The inflation rates and upcoming inflation speculation are highlighted more often in the media that it is essential to known certain fundamentals regarding inflation. Inflation describes an increase in the general level of price. Put simply, prices of several commodities including housing, food, apparel, fuel and transportation must be rising for inflation to take place in the general economy. In case price of merely a few types of commodities are increasing, there is not essentially inflation. The measurement of inflation is executed via the Gross Domestic Product Deflator or the Consumer Price Index (CPI) indicator.
The GDP Deflator describes a vast index of the economic inflation whereas the CPI Index describes or measures the alterations in the level of price of a vast basket of the products of the consumer. Inflation can as well as be measured by means of Personal Consumption Expenditure Chain Price Index (PCE Price Index) established by Bureau of Economic Analysis to measure inflation crossways the basket of commodities bought by household. The possible causes of high inflation rate in an economy and identification of and elaboration of the policies a government could adopt for an inflationary economy management form the backbone of this paper.
(i) Demand Pull Inflation
The demand pull inflation (DP inflation) takes place where the aggregate demand (AD) for the commodities within the economy surges more swiftly than the productive capacity of the economy. A single most potential economic shock to the AD could arise from the Central Bank (CB) that swiftly surges the money supply as explained by chart 1 above. The surge in the money supply within the economy shall upsurge the demand for commodities from D0 to D1 as seen in chart 1 above. In the short-term, the business can never substantially upsurge the production thereby holding the supply fixed. The equilibrium of the economy moves to point B from point A as shown above hence the price of commodities will tend to increase, culminating in the DP inflation (Neely 2017).
Where the economy operates at or near full employment, then a rise in the AD culminates in a surge in level of price. As the firms hit full capacity, their response is by means of putting up the prices culminating in inflation. Further, near full employment coupled with shortages of labor, employees can obtain higher wages that upsurge their corresponding spending power. This can be illustrated below:
The increase in the AD can be as a result of any of its constituents C+I+G+X-M. The demand pull is likely to occur where economic growth is overhead the long-run trend rate of growth. The of economic growth’s long run trend describes the average sustainable growth rate and productivity growth determines it. The instance of demand pull inflation in United Kingdom is presented below:
In the 1980s, the United Kingdom witnessed a swift growth in economy. The government of UK cut the rates of interest alongside taxes. The prices of house surged to thirty percent escalating the positive wealth effect and the increase in the confidence of the consumer (Humphrey 2017). This surged confidence culminated in higher spending, reduced saving and upsurge borrowing. Nevertheless, the economic growth rate hit five percent per year-well overhead the long run trend of the UK’s 2.5 percent. The aftermath was an increase in inflation as the firms could no longer meet the demand. It further culminated in the deficit of current account (Bianchi and Ilut 2017).
(ii) Cost-Push Inflation
Cost-Push Inflation (CP Inflation) takes place where inputs price of the processes of production upsurge. Swift wage rise or increasing prices of the raw materials are the common triggers of CP inflation. The high-pitched increase in the imported oil price during the year 1970s avails a typical instance of the CP inflation as shown in chart 2 below:
Increasing prices of energy triggered the producing and subsequent transporting cost of goods to soar. Soared cost of production culminated to a descended aggregated supply (AS) to S1 from S0 and a rise in the general level of prices due to the equilibrium position moving to point Y from point Z.
Where there is a rise in the firms’ costs, then the business tend to pass on such a rise to the final consumers of their corresponding commodities thereby shifting the AS leftwards as illustrated below:
Cost push inflation can be triggered by the following factors;
Where trades union are able to present a united front, the unions will bargain for higher wages. The increasing wages are the key trigger of the cost-push inflation since wages remain the most substantial cost for several firms. Higher wages can as well as lead to rising demand (Cochrane 2017).
A third of the total commodities are imported in the UK. In case of devaluation, prices for imports will be more expensive culminating in a surge in inflation. The depreciation or devaluation implies the worthless Pound. Accordingly, the locals have to pay additional Pounds to purchase the identical imported commodities (Marelli and Signorelli 2017).
From the above diagram, it is observable that UK witnessed an increase in cost-push inflation in the year 2011/2012 partially as a result of Pound depreciation against the euro (further due to surged taxes).
Where firms push their prices up to get spiked inflation rates. This is more probably to take place in the course of strong growth of economy.
This takes place where firms converts to being less productive and permit the cost to surge thereby invariably leading to higher prices.
In case the government impose taxes like VAT or Excise duty, the imposition will culminate in higher prices, and hence, CPI shall surge. Nevertheless, such increase in taxes are probably to be one-off surges. There is even a measure of the inflation (CPI less CT) that disregards the temporary tax surges/plunges.
The CPI less CT remains less volatile as it disregards the influence of taxes. Some of the United Kingdom CPI inflation in 2010 was as a result of increasing taxes.
