What Is Inflation?
The basics of what price inflation is and how the CPI-U is calculated
Definition Types Of Inflation
Basically there are four main types of inflation and each type has different causes.
The term inflation usually refers to rise in general price level but usually inflationary movements are restricted to any single price or group of prices.
Types of Inflation:
The first type of inflation is known as demand-pull.
It is also known as excess demand inflation. This type of inflation occurs when the total demand for services and goods in an economy is more that the available supply which leads to increases in prices of those goods and services. This is the most common type of inflation and is considered to be the most serious. Almost all other types of inflation occur in conjunction with demand-pull inflation.
The next type of inflation is cost-push inflation.
In this type of inflation the costs of production increase for some reason or the other and it results in the increase in prices of finished goods and services. Usually increase in wages in excess of any gains in labor productivity leads to increased unit costs, which in turn leads to increase in prices.
The third type of inflation is pricing power inflation.
This inflation is more commonly known as administered price inflation and it occurs when businesses decide to increase their prices in order to increase their profit margins. This type of inflation does not occur during a recession. It occurs when the economy is booming and sales are high.
The fourth and the last type of inflation is known as sectoral inflation and it occurs when any of the other three factors hits a basic industry and causes inflation in that particular industry.
For example, if the oil industry raises its prices, all industries using oil will be hit by the increase and this forces them to increase their prices and as a result the inflation occurs throughout the economy because it started in one sector.
What Is Imported Inflation
Imported inflation refers to the fact when imported raw or partly finished goods become more expensive than usual. Generally imported inflation occurs as a result of currency depreciation.
For years now, globalization has been promoted as way delivering low priced goods and services to consumers. In the United States, for nearly a decade Chinese goods were cheap to purchase because of exporting deflation.
However, in the last few months, Chinese imports have become expensive because of imported inflation.
What economists now want to figure out whether one country can import inflation to another. Where China is concerned, it pegs its currency against the US dollar so when there is inflation in the United States, China too see inflation.
But if the Yuan inflates, the US does not see the inflation. However, economists are now trying to find out whether a sovereign nation with its independent central bank can import inflation from overseas.
According to former Federal Reserve Chairman, relative change in prices does not cause imported inflation per se. For instance, for a given stock of money, rise in oil prices may translate to a one time rise in price level but with over a period of time the price of something else falls as consumers cut back on non-oil purchases.
This same logic is also true for imported inflation.
If consumers have to pay more for imported goods and items, they will have less money to spend on domestic goods and services. The Federal Reserve then has to accommodate the higher prices by allowing the money supply in the nation to increase.
Why Does Inflation Occur
Inflation is primarily the decrease in the market value of money.
Many consumers see inflation as increase in prices of goods and often applies to a specific region with regard to a specific economy. Inflation also sees an increase in overall supply of money and this process is known as monetary expansion.
Inflation occurs for many reasons.
Inflation and devaluation of currency are related to a certain extent. A currency is usually devalued based on perception and investor demand. This causes currency inflation or the addition of printed or virtual currently in the money supply. However, currency inflation does not always cause price inflation.
Why does Inflation Occur?
There are many theories floating around that try to explain why inflation occurs.
The Neo-Classical Theory believes that inflation occurs because of increase in money supply while the Neo-Keynesian Theory asserts that inflation occurs by the lowering of productivity.
The Neo-Classical Theory is the oldest and most widely accepted theory when it comes to understanding why inflation occurs.
Before introduction of fiat currency, there was a limit on the inflation rate as gold and silver values were limited because these metals were in limited supply. The supply was limited as there was a cap on how much gold and silver could be mined and minted. Fiat currency metals like copper were valued by the gold and silver that made up the coins. Hence, gold and silver were not just currency, they were also money.
As money supply increased (that is copper fiat currency), inflation also increased and this caused people to hoard gold coins. This theory is even true today and many attribute this as the main cause of inflation.
The other school of thought is the Monetary Theory who believes that inflation is caused because there is too money to buy too many good or there is a lack of currency and increase of money causes prices to rise and hence, an economy sees inflation.
How Does Inflation Affect The Economy ?
In layman’s terms inflation is a rise in general level of prices of goods and services.
The term inflation is also used to refer to increase in prices of specific goods and services. Inflation is measured as the percentage rate of change of a price index and has a dramatic effect on the economy of a nation.
How does Inflation Affect the Economy:
When inflation occurs, the first to be hit are businesses as it becomes more expensive to produce and manufacture goods and services. This in turn results in increased prices of the finished goods and services. In addition, the employees working in these businesses start demanding for wage hike to maintain their real standard of living which further push up the prices.
The economy also suffers as exports become more expensive. On the other hand, imports become cheaper and this leads to people purchasing imported goods and items. This has a drastic effect on all domestic companies and businesses as they are forced to layoff workers to try and compete with imports and the only way they can reduced their unit costs is by reducing the workforce. In the end, unemployment increases and economic growth is adversely affected.
However, inflation gives rooms to the central bank to maneuver since its primary tool for controlling the money supply is by setting the lowest interest rate in an economy. However, the central bank is controlled by the government and there is often political pressure to increase the money supply to pay for government services and this tends to create more inflation and decreases the net money owed by the government in previously negotiated contractual agreements and in debt.
Why The Central Bank Should Not Aim For Zero Inflation ?
In the last few decades we have seen that hyper inflation has been affecting almost all developing countries. Even the developed countries in the world have been fighting on and off with high inflation, especially after World War II.
