Money, Value of Money, Inflation and Policy Responses

Topics: Inflation, Monetary policy, Unemployment Pages: 7 (2475 words) Published: June 7, 2013
Money, Value of money, Inflation and
Policy Responses

Inflation: Inflation is a sustained increase in the cost of living or the average / general price level leading to a fall in the purchasing power of money. Causes of Inflation:–There are a few different reasons that can account for the inflation in our goods and services; let's review a few of them. * Demand-pull inflation refers to the idea that the economy actual demands more goods and services than available. This shortage of supply enables sellers to raise prices until an equilibrium is put in place between supply and demand.  

* The cost-push theory , also known as "supply shock inflation", suggests that shortages or shocks to the available supply of a certain good or product will cause a ripple effect through the economy by raising prices through the supply chain from the producer to the consumer. You can readily see this in oil markets. When OPEC reduces oil supply, prices are artificially driven up and result in higher prices at the pump.  

* Money supply plays a large role in inflationary pressure as well. Monetarist economists believe that if the Federal Reserve does not control the money supply adequately, it may actually grow at a rate faster than that of the potential output in the economy, or real GDP. The belief is that this will drive up prices and hence, inflation. Low interest rates correspond with a high levels of money supply and allow for more investment in big business and new ideas which eventually leads to unsustainable levels of inflation as cheap money is available. The credit crisis of 2007 is a very good example of this at work.  

* Inflation can artificially be created through a circular increase in wage earners demands and then the subsequent increase in producer costs which will drive up the prices of their goods and services. This will then translate back into higher prices for the wage earners or consumers. As demands go higher from each side, inflation will continue to rise.

Measuring Inflation-
The assessing of inflation could have been very easy if the prices had risen in equal proportion of the every goods and services, but which was impossible at all as there are different goods and services demanding different money values and purchasing powers. For e.g In 1982-1984 which the United States used as a base year for determining the the price rise of different goods in a specified manner, apparel rose by 24%, price of medical care by 186%, price of housing by 80%, and this way they identified the prices for the goods in the following year to the base year. The price index also plays a very crucial role in determining the average rise in the price for any year in relation to the common base year as it note a price index for a particular good in the base year and differentiate it to any of the following year, which can be very easily defining the growth of rates. The method of measuring inflation by price index is called consumer price index CPI. Consumer price index is defined as the price index which defines how much a typical consumer can purchase. There are separate price indexes for separate bundles of goods and hence average spending of household can also be represented by what type of bundles are purchased by consumer. If the person has its price index Rs.100 for the base year 2009 and in 2010 the price index for that person is 110 then the rate of inflation will be 10%. The alternative way, other than CPI is PPI Producer price index which measures the average level of supply of goods prices sold by producers. Limitations of the Consumer Price Index as a measure of inflation * The CPI is not fully representative:-

* Since the CPI represents the expenditure of the ‘average’ household, inevitably it will be inaccurate for the ‘non-typical’ household, for example, 14% of the index is devoted to motoring expenses - inapplicable for non-car owners. * Single people have...
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