Chapters :

Economic Inflation – 01

INTRODUCTION

Inflation is the general price rise of goods and commodities in an economy. This concept of inflation happens to be the most central concept in macro as well as microeconomics and is the core concept which has a functional and structural relationship with several other concepts like income, demand, employment, monetary policy etc.

It may be one of the most familiar words in economics. Inflation has plunged countries into long periods of instability. Central bankers often aspire to be known as “inflation hawks.”

Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. But it can also be more narrowly calculated—for certain goods, such as food, or for services, such as a haircut, for example. Whatever the context, inflation represents how much more expensive the relevant set of goods and/or services has become over a certain period, most commonly a year.

Inflation meaning

Inflation is the rate at which the general level of prices for goods and services is persistently rising over a period of time. Consequently, the purchasing power of currency is falling over the course.  It indicates a decrease in the purchasing power of a unit of a nation’s currency as the products and services get more expensive. Basically, inflation is the difference between aggregate demand and aggregate supply of goods and services. When aggregate demand exceeds the supply of goods at current prices, there is a rise in the price level. It has a specific effect on the overall economy as a whole and sometimes can lead to long periods of recession or depression in the country.

Inflation and value of money

  • Inflation leads to a decline in the value of money. “Inflation means that your money won’t buy as much today as you could yesterday.”
  • If the prices of goods rise. The same amount of money will purchase a smaller quantity of goods.
  • As money generally loses its value over time, it is important for people to invest the money. Investing ensures the economic growth of a country.

Inflation can be viewed positively or negatively depending on the individual viewpoint and rate of change.

Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets.

People holding cash may not like inflation, as it erodes the value of their cash holdings.

Ideally, an optimum level of inflation is required to promote spending to a certain extent instead of saving,thereby nurturing economic growth.

Causes of Inflation

An increase in the supply of money is the root of inflation, though this can play out through different mechanisms in the economy. Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, by legally devaluing (reducing the value of) the legal tender currency, as money supply increase, the money loses its purchasing power. The mechanisms of how this drives inflation can be classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.

  • High demand and low production or supply of multiple commodities creates a demand-supply gap, which leads to a hike in prices.
  • Excess circulation of money leads to inflation as money loses its purchasing power.
  • With people having more money, they also tend to spend more, which causes increased demand.
  • Spurt in production prices of certain commodities also causes inflation as the price of the final product increases. This is called cost-push inflation.
  • Increase in the prices of goods and services is also a factor to consider as the involved labour also expects and demands more costs/wages to maintain their cost of living. This spirals to further increase in the prices of goods.

Demand-Pull Effect

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy’s production capacity. This increases demand and leads to price rises.

With more money available to individuals, positive consumer sentiment leads to higher spending, and this increased demand pulls prices higher. It creates a demand-supply gap with higher demand and less flexible supply, which results in higher prices. For example when production cannot keep up with consumer demand, higher prices quickly follow.

  1. Increase in govt. expenditure
  2. Rising population

iii.      Black money

  1. Changing consumption patterns
  2. Increased wages
  1. Cost-Push Effect

Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channelled into commodity or other asset markets and especially when this is accompanied by a negative economic shock to the supply of key commodity, costs for all kind of intermediate goods rise. These developments lead to higher cost for the finished product or service and work their way into rising consumer prices. For instance, when the an expansion of the money supply creates a speculative boom in oil prices the cost of energy of all sorts of uses can rise and contribute rising consumer prices, which is reflected in various measures of inflation.

Factors are:

  1. Rise in wages
  2. Increase in Indirect taxes
  3. Increase in administered prices Eg : MSP
  4. Infrastructural bottlenecks
  5. Fluctuation due to seasonal and cyclical Reasons.

Built-In Inflation

Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs/wages to maintain their standard of living. Their increased wages result in higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.

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