Effects that Inflation Has on the Economy - Essay Example

Inflation and its Causes Inflation has been one of the major s that have been addressed in the economic world and in order to properly understand it, one has to delve into all the aspects that are related to it. This paper will attempt to do just that as it aims to first identify what inflation is before delving deeper into issues that are related to it such as what are the main causes that bring about this situation. The paper will also look into the effects that inflation has on the economy and by extent the society as a result as it attempts to discover ways in which this situation brings about a difference in the way individuals live their lives. It will also look at some of the ways that an individual is able to calculate the inflation rate in an economy. However, the paper will not only focus on the negative side of matters and in conclusion it will also determine what solutions have been brought about on how the economy can avoid such a situation. Introduction Inflation can be described as the increase in the price level of various services and goods within an economy that takes place over a period of time. It should be noted that this increase happens in all sectors of the market meaning that almost goods and services suffer as a result and those in the economy end with a rising expenditure for the same things that they used to buy before (Taylor 89). It may not be very noticeable at first as it is a gradual process and prices do not sky rocket on the first day meaning that many individuals are usually caught off their guard by the situation leading to a financial panic as they realize just what exactly is going on. As a result of inflation, money also loses a fair amount of purchasing power meaning that an individual is able to buy less with a certain amount that before was adequate for his expenditure needs (Svensson 148). Loss of purchasing power of a currency is not good for the economy as this serves to lower the value of a currency as a whole in the end. It is due to this fact that individuals and institutions struggle against any signs of inflation in a bid to avoid from taking place and stopping it in its tracks as early as possible, the sooner the better (Taylor 101). Though inflation is viewed mostly as a negative impact on the economy, it should be noted that there are both positive and negative effects that are associated with this occurrence. Measures of Inflation One is able to identify the onset of inflation in an economy by measuring the inflation rate of that economy. Though there are a number of other ways in which measuring can be done, this is the main method that is used by economists on a global scale. Measuring the inflation rate is done by taking note of the yearly change in percentage terms of a price index over a period of time (Abel & Bernanke 93). The price index that is mostly used for these purposes is the consumer index though other can be used as well. The consumer price index is determined by measuring the prices of a selection of various goods and services that are usually bought by the average consumer and include items that may be needed on a daily basis such as foodstuffs and other supplies (Baumol & Blinder 25). High end items are not included in this collection of goods and services as they are first o f all not bought by the typical consumer and second of all not purchased on a regular basis thus they would reflect dishonestly on the final figure that is obtained in the end. Apart from the consumer price index, other indices that are also used to obtain the level of inflation in an economy also include the producer price index. This index concentrates on the producers rather than the consumers and determines the amount of money that domestic producers receive for their products over time determining the changes calculated in percentage in the process (Abel & Bernanke 98). The difference between this and the Consumer Price Index is mainly due to issues such as taxes and the intention of profit that will make the prices different from what the consumer will eventually pay. Causes of Inflation There are a number of reasons that inflation may occur in an economy and the causes can occur from different origins in the economic sector. A number of theories have risen as a result of this to explain the causes of inflation in an economy. Some of these theories include the Keynesian theory which states that the changes in the available supply of money does not necessarily cause inflation or affect prices and that inflation is as a result of the various pressures that have been put on the economy revealing themselves in the form of a change in prices. These pressures may include a number of various issues such as an increase in demand for goods or a drop in its supply for a certain reason that may lead to the onset of inflation as a result (Abel & Bernanke 103). Another theory that explains the cause of inflation is the Monetarist theory which states the increase or drop in money supply within an economy is responsible for the onset of inflation. In this theory, the explanation is simple; an increase in the supply of money will lead to a large number of individuals able to obtain it thus leading to the increase in the prices of goods and services as the market notices the change and attempts to balance itself out (Abel & Bernanke 112). A decrease in the supply of money on the other hand will lead to fewer people able to obtain large amounts of currency and thus lead to a drop in the prices of goods and