Increasing prices of houses do not trigger inflation directly, nevertheless, they are able to provoke a positive wealth impact thereby encouraging consumer-oriented economic growth. This in turn trigger demand pull inflation indirectly (Thornton and Vasilakis 2017).
Where the CB prints additional money, an increase in inflation is anticipated. Money supply plays a key role in price determination. With more money chasing few commodities, price will surge. Hyperinflation is often triggered by the extreme rise in money supply unless in liquidity trap or recession where a rise in money supply could just be saved as banks fail to increase lending rather than keeping additional reserves (Zhou, Yu and Li 2017).
Most CBs target low inflation and a rise inflation above the target provokes several policies like monetary, tight fiscal, and supply side policies to reduce the rate of inflation.
(i) Monetary Policy
This focus on higher rates of interest. This increases borrowing cost while discouraging expenditure. This culminates in lower growth of economy and lower inflation. In UK, it is the most significant technique for the low inflation maintenance. It is set by Bank of England’s MPC while adhering to inflation target (2%+/-1) given by the government and utilizes to attempt and accomplish such a target (Bayramoglu and Allen 2017). The first phase is for MPC to attempt and forecast upcoming inflation by looking at several economic statistics and attempt to decide whether or not the economy is overheating. Where inflation is predicted to rise above target, the MPC are probably to raise rates of interest. Surged rates of interest shall assist decrease AD growth in economy (Cochrane 2017). The sluggish growth will in turn culminate in lower inflation. Higher rates of interest decrease consumer expenditure due to:
The above diagram shows a decline in AD to decrease inflation.
(ii) Supply Side Policies
This aims at raising long run competitiveness alongside productivity. For instance, it was expected that privatization alongside deregulation would make UK firms increasingly productive and competitive. Hence, in the long term, supply side policies can assist decrease inflationary pressures. Nevertheless, supply side policies function extremely much in long run; they can never be utilized to decrease sudden rise in rate of inflation. Further, there is never guarantee government supply side policy shall be fruitful in inflation reduction (Babb and Kentikelenis 2017).
(iii) Fiscal Policy
This is a demand side policy identical in impact to monetary policy. It involves government altering tax alongside expenditure levels to influence AD levels. To decrease inflationary pressures, the government raise tax and decrease government spending thereby reducing AD. Other policies include wage control, exchange rate policy, and money supply target or monetarism (Abrams and Butkiewicz 2017).
Conclusion
Possible causes of inflation can be understood through two types of inflation; demand pull- and cost-push inflation. Economist have distinguished two kinds of inflation: demand pull- and cost-push inflation and both kinds trigger a surge in the general level of price within the economy. Put in other words, the main triggers of a sustained upsurge in the level of price are either excess AD (economic growth too swift) or the cost push variables (supply-side factors). Monetary policy, fiscal policy, wage control, exchange rate, monetarism, and supply side policies have been elaborated as the possible means by which government arrest inflationary economy (Humphrey 2017).
References
Abrams, B.A. and Butkiewicz, J.L., 2017. The political economy of wage and price controls: evidence from the Nixon tapes. Public Choice, 170(1-2), pp.63-78.
Babb, S.L. and Kentikelenis, A.E., 2017. International financial institutions as agents of neoliberalism. The SAGE handbook of neoliberalism. Thousand Oaks: SAGE Publications.
Bayramoglu, A.T. and Allen, L., 2017. Inflation Dynamics and Monetary Transmission in Turkey in the Inflation Targeting Regime. Journal of Reviews on Global Economics, 6, pp.1-14.
Bianchi, F. and Ilut, C., 2017. Monetary/fiscal policy mix and agents’ beliefs. Review of Economic Dynamics, 26, pp.113-139.
Cochrane, J.H., 2017. Michelson-Morley, Occam and Fisher: The Radical Implications of Stable Inflation at Near-Zero Interest Rates. In NBER Macroeconomics Annual 2017, volume 32. University of Chicago Press.
Humphrey, J., 2017. Capitalist control and workers’ struggle in the Brazilian auto industry. Princeton University Press.
Marelli, E. and Signorelli, M., 2017. Monetary Policy and the European Central Bank: A Progressive Divorce from the Bundesbank Legacy?. In Europe and the Euro (pp. 45-57). Springer International Publishing.
Neely, C.J., 2017. Chinese Foreign Exchange Reserves, Policy Choices and the US Economy.
Thornton, J. and Vasilakis, C., 2017. Inflation targeting and the cyclicality of monetary policy. Finance Research Letters, 20, pp.296-302.
Zhou, D.T., Yu, H.Y. and Li, Z.G., 2017. Effects of fluctuations in international oil prices on China’s price level based on VAR model. Journal of Discrete Mathematical Sciences and Cryptography, 20(1), pp.125-135.
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