This article defines inflation. It explains how inflation is measured. Also, it describes the pattern of inflation in the UK in recent years.
With the use of charts, it the article explains the causes of inflation and the processes with the Aggregate Demand (AD) and Aggregate Supply (AS) curves.
Finally, it calculates inflation using The Fisher Formula, or Quantity Theory of Money. In the end, costs and effects of inflation are explained in details.
Definition of inflation
Inflation is regarded as ‘a sustained rise in average prices of goods and services within an economy’. Maintaining low inflation is a major challenge and an important objective for governments.
If they fail in this task an economy may experience incredibly high inflation; termed ‘hyper-inflation’, e.g. Russia experienced inflation of 2,000% in 1992.
Though, much more rare, an economy may experience a period in which there is a fall in the general price level. This phenomenon is known as ‘deflation’.
Measuring inflation
Measuring inflation involves determining average prices and their changes within an economic system; and some countries may use differing systems to calculate inflation. It is common for prices in an economy to be represented as a ‘basket of goods’. These goods are commonly consumer goods, so may change over time as fashions dictate.
A common example in the UK is that rabbit meat is no longer considered to a common good. Approximately 650 prices are checked in the UK in roughly 150 locations, every month in order to calculate inflation.
In the past, the UK used the Retail Price Index (RPI) system for determining the existing level of inflation. However, the desire to harmonize with neighboring economies has lead to the UK using the Consumer Price Index (CPI).
The Consumer Price Index (CPI) system is designated as the official inflationary indicator within the EU. A measure adopted by many countries because it makes comparisons between various countries easier.
Causes of inflation
There are three major causes of inflation, which can be placed under the following categories:
- Demand-pull
- Cost-push
- Growth of the money supply
1. Demand-pull inflation
Demand pull inflation is caused by increases in aggregate demand.
An outward shift increases prices within the economy and output to rise as shortages are evident. A boom or peak within an economy will be the cause of demand-pull inflation, with persistent outward shifts of the aggregate demand curve being unable to be satisfied by a more inelastic supply curve.
These shifts, represented on the graph below can be caused by:
- Consumer consumption.
- Investment.
- Government expenditure.
- Surplus in the trade balance.
The aggregate demand increases from AD1 to AD2 that results in increasing the price from P1 to P2 as the aggregate supply (AS) remains unchanged.
2. Cost-push inflation
Cost push inflation is caused by an increase in the costs of production resulting in business’ increasing their prices in order to protect their profit margins. The various reasons for cost push inflation are:
- Increases in labor costs, e.g. trade unions have been held responsible for cost push inflation.
- Cost of materials, such as raw materials (especially imported) and could be related to the exchange rate or inflation in another country.
- Increase in indirect TAXes, e.g. sales TAX such as VAT.
The aggregate supply decreases from AS1 to AS2 that results in increasing the price from P1 to P2 as the aggregate demand (AD) remains unchanged.
3. Growth in the money supply
An excessive increase in the money supply will cause inflation and even produce a state of hyper-inflation; like that seen in Germany during 1923.
The effect of the money supply can be calculated using ‘Quantity Theory of Money’.
This theory is sometimes called The Fisher Formula and is calculated as:
M x V=P x T
Where:
M = Money Supply
V = Velocity of Circulation
P = Price Level
T = Number of Transactions
Assuming that V and T are constant we can determine an increase in the money supply will result in the price level increasing. The rise in price is inflation caused by ‘too much’ money and is a form of demand pull inflation. It is acceptable, if the government introduces controlled increases in the money supply and will be required in economies under going great changes such as China. A
n increase in the money supply increases the amount of money available at banks; leading to an increase in the amount of money which is able to be loaned out. This leads to an increase in spending and an outward shift of the aggregate demand curve.
For example, if an economy has USD$100 (M) in circulation and on average USD$1 changes hands 5 (V) times in one year, it means USD$500 has been spent in one year. If the average price was USD$2.50 (P), then economy must have had 200 transactions (T).
In this example:
M = USD$100
V = 5
P = USD$2.50
T = 200
So:
USD$100 x 5 = USD$2.50 x 200
If the money supply is increased to USD$300, the price level must increase by USD$5 to USD$7.50.
In this following example:
M = USD$300
V = 5
P = USD$7.5
T = 200
So:
USD$300 x 5 = USD$7.50 x 200
Problems caused by inflation
Inflation, the gradual increase of prices over time is seen as a problem particularly if the inflation rate is ‘too high’ (often considered to be more than 3%). The higher the rate of inflation becomes, the greater the problem becomes.
There are numerous problems associated with inflation including:
- Shoe leather costs.
- Menu costs.
- Psychological costs.
- Redistribution costs.
- Lending and saving.
- Unemployment and trade.
1. Shoe leather costs
When inflation is low consumers and firms know what the market price is; thus have a greater degree of consumer sovereignty. Conversely when inflation is higher consumers will have less idea of the market price since perfect knowledge of the market is impossible. During this time, people spend a large amount of time ‘shopping around’ or ‘browsing the web’ in order to find the best deal or price. When inflation is high consumers prefer to deposit their money in a savings account rather than keep cash, therefore they must go to the bank more often. Whether this is physically, through the internet or telephone banking, it still takes more time, as does searching for prices. The time taken searching for the best deal and dealing with banks ‘wears out consumers shoes’; it is an opportunity cost to the consumer.
2. Menu costs
Rising costs due to inflationary pressure mean that firms will have to change their prices. Firms will need to change menus, adverts, price stickers, vending machines and even parking meters. At times of hyperinflation (very high inflation), changes may occur every day, so producing official menu’s and other related signals of prices could become meaningless.
3. Psychological
If prices are increasing it usually has a detrimental effect on people’s attitudes. It is natural to feel that you are worse off than before, even if incomes have increased equal to or more than the level of inflation. For example, prices increase 10%, but income increases 25%, the majority of people would see higher prices in stores and feel worse off, even though the reality is that their spending power has increased.
4. Redistribution costs
Inflation reduces the value of money, so those who are on fixed incomes are affected the most, this is usually those on salary based contracts and private pensions. Additionally, if TAX allowances are not changed individuals pay a higher percentage of income in TAX when they purchase goods and services.
5. Lending and saving
Savings can be damaged by inflation particularly, if the real interest rate is negative (the interest rate provided on savings is lower than the current rate of inflation). However, if you are a borrower, you will find that you will benefit from the actual value of the amount owed (debt) falling; particularly good news if you are paying for a large and expensive durable goods like a house or a car.
6. Unemployment and trade
Inflation increases the costs of production and creates uncertainty. A sombre feeling about the future will lower the level of investment in an economy. Lower levels of investment result in lower economic growth that will have a negative effect on employment levels. Inflation can cause the cost of exports to rise and the cost of imports to fall. All things being equal, the value of currency will not change, so there will be lower international demand for domestically produced goods. This will have several effects on the economy:
- Falling competitiveness with overseas markets.
- Uncertain prices hindering investment and growth.
- The Trade Balance worsening as exports fall
Summary about causes and consequences of inflation
Inflation is a measure of an economy’s price increases over time. It is caused by increases in demand, costs and the money supply.
It can be measured using various different ways such as the Retail Price Index (RPI) and more commonly the Consumer Price Index (CPI).
There are various effects caused by inflation, they can be personal (shoe leather) or effect business (menu costs) or even the whole economy (exports).
