buys fewer goods and services; consequently, inflation is also an erosion in
the purchasing power of money a loss of real value in the internal medium of
exchange and unit of account in the economy.
Inflation is best defined as a sustained increase in the general price level leading
to a fall in the purchasing power or value of money.
list index summary analysis (LISA) which measures the change in volume of
peoples' voices.
GDP Deflators measures price increases in all assets rather than some
particular subset. The term "deflator" in this case means the percentage to
reduce current prices to get the equivalent price in a previous period. The
US Commerce Department publishes a deflator series for the US economy.
1. People on a fixed income (e.g. pensioners, students) will be worse off in real
terms due to higher prices and equal income as before; this will lead to a
reduction in the purchasing power of their income.
2. Rising inflation can encourage trade unions to demand higher wages. This can
cause a wage spiral. Also if strikes occur in an important industry which has
a comparative advantage the nation may see a decrease in productivity and
suffer.
3. If inflation is relatively higher in one country, exports will become more
expensive for other countries to purchase, this will create a deficit on the
current account.
Effects of inflation:
1. General effects of inflation
2. Negative effects of inflation
3. Positive effects of inflation
These effects are summarized below:
1. General effects of inflation
An increase in the general level of prices implies a decrease in the purchasing
power of the currency. That is, when the general level of prices rises, each
monetary unit buys fewer goods and services. The effect of inflation is not
distributed evenly in the economy, and as a consequence there are hidden costs
to some and benefits to others from this decrease in the purchasing power of
money. For example, with inflation lenders or depositors who are paid a fixed
rate of interest on loans or deposits will lose purchasing power from their
interest earnings, while their borrowers benefit. Individuals or institutions with
cash assets will experience a decline in the purchasing power of their holdings.
Increases in payments to workers and pensioners often lag behind inflation,
especially for those with fixed payments. Increases in the price level (inflation)
erodes the real value of money (the functional currency) and other items with
an underlying monetary nature (e.g. loans and bonds). However, inflation has no
effect on the real value of non-monetary items, (e.g. goods and commodities,
gold, real estate)
2. Negative effects of inflation
High or unpredictable inflation rates are regarded as harmful to an overall
economy. They add inefficiencies in the market, and make it difficult for
companies to budget or plan long-term. Inflation can act as a drag on
productivity as companies are forced to shift resources away from products
and services in order to focus on profit and losses from currency inflation.
Uncertainty about the future purchasing power of money discourages
investment and saving. And inflation can impose hidden tax increases, as
inflated earnings push taxpayers into higher income tax rates.
With high inflation, purchasing power is redistributed from those on fixed
incomes such as pensioners towards those with variable incomes whose earnings
may better keep pace with the inflation. This redistribution of purchasing
power will also occur between international trading partners. Where fixed
exchange rates are imposed, rising inflation in one economy will cause its
exports to become more expensive and affect the balance of trade. There can
also be negative impacts to trade from an increased instability in currency
exchange prices caused by unpredictable inflation.
High inflation can cause the following negative effects:
Cost-push inflation Rising inflation can prompt employees to demand higher
wages, to keep up with consumer prices. Rising wages in turn can help fuel
inflation. In the case of collective bargaining, wages will be set as a factor of
price expectations, which will be higher when inflation has an upward trend.
This can cause a wage spiral. In a sense, inflation begets further inflationary
expectations.
_______
so r = i
Types of inflation:
A transversal classification distiguish inflations, basing on their broadlydefined origins:
1. domestic demand;
>Demand pull inflation
>Domestic inflation
2. domestic costs, as wages;
>Cost push inflation
>Tax based cost push inflation
3. external sources,
>Imported inflation
as oil price increases or currency relative devaluation.
Types of Inflation
There are four main types of inflation. The various types of inflation are
briefed below.
Wage Inflation: Wage inflation is also called as demand-pull or excess demand
inflation. This type of inflation occurs when total demand for goods and
services in an economy exceeds the supply of the same. When the supply is less,
the prices of these goods and services would rise, leading to a situation called
as demand-pull inflation. This type of inflation affects the market economy
adversely during the wartime.
Cost-push Inflation: As the name suggests, if there is increase in the cost of
In the diagram above we see a large outward shift in AD. This takes the
equilibrium level of national output beyond full-capacity national income (Yfc)
creating a positive output gap. This would then put upward pressure on wage
and raw material costs leading the SRAS curve to shift inward and causing
real output and incomes to contract back towards Yfc (the long run equilibrium
for the economy) but now with a higher general price level (i.e. there has been
some inflation).
The main causes of demand-pull inflation
Demand pull inflation is largely the result of the level of AD being allowed to
grow too fast compared to what the supply-side capacity can meet. The result is
excess demand for goods and services and pressure on businesses to raise
prices in order to increase their profit margins.
Possible causes of demand-pull inflation include:
1. A depreciation of the exchange rate which increases the price of imports
and reduces the foreign price of UK exports. If consumers buy fewer
imports, while exports grow, AD in will rise and there may be a multiplier
effect on the level of demand and output
2. Higher demand from a fiscal stimulus e.g. via a reduction in direct or
indirect taxation or higher government spending. If direct taxes are
reduced, consumers will have more disposable income causing demand to rise.
Higher government spending and increased government borrowing feeds
through directly into extra demand in the circular flow
3. Monetary stimulus to the economy: A fall in interest rates may stimulate
too much demand for example in raising demand for loans or in causing a
sharp rise in house price inflation
4. Faster economic growth in other countries providing a boost to UK
exports overseas. Export sales provide an extra flow of income and spending
into the UK circular flow so what is happening to the economic cycles of
other countries definitely affects the UK
Cost-push inflation
Cost-push inflation occurs when firms respond to rising costs, by increasing
prices to protect their profit margins. There are many reasons why costs might
rise:
1. Component costs: e.g. an increase in the prices of raw materials and other
components used in the production processes of different industries. This
might be because of a rise in world commodity prices such as oil, copper and
agricultural products used in food processing
2. Rising labour costs - caused by wage increases, which are greater than
improvements in productivity. Wage costs often rise when unemployment is
low (skilled workers become scarce and this can drive pay levels higher) and
also when people expect higher inflation so they bid for higher pay claims in
order to protect their real incomes. Expectations of inflation are important
in shaping what actually happens to inflation!