INFLATION-EFFECTS, MEASURES & CAUSES
According to International Monetary Fund (IMF), Inflation is the rate of increase in prices over a given period of time. Typically, Inflation is a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. However, it can also be more narrowly calculated- for certain goods, such as food, or for services, such as a haircut, for example.
Inflation measures how much expensive a set of goods and services has become over a certain period, usually a year. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time.
Very high inflation and hyperinflation are believed to be caused by persistent excessive growth in the money supply and is the harmful event. Low or moderate inflation may be due to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities.
Effects of Inflation
It affects economies in positive and negative both ways. So, it is related to good and bad both.
- The negative effects include an increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings. If, inflation is rapid enough results in shortages of goods as consumers begin hoarding out of concern that prices will increase in the future.
- Positive effects include reducing unemployment due to stick nominal wage, allowing the central bank greater freedom in carrying out monetary policy, encouraging loans and investment instead of money hoarding, and avoiding the inefficiencies associated with deflation.
- Generally the households’ nominal income, which they receive in current money, does not increase as much as prices; they are worse off, because they can afford to purchase less. It means their purchasing power or real inflation adjusted—income falls. Real income is a proxy for the standard of living. When real incomes are rising, so is the standard of living, and vice versa.
- In reality, prices change at different paces. For instance, the prices of traded commodities change every day; others, such as wages established by contracts take longer to adjust. In an inflationary environment, unevenly rising prices certainly reduce the purchasing power of some consumers, and this loss of real income is the single biggest cost of inflation.
- Inflation can also affects purchasing power over time for recipients and payers of fixed interest rates. For example, pensioners who receive a fixed 5 percent yearly increase to their pension. If inflation is higher than 5 percent, pensioner’s purchasing power falls. On the other hand, a borrower who pays a fixed-rate mortgage of 5 percent would benefit from 5 percent inflation, because the real interest rate(the nominal rate minus the inflation rate) would be zero; servicing this debt would be even easier if inflation were higher, as long as the borrower’s income keeps up with inflation. However, the lender’s real income, of course, suffers.
- High levels of inflation is disastrous, and sometimes countries have to take difficult and painful policy measures to bring inflation back to reasonable levels, sometimes by giving up their national currency. Although high inflation hurts an economy, deflation, or falling prices, is not desirable either. When prices are falling, consumers delay making purchases, anticipating lower prices in the future. For the economy this means less economic activity, less income generated by producers, and lower economic growth.
Most economists now believe that low, stable, and most important predictable inflation is good for an economy. If inflation is low and predictable, it is easier to capture it in price-adjustment contracts and interest rates, reducing its distortionary impact. Moreover, knowing that prices will be slightly higher in the future gives consumers an incentive to make purchases sooner, which boosts economic activity. Many central bankers have made their primary policy objective maintaining low and stable inflation, a policy called inflation targeting.
Measuring inflation
Normally consumers’ cost of living depends on the prices of many goods and services and the share of each in the household budget. To measure the average consumer’s cost of living, government agencies conduct household surveys to identify a basket of commonly purchased items and track over time the cost of purchasing this basket. The cost of this basket at a given time expressed relative to a base year is the consumer price index (CPI), and the percentage change in the CPI over a certain period is consumer price inflation, the most widely used measure of inflation. (For example, if the base year CPI is 100 and the current CPI is 110, inflation is 10 percent over the period.)
Core consumer inflation focuses on the underlying and persistent trends in inflation by excluding prices set by the government and the more volatile prices of products, like food and energy, most affected by seasonal factors or temporary supply conditions. Core inflation is also watched closely by policymakers.
Causes of inflation?
- In an inflationary environment, unevenly rising prices certainly reduce the purchasing power of some consumers, and this loss of real income is the single biggest cost of inflation.
- Long-lasting episodes of high inflation are often the result of loose monetary policy. If the money supply grows too big relative to the size of an economy, the unit value of the currency diminishes; in other words, its purchasing power falls and prices rise. An increase in the supply of money is the root of inflation.
- Pressures on the supply or demand side of the economy can also be inflationary. Supply shocks that disrupt production like natural disasters, or raise production costs like high oil prices, can reduce overall supply and lead to “cost-push” inflation, in which the stimulus for price increases comes from a disruption to supply.
- Expectations also play a key role in determining inflation. If people or firms anticipate higher prices, they build these expectations into wage negotiations and contractual price adjustments (such as automatic rent increases). This behavior partly determines the next period’s inflation; once the contracts are exercised and wages or prices rise as agreed, expectations become self-fulfilling.
How policymakers deal with inflation
The right set of reducing inflation depends on the causes of inflation. If the economy has overheated, central banks, if they are committed to ensuring price stability can implement contractionary policies that rein in aggregate demand, usually by raising interest rates.
Inflation control is done by implementing measures through monetary policy, by central bank that determine the size and rate of growth of the money supply. Some central bankers have chosen, with varying degrees of success, to impose monetary discipline by fixing the exchange rate, tying the value of its currency to that of another currency, and thereby its monetary policy to that of another country. However, when inflation is driven by global rather than domestic developments, such policies may not help.
Central bankers are increasingly relying on their ability to influence inflation expectations as an inflation-reduction tool. Policymakers announce their intention to keep economic activity low temporarily to bring down inflation, hoping to influence expectations and contracts’ built-in inflation component.
(Note- Some parts of this Article are taken from IMF Article.)
FAQ (Frequently Asked Question)
What is Inflation?
Inflation is a rise in the general price level throughout the economy. This general price level is commonly measured by the Consumer Price Index.
What causes Inflation?
Loose monetary policy, unevenly rising prices certainly reduce the purchasing power of some consumers, and this loss of real income is the single biggest cost of inflation. An increase in the supply of money is the root of inflation.
How can we measure Inflation?
There are several ways, but the most commonly recognized is the Consumer Price Index (CPI).
What is CPI?
CPI is a measure of what it costs to buy a basket of goods today compared to what that basket of goods cost in the past.
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