The Broader Definition of Inflation - Essay Example

INFLATION: A HIDDEN TAX? Term Paper April 16, 2064 Words   This paper focuses on inflation, what it is and how it affects economy. It discusses the broader definition, factors causing inflation and how it can be estimated using indicators. This paper also outlines a detailed discussion of the effects inflation with respect to economic development, economy growth as well as on the society. This discussion concludes by outlining control measures necessary to manage inflation and the alternatives polices that can be taken by the government to manage inflation. Introduction Inflation refers to increment of price levels in general that is the rise in prices all commodities and not on individual over a period of time. It’s a change expressed in percentage and compared over a time period. Economists have defined inflation as the sustained general increase in the price of goods and services1. When the prices goes up more money can only pay for fewer goods and services and the currency is said to have lost its purchasing power as the medium of exchange as well as the unit of account in an economy. When the prices goes up the situation is said to be price inflation while the money is in large supply the situation is referred to as monetary inflation2. Several other concepts are related to inflation such as deflation which refers to a fall in the price levels generally while disinflation refers to a rate decrease in inflation while hyperinflation is when the price increase is beyond control3. A general belief among economist is that inflation is caused by excess money supply in the economy which pushes demand for both goods and services. How to Measure Inflation The measure of inflation is done through rating the increase in prices over a specified period of time. Inflation rate is expressed as a percentage and is calculated by working out the change in the price index and more so the consumer price index4. The price index on itself cannot give the rate of inflation but it becomes useful when calculating the inflation rate. This rate is the percentage change rate of price index over a period of time. To calculate the inflation rate the formula below is used  *100 where F is the final value while I is the initial value of the index The widely used examples of indices to calculated inflation include consumer price index (CPI) which measures change in prices of goods and services (in a fixed basket) purchased by a consumer5. This fixed basket has goods and services put together and are representative of the economy. The producer price index measures price change on average as received by domestic producers. It measures the price paid by producers. It differs from the CPIs in that subsidizes in price, tax and profit may cause change in amount given to producer differ with what was paid for by the consumer. Commodity price index is also used to calculate inflation and measures the price change in selected commodities. The GDP deflator which measures the price change in all goods and services is included in GDP6. There is the cost of living index used to measure cost of maintaining constant living standard that is year to year cost of living the same way. Lastly the core price index which excludes food and oil prices from CPIs because their prices can change due to demand and supply changes7.In measuring inflation it is important to note that price changes that occur due to change in volume, performance and quality do not constitute inflation. Cause of Inflation Historically all medium of exchange are said to have depreciation in value. Long before introduction of money, products such as silver and gold were used. Different reasons have been put forward as the causes of inflation in an economy. However the major causes of inflation are excess in demand and rise in costs. The two factors lead to different types of inflation for instance excess demands leads to demand pull inflation while rise in cost leads to cost push inflation. Demand pull inflation occurs when the aggregate demand is increasing at a faster rate than the aggregate supply8. When there is high increase in aggregate demand businesses will increase price levels to in order to increase profits thereby leading to inflation. This inflation encourages growth because the excess demand and favoring conditions in the market stimulate expansion as well as investment. Demand pull inflation is accelerated by a number of factors such as weak exchange rate that results to high import prices, reduction in taxes both direct or indirect taxes will lead to more demand as consumers have more income at their disposal. Rapid money supply growth will increase the money supply increasing demand9. Cost push inflation occurs when the production cost or operation cost increase for instance rise in raw material prices, energy or increase in taxes10. This leads the firms to increase their prices so as to shield profit margins and wages to go up. The pass the rise in cost to the consumer for instance when crude oil prices go up, production costs are affected and most goods increase their prices. Other factors such as the increase in indirect taxes will cause inflation temporary since all go that are taxed will go up in prices . Weak currency or depreciation on exchange rate as well will trigger inflation since as much money will only buy a few goods11. Once inflation is found in an economy, measures to reduce it are left to the monetary authorities to slow or reduce it by establishing policies that aim at curbing the situation. Effects of Inflation Inflation has both positive and negative effects on an economy. Contrary to be believe of negative effect of inflation some positive effects of inflation is regulation of interest rates by central banks to avoid economies going into recession. Inflation encourages people to invest in capital projects that are non monetary12. It also helps to bring market equilibrium when maintained at steady low levels since it allows the nominal wages to remain constant while the real wages fall this help to equibilize the labor market. Moderate inflation encourages more buying as well as more borrowing hence making the economy grow faster. High and unpredicted inflation harms the economy in general it causes market inefficiency and makes it difficult for the firm to have long term plans. When there is inflation on the currency there is a drag in productivity levels as firms shift their resources away from investment to maintain profits and avoid losses13. Inflation has the following negative effects on the economy. When inflation occur especially due cost push inflation, the workers through their bargaining union want increase in wages