Inflation
Definition of Inflation: It is a persistent and appreciable rise in the general level of prices. The annual
increase in prices may be small or gradual (creeping inflation) or large and accelerating
(hyperinflation).
The avoidance of inflation has been one of the main objectives of Macroeconomic policy.
Inflation is considered undesirable because of its adverse effects on:
1. Income distribution
2. Lending and borrowing
3. Speculation: pushes savings away from industry into commodity and property speculation
4. International competitiveness
5. Unemployment
Types of Inflation
Low Inflation is characterized by prices that rise slowly and predictably. It can be measured in single
digits, even annually.
Galloping Inflation: it is very high rate of inflation, usually double or even digits, annually. It is
common to countries, where the governments are weak, political instability, war or revolution. This
kind of inflation, if sustained over longer periods of time can give rise to serious economic
distortions. Capital goes abroad, people hoard money, and financial markets do not function.
Hyperinflation: where money loses all value and becomes worthless, e.g. Germany during First
World War
Economic Impacts of inflation can be divided into
1. Redistribution of income and wealth among different groups
2. Lending and borrowing: lenders lose while borrowers gain
3. Speculation: pushes savings away from industry into commodity and property speculation
4. International trade competitiveness: exports become relatively more expensive, while
imports become cheaper
5. Unemployment: inflation itself can cause unemployment by increasing money wages and
consumer prices, leading to labour ‘pricing itself out of jobs’ and domestic products
becoming uncompetitive against lower-priced foreign imports.
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Redistribution of income and wealth
The major redistributive impact of inflation comes through its effect on the real value of people’s
wealth.
In general unanticipated inflation redistributes wealth away from lenders and to the creditors. This
happens because the money paid back to the lender is worth much less (in real terms), than the
value of money lent.
Also inflation hurts those people most who have a fixed income, like pensioners.
However over the longer run, if inflation persists, markets try to make appropriate adjustments. (e.g.
there are adjustments to interest rates)
• There are distortions in price signals in case of high inflation. People are unable to
distinguish between relative price changes and changes in overall price levels.
• Inflation also distorts the use of money. High inflation brings down the real rate of interest.
There is also a possibility of negative rate of interest, wherein, real wealth of people
declines.
• Distortionary effect on taxes: some taxes are designated in monetary terms. Value of those
taxes goes down
• Menu costs: in inflationary situations, prices change and firms, businesses, restaurants have
to spend real resources to make necessary adjustments in prices, e.g. print new menus,
mail-order forms, change price tags, or even have a new pricing policy
Modern Theory of Inflation
The theory says that inflation does not have a single source. There are many different things that
cause inflation, they could be demand-pull inflation or cost-push inflation.
However in modern industrial economies, inflation has great momentum and tends to persist at the
same rate. The economy has an ongoing inertial rate of inflation to which people’s expectations have
adapted. This built-in inflation rate tends to persist until a shock causes it to move up or down.
Demand Pull and Cost Push Inflation
Demand-Pull Inflation
One of the major shocks to inflation is a change in aggregate demand. Demand-pull inflation occurs
when aggregate demand rises more rapidly than the economy’s productive potential, pulling prices
up to equilibrate aggregate supply and demand. (one important factor behind demand-pull inflation
is rapid money-supply)
In effect, the limited supply, cannot fulfill the increased demand and prices rise.
There is fall in unemployment, workers are scarce, wages go up, which accelerates inflation.
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Cost-Push Inflation
• In modern economies, there are inflationary pressures, even during recession, when
production capacity is idle and there is unemployment. This phenomenon is known as cost-
push inflation.
• Inflation resulting from rising costs during periods of high unemployment and slack resource
utilization is called cost-push inflation.
• One major cause is wages. They are many times, administered prices and there is strong
resistance to cut wages.
Controlling Inflation
Controlling inflation, i.e., ensuring price stability is one of the central goals of macro-economic
policy. This goal can be achieved via Monetary and Fiscal Policy Instruments.
Fiscal Policy and Inflation
Fiscal policy denotes the use of taxes and government expenditures.
• From a macroeconomic perspective government spending affects overall spending in the
economy.
• Taxation affects the overall economy in two ways.
• Taxes affect the amount people spend on goods and services. It leaves households with
more or less disposable income
• Taxes also affect the prices of goods and factors of production
Monetary Policy and Inflation
• Monetary policy affects money, credit and banking system.
• By impacting the money supply, the monetary authority can influence many financial and
economic variables, such as interest rates, stock prices, housing prices.
Restricting the money supply leads to higher interest rates and reduced investments, which
in turn causes a decline in GDP and lower inflation
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