Inflation & Its Causes and Effects

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Inflation is the rise in the general level of prices. This is equivalent to a fall in the value or purchasing power of money. It is the opposite of deflation.

Measuring inflation

Inflation is measured by observing the changes in prices of goods in the economy using econometric techniques. The rises in prices of the various goods are combined to give a price index that reflects the change in prices of these many goods, where the inflation rate is the rate of increase in this index. There is no single true measure of inflation, because the value of inflation will depend on the weight given to each good in the index. Examples of common measures of inflation include: • consumer price indexes which measure the price of a selection of goods purchased by a "typical consumer". In many industrial nations, annualised percentage changes in these indexes are the most commonly reported inflation figure. • producer price indexes which measure the price of a selection of inputs purchased by a "typical firm". • wholesale price indexes which measure the change in price of a selection of goods at wholesale (i.e., typically prior to sales taxes). • GDP deflator which is used to adjust measures of gross domestic product for inflation.

The role of inflation in the economy

A great deal of economic literature concerns the question of what causes inflation and what effects it has. A small amount of inflation is often viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Inflation may also have negative effects on the economy: • Increasing uncertainty may discourage investment and saving. • Redistribution

o It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and profits which may keep pace with inflation. o Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax. • International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade. • Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.) • Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus. On balance many economists see moderate inflation as a benefit, and so there are a variety of fiscal policy arguments which favor moderate inflation. Central banks can affect inflation to a significant extent through setting the prime rate of lending and through other operations. This is due to the fact that most money in industrialised economies is based on debt (see money and credit money), and so controlling debt is thought to control the amount of money existing and so influence inflation. A government may find some level of inflation to be desirable, particularly in order to raise funds.

Causes of inflation

Inflation may be caused by an increase in the quantity of money in circulation. This has been seen most graphically when governments have financed spending in a crisis by printing money, leading to hyperinflation where prices rise at extremely high rates. Another cause of inflation occurs when there are many people and organisations with enough market power to increase their prices....
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