services. According to this theory the supply of money and the rate at which it is being supplied can lead to inflation. One of the more popular theories on the causes of inflation is the relationship that has been drawn up between inflation and unemployment. This theory can be considered to be one of the simplest as well as the most sensible theories of all and was derived since the onset of large scale unemployment that affected the country after industrialization. According to this theory, large scale unemployment will result in inflation (Svensson 158). This is because as a large number of people lose their jobs, they will no longer be able to afford the goods and services that they purchased before and as a result drastically reduce/limit their expenditure. The market will notice that the amount of goods and services that were previously being sold have reduced dramatically and in an attempt to adjust themselves to these new circumstances, it will also try and accommodate the financial restrictions that have been placed on most members of the society by the increase in the unemployment rate by reducing the prices of many of its goods and services in a bid to raise the level of consumption once more (Abel & Bernanke 121). Once the unemployment rate in an economy has sufficiently improved, the market will notice that individuals have raised their level of consumption once more and in order to capitalize on that fact, the market will also raise the prices of their goods and services back to their original settings as the economy recovers. As a result it can be said that unemployment especially on a larger scale plays a huge role in the inflation/deflation of an economy (Baumol & Blinder 38). Effects of Inflation As mentioned earlier, there are a number of effects that can result from inflation and these occur as both positive and negative. This means that inflation has the chance to either be beneficial or detrimental to the economy of a society depending on the situation and the sectors that it mostly affects (Svensson 163). The main concept of these effects is that as a result, the purchasing power of a currency is subdued and thus as a result one is able to buy less with more in a manner of speaking. As the old adage goes, there are two sides to every coin and as a result this decrease in purchasing power holds a disadvantage to some and an advantage to others. A good example of a disadvantage involves individuals and financial institutions who may have lent out money on a fixed rate as they end receiving lesser value for the money they had originally given out due to the loss in purchase power of the currency. This means that the interest that they will receive from the money they had lent out will not hold as much value as was initially planned (Abel & Bernanke 126). On the other hand, the borrowers will benefit from this inflation as the money they are supposed to pay back will not hold as much value as the money they had borrowed from the institution thus it can be said that they are left better off than they started. Control Measures There are a number of ways that governments and other institutions can take to prevent or control the rate of inflation in an economy. One way of doing this is through the stimulation of economic growth in a sector to match the money supply that is available in that area. If the economic growth and the increase in money supply occur hand in hand, inflation is less likely to occur. However, it should be noted that this is easier said than done as there are a number of factors that can affect the growth rate of one without affecting the other. Monetary policies are another means of controlling the rate of inflation in an economy (Svensson 152). This is done by overseeing that the lending rates between banks remain at a reasonable low level. High interest rates and low growth in money supply by the central bank is also a good way of preventing inflation as it ensures there is no excess of currency present in the market at any time. Another popular method of controlling the inflation rate in a country is through the used of fixed exchange rates. This is whereby one country attaches it currency to that of one or more countries and use these currencies to determine the value of their own currency (Svensson 145). This can be used to anchor the value of the currency of the country involved but also comes with its reservations as well such as the rise and fall of the reference currency will affect the currency in a similar manner thus a country has to be sure that the economies they choose as reference currency are adequately stable and not prone to often and significant change. In conclusion, Inflation can be said to have both its negative and positive outcomes but it should be noted that many of these positive outcomes can only be enjoyed if the inflation is under the control of a guiding hand and not just occurring spontaneously (Baumol & Blinder 45). All in all it is rather avoided by economies as it destabilizes the financial structure of the currency which more often than not leads to unnecessary complications that have to be dealt with. Works Cited Abel, Andrew. & Bernanke, Ben.Macroeconomics (5th ed.), 2005. .New Jersey: Pearson Baumol, William J. & Alan S. Blinder. Macroeconomics: Principles and Policy, Tenth edition, 2006. . Thomson South-Western. Lars E.O. Svensson. Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others, 2003. Journal of Economic Perspectives 17 (4). Taylor, Timothy. Principles of Economics, 2008. Minnesota: Freeload Press. Read More