Economics and Finance
An Essay on Inflation

Introduction to Inflation

Economically speaking, inflation can be defined as an increase in the general prices level (Moss, 2007). It is often referred to as the situation where too much money is chasing too few goods. A textbook definition of inflation is much complicated, whereby inflation is often defined as the continuing rise in the general level of prices, such that it costs more to purchase the typical bundle of goods and services that is produced or consumed or both (Thomas, 2006). In such situation, as the average price level is becoming higher, a dollar of equal amount will purchase less than it can in the past. Thus, inflation is sometimes also referred to the case where a decline in the value of the monetary unit (Samuelson & Nordhaus, 2005).

 

Causes of Inflation

Generally, inflation is defined as too much money chasing after too few goods. Thus, the main cause of inflation is due to the increase of money in the economy. This is often the case when the central bank of a nation implements expansionary monetary policy, whereby the government printed more money (often, electronically) to buy over the government bonds. This provides liquidity in the market. Effectively, such an act increases the money supply in the economy. However, if the productivity of a society or a country remains the same, the increase of money supply will create a situation whereby too much money is chasing after equal amount of products or services (Browne & Cronin, 2010). According to the law of supply and demand, the prices of the various products and services in the market should increase – thereby creating inflation in the market place (Samuelson & Nordhaus, 2005).

There can be many other factors leading to inflation. For example, when the exchange rate of a country depreciates, inflation may be created. This is particularly true when the country is highly dependent on imported goods from other countries. When the currency of a country depreciates, it makes it more expensive for the people in the particular country to purchase goods from the other nations (as now it takes more domestic currency to exchange for foreign currency). Thus, the prices of goods will increases, creating inflation in the country whereby exchange rate is depreciating (Baek & Kov, 2010).

Apart from that, inflation may occur when the productivity of a country drops significantly, particularly during war time, whereby the production assets and capital are being destroyed (Moss, 2007). When the total goods produced decrease, but the money supply remains constant, the prices of goods will increase (due to the law of supply and demand in the marketplace).

Not only that, economic growth may also create inflation. As the economy growth, people are more willing to spend and consume as they are experiencing prosperity in the growing economy. As more people are willing to spend, but the amount of goods remains constant (usually, over the short term), inflationary pressure may set in (Moss, 2007). This is similar to the case whereby too many demands from a richer public while the goods available are remaining unchanged in the short term (Baek & Kov, 2010). As a result, the prices of various goods greatly demanded by the public will experience increment in prices. Thus, inflation happens.

 

The Costs of Inflation

It is general that certain groups of people perceive the inflation as bad, because inflation does comes with come inherent costs. Depending on the rate of increase of inflation, the costs of inflation may vary (Samuelson & Nordhaus, 2005). Besides, the costs of inflation may hurt some people more than the others. The following paragraphs will discuss the costs of inflation in more details.

Inflation can hurt the purchasing power of workers that wages are fixed. For example, when the gasoline priced doubled between the years 2002 to 2004, the impact on consumers’ budgets is huge. For this, people with fixed income are hurt more by the inflation if compared to individuals whose wages are rising with inflation. As the general price level has increased significantly, people with fixed wages are hurt as they have lower purchasing power under the inflationary era. As a result, the standard of living for them decreases (Moss, 2007).

Inflation can also create instability in the economic system of a country. High inflationary pressure can create instability in the economy of a country as it tends to distort economic decisions. For example, in the period of escalating inflation, consumers and businesses may buy items that they do not need actually, in order to avoid future price increases. Their decision making process become guided by the expectation of inflation in the future. Should that happen, people may cut down spending on other items to buy those things that they believe prices will increase in the future (Baek & Kov, 2010).

Inflation can hurt the prices of equity, bond and exchange rate. Generally, high inflation is often a bad news for the investors in stock market. This is because high inflation indicates that the economy is overheating and this may in turn cause the Central Bank to increase interest rates to cool of the economy (Moss, 2007). Not only that, high inflation may hurt the bondholders as well. When inflation is high, the existing interest rates on bonds may not sufficient to compensate for the inflation rate in the economy. As a result, the bondholders turn out to be losers under high inflationary era (Browne & Cronin, 2010). Besides, as inflation getting higher and higher, bond prices tend to drop as well, so that the interest rates of the bonds are adjusted to compensate for the higher inflation rate in the economy (Samuelson & Nordhaus, 2005).

