December 12, 2010
Inflation in Macroeconomics
The most effective indicator of country’s economic health is its financial state. Financial system not only provides interconnections in economics, but also conducts macroeconomic regulation, and serves as a tool for governments to regulate economic development. For this reason, the activity of executive power in every country is directed towards stability of financial and credit system and overall financial state. In order to ensure the stability, inflation processes must be controlled. It is necessary because inflation results in harmful socio-economic outcomes: inflation leads to deformation of macroeconomic regulation instruments.
Inflation is a process of price level increase in a country, leading to money devaluation. Inflation is a socio-economic occurrence, which appears due to disproportions in production, and is one of the biggest problems of contemporary economics worldwide.
Inflation Definition and Causes
Inflation is a long-term general price increase, inevitably leading to a fall of the purchasing power of money. It is caused by the excess of money in circulation, which is not supported by real products or services (Moss 2007, p. 5). Inflation occurs when the rate of increase in nominal currency amount starts exceeding the rate of increase in national revenue. The effect of money emission of the banking system solves the problem of budget deficit, making money circulation speed exceed real national revenue while its quantity remains unchanged. It presents a non-monetary cause of inflation. Additional non-monetary short-term inflation causes are re-distribution of national revenue, increase in total demand, changes in demand structure, or administrative price level increase by monopolies, oligopolies or state.
Inflation can come from either domestic economy or from external sources. A rise in government value added tax or decisions of the largest utility companies increase production costs and price levels, and are examples of domestic economy inflation source. Inflation coming from external sources can be caused by fluctuations in the exchange rate or unexpected price growth of crude oil (Moss 2007, p. 20).
Besides, there are terms like deflation – a long-term continuous decrease in general price level, and disinflation, a slowdown of inflation increase. Price index and price level are used to measure inflation quantitatively. In practice, inflation is usually measured by the change of consumer price index (Moss 2007, p. 45).
Inflation expectations or expectations of further price level growth are imperative concepts in studying inflation. As Moss (2007) said, adaptive inflation expectations are based on the inflation changes, which happened in the past. Inflation expectation changed consumer behavior of individuals, enhancing further development of inflation. While rational inflation expectations are based not only on the past experience, but also on the analysis of future prices as a result of economic policies. Therefore, inflation expectations shorten and their behavior changes (p. 89).
Types of Inflation
According to Robert J. Gordon, there are three major types of inflation, or so called “triangle model”.
Demand-pull inflation occurs when there is high demand and full employment of resources. It is a result of rapid growth of aggregate demand compared to the level of supply. Thus, the demand for goods and services becomes so high that businesses are forced to raise prices (Moss 2007, p. 94). Demand-pull inflation can be caused by higher demand from a fiscal stimulus, for instance, because of increased government spending or taxation reductions. The cause of exchange rate depreciation reduces export prices and increases import prices. Faster economic growth in other countries is another possible cause of this type of inflation. It provides boost to country’s exports, providing income and increasing spending.
When national companies experience rising costs and increase their prices accordingly to survive on the market, cost-push inflation occurs. Various reasons why costs rise include increase in prices of raw materials or any other components which are used by companies to manufacture goods. It relates to many different industries and can happen due to increasing prices for oil, copper, wood, or any agricultural products.
According to Cencini and Baranzini (1996), rising labor costs may occur when wages rise, for example, when the rate of unemployment is low or when inflation is expected to grow and people try to protect their real incomes (p.73). Therefore, previously described expectations of inflation play a very important role and shape the future of any inflation.
Cost-push inflation can appear also when the government imposes higher indirect taxes, such as increase in fuel duties. As a result, suppliers can increase prices depending on the price elasticity of demand and supply for their goods.
According to Kasun (2008), this type of inflation is caused by adaptive inflation expectations. Whenever employees of a company try to keep their salaries up with growing prices, employers have to raise prices for their products and services in response.
Consequences of Inflation
Lower level of life satisfaction always becomes inflation consequence. The value of savings falls while the level of net earnings decreases, since prices for goods change rapidly and prices for labor change with a delay. In this case government can conduct indexation to adjust income payments in order to maintain the purchasing power of the population (Moss 2007, p.145). However, indexation may not always help, since compensations do not keep up with growing prices and do not cover cut off earnings of the public.
Furthermore, inflation leads to the fall of production, as a result of work incentives decrease, while costs to overcome inflation and unemployment rise (Cencini & Baranzini 1996, p.87).
Nowadays inflation control is one of the priorities and macroeconomic objectives of the world governments. Inflation reduction can be achieved by policies which decrease aggregate demand growth or increase aggregate supply growth. The major anti-inflation policies include monetary policy, fiscal policy, and supply side economic policies (Kasun 2008). Monetary policy implies interest rates increase in order to reduce consumer and investment spending. Fiscal policy can be applied firstly, whenever total demand level is too high. In this situation government either reduces its spending on public goods or welfare payments or raises taxes aiming to reduce disposable income of the public. As for supply side economic policies, they try to maintain low prices for goods and services by increasing innovation, competition, or productivity.
Inflation is a harmful phenomenon of contemporary market economy, which requires government to take immediate necessary actions. However, if the rate of inflation was decreased to a certain extent, a number of negative consequences such as unemployment arise. Every country has their own approaches and experience in fighting inflation, and they cannot be universal, since every economy has its own peculiarities, related to finance, foreign trade or even culture. However, countries pursuing market changes have already succeeded in restraining inflation processes, growing production volume, and increasing the level of life satisfaction.
Cencini, & A., Baranzini, M. (1996). Inflation and Unemployment: Contribution to a New Microeconomic Approach. Routledge.
Kasun, K. (2008). Must-Read Article on Inflation. In GreenFaucet. Retrieved on December, 12, 2010, from http://www.greenfaucet.com/fundamentals/must-read-article-on-inflation
Moss, D.A. (2007). Concise Guide to Macroeconomics: What Managers, Executives, and Students Need to Know. Harvard Business School Press.