Inflation

How to define Inflation?

This can be defined as a sustained rise in the general price levels of goods and services in an economy, over a specified period of time. It is usually measured as an annual percentage of price change. This annual percentage is known as the inflation rate.

Factors that lead to a rise in Inflation:

This is primarily caused by two different sets of factors:

(1) Demand Side Factors
(2) Supply Side Factors

(1)Demand Side Factors:

When the aggregate demand exceeds the aggregate supply, there is a rise in the overall price level. This type of inflation is known as  Demand-Pull Inflation.

Some of the major factors that cause this are:

(a) Expectation of Inflation:
When people expect a higher inflation in the future, there will be a rise in the present actual inflation. Suppose you expect a high inflation in the future i.e. you expect the prices of goods and services to rise in the future. So to avoid the rise in price you will buy the good or service today.

Imagine a hundred people doing the same thing. This will increase the demand for that good or service. Now there is only a limited amount(supply) of that good or service so when a hundred people want the same thing not all of them will be able to get it so they will be willing to pay a higher price to get it as such the price level will increase.

Thus a higher inflation expectation will lead to aggregate demand exceeding aggregate supply and hence an increase in overall price level at present.

(b) An Over-Expansionary Monetary Policy:
When a government has too much debt, then sometimes to repay such debts, it prints new money. As a result, there is too much money in the economy and not enough goods. Hence the price level rises as people are willing to pay more for a good or service. And, hence inflation rises.

(c)  A Discretionary Fiscal Policy:
Suppose the government reduces the income tax. As a result, consumers will now have more money in their hand to spend on goods and services. This, in turn, increases aggregate demand. If the aggregate demand exceeds the aggregate supply then the overall price level will increase.

(2) Supply Side Factors:

When the overall price level rises on account of an increase in the cost of wages and other raw materials, it is known as Cost-Push Inflation.

Some important factors that cause this are:

(a) Oil-Price
An increase in oil price will lead to an increase in petrol prices which in turn will increase the transportation costs. As a result, almost all businesses will experience a rise in the cost of production. The businesses will transfer this rise in the cost of production to the consumers in the form of a higher price. As such the overall price level will increase.

(b) Rise in Wages
A rise in wages will lead to a higher cost for the businesses which in turn will lead to a higher price for the goods and services. As a result, there will be a rise in the overall price level.

(c) Exchange Rate:
A country which allows a decline in the value of its currency in terms of the foreign currency(devaluation) will experience a higher cost of imports which in turn will lead to a  rise in overall price level.

Effects of Inflation on the economy:

It has the following major effects on the different sectors of an economy:

(1) Debtors and Creditors

Inflation leads to a fall in the real value of money and hence debtors have to pay less while creditors will be receiving less than what they had actually lent.

So this situation is good for debtors and bad for creditors.

(2) Salaried Persons:

Salaried persons lose during periods of inflation as their salaries are slow to rise as compared to the pace at which the price of goods and services are increasing.

(3) Fixed Income Holders:

All fixed income holder such as bondholders, pensioners, recipients of transfer payments, etc all lose during this period of sustained rise in prices as they receive fixed payments while the value of money falls with rising prices.

(4) Equity Investors:

Equity Investors gain during this sustained rise in the overall price level.

This is because as prices are rising businesses expand and earn higher profit which is translated into higher dividend payments (higher than the price rise).

(5) Businesses:

During a period of sustained price rise, producers gain on account of profits exceeding the cost of production.

Also, most businesses borrow money and hence during this period they stand to gain.