All countries have had varying degrees of success when combating inflation and bring the prices down to acceptable levels.
Generally speaking the central bank should not aim for zero inflation.
Few countries are trying to achieve zero inflation by adopting price stability. However, lessons from the past have shown us achieving zero inflation is quite contentious. This means that there is no universally accepted solution to fight inflation and therefore, it will be impossible for the central bank to aim for zero inflation.
Zero inflation usually refers to inflation rate slightly above zero. In the true sense, the inflation rate is not zero. The central bank should not aim for zero inflation because the real interest rates and nominal interest rates will also be close to zero. Since costs of holding cash are minimal, the central bank cannot afford to push nominal interest rates to below zero.
If the central bank does target zero inflation, it will be unable to ease the monetary policy in response to any recession shocks. If the nation gives in to zero inflation, it will have a very difficult time coming out of it and it is best avoid the dangers of zero inflation. This is the main reason why the central bank should not aim for zero inflation. It is better to target for a low positive rate of inflation as there will be room to maneuver the monetary policy.
Related: How Debt Consolidation Works?
How To Solve Inflation ?
Inflation is usually referred to general increase in prices of goods and services, and many economists have offered several ways to solve the problem of inflation. It may not be possible to completely eradicate inflation but by using the methods suggested by economists, one can limit inflation to a certain extent.
The main ways to solve inflation is through setting monetary policies and price control but there are also some less popular ways to solve inflation.
The US Federal Reserve System plays an important role in setting monetary policies to solve inflation. The Federal Reserve can use traditional methods like setting high interest rates or using unemployment and declining production to slow or stop rising prices.
Although the monetary policies set by the Federal Reserve help solve inflation, there is still some ongoing debate as to how the policies should be used.
While some economists want the money supply to be decreased, there are others who advocate the overall reduction of demand through fiscal policy like higher taxes or reduction in government spending. There are still other economists who believe that the exchange rate needs to be fixed so that the rate is tied to a reference currency like gold.
These economists believe that in a floating currency economy, there can be a reduction in marginal tax rates so that capital formation is encouraged.
While some economists argue that changing the monetary policy of the nation is the best way to control inflation, there are others that insist that controlling prices is the way forward.
The economists say that price supports are used to set minimum prices and therefore, they help to prevent deflation and allow continued production of certain goods. This theory is not supported by many economists since there are many counterproductive effects to it.
Research On Inflation And Collective Bargaining
A lot of research has been done on inflation and collective bargaining.
While most of us know what inflation is or we have the basic idea of what is inflation, collective bargaining is something not everyone is aware of.
Collective bargaining refers to a set of terms on which the employer offers individual work contracts to each employee in the bargaining trust.
Usually unions resort to collective bargaining to protect the purchasing power of employees from price inflation. Many collective bargaining agreements have a provision of wage rates that need to be periodically adjusted based on the rate of increase of consumer prices. This provision or clause is known as cost-of-living escalator clause or cost-of-living adjustment (COLA) clause.
The Bureau of Labor Statistics issues the national consumer price index (CPI) in the United States and most escalator clauses are based on this price index. Some escalator clauses provide a limitation on the size of cost-of-living adjustments in wages and these are known as caps.
Usually collective bargaining occurs when rising inflation makes it hard to keep up with consumer prices. This prompts the trade unions to demand for higher wages which in turn further fuel inflation. It is this aspect which has led many economists to conduct research on inflation and collective bargaining.
Through research, economists have found that in collective bargaining, wages are set as a factor of price expectations and usually this is higher when inflation is on the rise. This causes a wage spiral and inflation then causes further inflationary expectations. Research on inflation and collective bargaining suggests that collective bargaining is a way of regulating the market and it is important for improving working conditions, achieving economic growth, equality and fair distribution of wealth.
Cause And Effect Of Inflation
Inflation is a conundrum that many economists and financial analysts are still trying to solve.
While some say that price inflation is caused by monetary inflation, others insist that money inflation is caused by price inflation.
However, before we proceed further, it is best to understand what monetary inflation is and where it comes from.
Monetary inflation basically refers to the government figuratively increasing the printing of money in printing presses so that there is more supply of currency in the market.
When the government increases the supply of money faster than the quantity of goods, we have what is known as inflation. The best part is the when the supply of goods increase, the money supply also has to increase or else the prices of goods will actually go down.
Cause and Effect of Inflation:
The major cause of inflation is the increase in supply of money by the government.
Inflation has multifold effect and we will discuss just a few.
Inflation affects a country’s exports as the exports reduce but there is an increase in import penetration. This ultimately leads to a fall in the rate of economic growth and level of employment. As prices of goods increase because of inflation, immediately there is demand for high wages as workers try to maintain their real standard of living.
Higher wages above any gains in labor productivity results in increase in unit labor costs. Therefore, to maintain their profit margins, companies in turn increase their prices and the entire process starts all over again and this can result in inflation getting out of control.
Inflation also causes a reduction in the real value of savings and this is especially true when it becomes real interest rates as they become negative due to inflation. This means that the rate of interest does not compensate completely for the increase in general price level. However, borrowers are benefitted by inflation as they see the real value of their debt reduce. This means that inflation favors the borrowers while harming the savers.
Inflation also leads to higher interest rates and causes disruption in business planning as the future becomes uncertain and this makes planning difficult. This can have adverse effect on the level of planned capital investment.
Another effect of inflation is felt by consumers and businesses with fixed incomes. Many pensioners received fixed pension each month and due to inflation the real value of their pension reduces year on year.