so as to afford the high consumer goods, the increase in wages will not stabilize inflation and instead will cause a wage spiral14. When economies anticipate inflation people will buy durable commodities as a store of their wealth such as gold this leads to shortage of the goods in the market. Social unrest and massive demonstration have been experienced in the past due to inflation15. These demonstrations are so in developing economies that are prone to inflation thus raising the cost of living. These demonstration leads to business losses especially if looting occurs. Investors are also cautioned in investing in such economies. Hyperinflation can interfere with the working of an economy and go as far as having a country to withdraw the use of her currency as a measure to curb further inflation. Inflation leads to high cost of operation since companies are forced to adjust their prices. Individuals are also said to increase their withdrawal transactions as more money is needed in cash to acquire goods and services16. This situation causes an increase in holding cost. Inflation also leads to unemployment, the firms are reducing their costs to maintain profit they lay off people and the economy is also stagnant as businessmen are not investing. There is loss of money value that is its purchasing power making a lot of money just buys few products and pay for fewer services. This causes hardships for the poor families and those whose income is fixed. The banking sector is more adversely affected because the interest rates are raised due to increase of lending base from the central bank. This reduces their operation as fewer people are likely to take up loans when the interest rates are high17. This eventually leads to low profits. How to Control Inflation Economist has suggested various measures that should be applied in order to control inflation within an economy. These are both methods and policies put across to control inflation. Inflation encourages spending and discourages saving18. If there is anticipation of high inflation consumer will buy products because their prices escalate. Investment can only happen if there is saving. When an economy does not have a saving culture investment is also low. Low investment slows economic growth and in long run affects the country gross domestic product19. Capital formulation occurs when money is saved and in turn used by investors for investment inflation makes this capital formulation difficult since it makes consumption attractive compared to savings. Once inflation passes its initial stages it strain the financial system which leads to speculation and further expectation in prices which combined increase fall in output and rise in unemployment. Inflation has been perceived as a hidden tax as it leads to fall in the money purchasing power. Therefore money authorities are able to collect extra money from taxpayers without imposing more tax on them. It also leads to inequalities in terms of wealth and income distribution this because it distorts prices in the market. Individuals experiencing high rise in income than the inflation rate will increase their real incomes. Consumers tend to buy assets which increase their nation wealth share. Those with fixed income are disadvantaged because their incomes are not adjusted fast enough to compensate the cost and price push up. Various methods and policies can be applied to control inflation within an economy. The government through the central bank uses monetary policies to control inflation. In most economies the central bank is responsible for controlling the base lending rate. By increasing the rate there is less borrowing and this leads to a steady flow of money, the money supply in the market are slowed and this helps to control inflation. Fiscal policy is also used by the government to control inflation; increase in tax ensures that the consumers have less money thereby lowering the aggregate demand20. Government also reduces its spending in order to demand. Reducing of aggregate demand when there is an economic expansion helps to stabilize inflation. Use of a fixed exchange rate ensures that depreciation of a currency does not occur21. This helps to stabilize the currency since its value is tied to another value. This ensures that the currency is not affected by inflation of the mother country. Another strategy would be control of both prices and wages as these are a major cause of inflation. Economist advice that the government should not control the prices as this discourages investment in areas of controlled prices but it should ensure that the prices are liberalized. When the government wants to stimulating economic growth it ensures that there is equal growth in all sectors. These would be through creating policies and structures that encourage investment in all areas of an economy. Inflation results when money supply does not growth therefore making the two be at par will reduce inflation. Adjusting the cost of living ensures that inflation does not affect those with fixed income alone. Economies with low inflation rates adjust their salaries and cost of living annually while those with hyperinflation do it often. Conclusion Economists have noted that Inflation has been in existence as long as money is used as a form of exchange and unit of currency. The government must ensure moderate inflation so as to promote the growth of an economy. If an economy is able to balance economic growth and money supply then no inflation will occur. The inflation rates should not be controlled after they have surpassed but the targets but should be kept low at all times because hyperinflation and deflation are a danger to the economy. Control of inflation should be undertaken by all players that is government, consumers as well as the central banks. References Bernholz, P., Monetary Regimes and Inflation: History, Economic and Political Relationships, United Kingdom: Edward Eglar Publishing Limited, 2003, p.36-40. Dwivedi D., Macroeconomics; theory and policy: 3rd edition, New Delhi: McGraw Hill Education Private Limited, 2010, p.447-492 Frisch H., Theories of Economics, Cambridge: Cambridge University Press, 1983, p. 9 Geetika, P. Choudhury, R., Managerial Economics. New Delhi: McGraw Hill, 2008, p. 474 Gillman M., Inflation Theory in Economics: Welfare, Velocity, Growth and Business Cycles. Oxon: Routledge, 2013 p.10-12 Hart, Joyce. How Inflation Works. New York, NY: Rosen Pub, 2010, p.12-58 Karmann A., Financial Structure and Stability. New York: Heideberg, 2000, p.52 Mankiw, N., Principles of Economics: 6th Edition. Cengage learning, 2011, p.644-648. Robert, H., Inflation: Causes and Effects, Chicago: University of Chicago Press, 2009, p.153 Read More