 

Mathematical Calculation for Inflation

Although the concept of inflation can be easily defined as the increase in price level, the calculation of inflation is nothing straightforward. In fact, there is no easy equation to memorize, nor is there a single measure of inflation that everyone will agree is a comprehensive and acceptable industry standard. Depending on the index, or the goods or services being measured, different rates of inflation abound (Browne & Cronin, 2010).

There are many ways in which the inflation can be measured. The most popular measure of inflation perhaps is the consumer price index (CPI) or the GDP deflator. To compute the inflation rate, the general price index (PI) for an economy should be computed first. The annual inflation rate then is the percent change in the price index (PI) from one year to the next. Mathematically, it can be expressed as follow (Moss, 2007):

 

 

Issues with Inflation Calculation

There are many issues with measures of inflation as we have discussed above. These issues will be discussed as follow: Technically speaking, inflation can be measured with a fixed-weight or variable-weight basket. Thus, it will not be surprising that by analyzing commodity prices, wages, or prices of services will yield not only different inflation rates, but also varying degrees of response to the environment. Thus, there is no any best measure of inflation rate in the economy. Each inflation indicator may have its respective weaknesses or advantages. For example, the GDP inflation indices cover a broader range of items if compared to the CPI. However, its disadvantage is that it is released on a quarterly basis, while CPI is being released on a monthly basis (Moss, 2007). This is to illustrate that both CPI and GDP inflation measure has their respective weaknesses and advantages.

Another good example can be demonstrated by comparing CPI to producer price index (PPI). Specifically, PPI measures price changes mostly at the wholesale business level and does not include the cost of services. However, more than 50% of the items being measured in CPI include the fastest growing part of the economy – making CPI a more relevant measure for consumers as well as the workers (Thomas, 2006).

 

The Benefits of Inflation to a Country

Depending on the perspective, inflation can be either beneficial or damaging to people in a country. Generally, as we have discussed in several paragraphs above inflation, especially high inflation is bad for the public and the economy. Nonetheless, inflation can be a sought after phenomenon when a particular economy is being threatened by deflationary pressures. This is because deflation is a worse enemy to the economy, which could possibly cause Great Depression in the economy in the future (Samuelson & Nordhaus, 2005).

 

The Danger of Deflation

Deflation is perceived as a dangerous event in the studies of economic. Perhaps that is due to the negative memories of deflation during the Great Depression in US around 1930s. Generally, deflation can be considered as the opposite event of inflation. In simple explanation, deflation occurs when price level decline in an economy (Thomas, 2006). It is generally agreed by economists that deflation can be worse than inflation because deflation can lead the economy into serious recession. This is not hard to understand, as when people expect prices to decrease in the near future, they will delay their spending and consumptions (except those spending on necessities). That is similar for the case of a business owner that intends to make capital investment. By anticipating deflationary pressure in the future, the decision makers will likely to adopt a wait and see attitude until the prices and interest rates decline further in the future. If such a situation happens, a significant drop in aggregate demand in the economy may occur (Moss, 2007). A negative viral feedback loop may be invoked, where weakening demand in the economy leads to even weaker market demand. The weakening of demand may lead to structural unemployment as well as serious declines in wages of the general workers. As many of the people lost their income, a vicious cycle started; causing significant deduction in consumer demand. Apart from the harms due to deflation in US in the 1930s, another great example of the danger of deflation often cited by economists is the economic recession in Japan in the 1990s (Samuelson & Nordhaus, 2005).

 

Conclusion

Generally speaking, deflation or high inflation is a bad thing for the economy. Traditionally, a moderate rate of inflation is perceived to be the best scenario for an economy to growth. Stable prices are best; and the prices are usually considered as stable when the annual CPI rate is falling between 1 to 2 percent. As such, it is generally adopted the inflation targeting policy by the Federal Reserve in setting the monetary policy in the economy. In this writing, we have reviewed the definitions of inflation. It is generally referred to the increase of price level in an economy. It is also discussed on several possible factors that may create inflation in an economy. Not only that, it is also asserted that inflation is often accompanied with a cost to the society. This is particularly true when the inflation is too high – creating hyperinflationary environment that has damages several economy of a country in history. It is also discussed that there are various way to measure inflation, and the most famous one is the CPI. Each and every measures of inflation does have their respective advantages or disadvantages. In the last section, we have discussed that even though inflation may not be a phenomenon favored by the public, deflation is a worse enemy to the economy. This is because deflation may cause Great Depression as what happen in US in 1930s and Great Recession in Japan in 1990s.

 

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