a) Explain how economists define and measure inflation. Identify the costs and potentially damaging effects of inflation in an economy. Illustrate your answer with real-life examples wherever possible.?
b) Explain how the government can attempt to control inflation and illustrate the potentially damaging effect that such policies might have on the country’s unemployment rate in the short-run.?
c) Effective communication and presentation?
Inflation is a macroeconomic phenomenon. It is majorly observed in almost all the countries. It is a growing topic of discussion now days. In case of macro economics, we mainly deal with the problems of economic decision making in an aggregate level. It is found that the study of inflation is intuitively related with other macroeconomic issues like unemployment, poverty etc. In our daily life, we can observe that the rate of inflation severely affect the purchasing power of a person. It causes devaluation of money in the bank (Armour, 2006). Doing savings is a huge loss in the economy. Thus it encourages investment purpose. This is a good effect upon the economy. Again in case of Government’s side they have to provide the dearness allowance to the people. Again the price of the goods and services increases (Aucremanne, 2001). We know,
C=Consumption Expenditure,
I= Investment expenditure,
G= Government expenditure
So, as Y = C + I + G, where Y = income
As C, I, G all increase the aggregate expenditure increases. But the income does not increase initially. So, Income is less then expenditures. Thus budget deficit occurs in the economy. Now as ‘I’ increases, investment also occurs in case of capital goods which upgrade the technology of production. This indirectly pushes up the level of production thus increasing the national income. This is the cyclical process of the economy through which a minimum level of inflation is always maintained. When the inflation increases rapidly, suitable policy changes need to occur. Here point to be noted that the monetary policy is solely determined by the central bank authority of the economy. But to properly control the inflation, a proper adjustment in monetary (which is taken by central bank) and fiscal (which is taken by the government) as well as the Balance of payments (Bekaert and Wang, 2010).
Inflation is generally considered to be an increase in the general price level. If we consider an example, we can explain it properly. Suppose an apple costs 10 USD. Now suppose there will be 10% inflation. So the new price of that apple will be now (10+ 10 % of 10) = 10+1 =11 USD. But the income of a person does not increase in that amount. So, the person who bought the apple at 10 USD will have to buy the same in 11 USD with the same amount of income he earns. So what we can see is that the purchasing power of the person’s income diminishes (Camba-Mendez and Kapetanios, 2005).
Depending upon the rapidity of the inflation and obviously considering the magnitude of the economy we can divide them in various ways (Gagnon, n.d.).
Firstly we may consider the general price increase that is the positive inflation often observed in almost every economy (Granville, 2013).
Secondly, there occurs an incidence like deflation, in the economy. It puts a general downward pressure on the price level. That means, deflation refers such a situation where the general price level goes down. Apparently it is good for the common people as diminishing price level make them richer with the existing level of money they could access. But the economy as a whole suffers due to this deflation. For example, as deflation occurs, the laborers of a firm may be happy due to increasing purchasing power, but the entrepreneurs of the companies will suffer as the profit level diminishes. It causes difficulties in the path of generating capital. This lower capital accumulation occurring in the economy makes further capital accumulation in the business process thus making it difficult to expand the company further. This creates unemployment also, as it diminishes the demand for labour (Gupta and Saxegaard, 2009).
Thirdly, there occur hyperinflations sometimes in a few economies. It is a kind of positive inflation. But the magnitude is very high. The rapid pace of inflation which often gets noticed in the third world countries is the way how hyperinflation occurs. There are various reasons behind this occurring of hyperinflation. One of the most important reasons is losing faith of one’s own country’s currency. It implies people are less interested to hold the promissory notes printed by the Government. So they try to exchange them with the foreign currency, as government himself does not honor own currency. So, the supply of the domestic currency increases in the foreign exchange market which causes to deteriorate the price level of the domestic currency due to this excess supply. It has been observed in Zimbabwe in the year of 2008. The rate of inflation was 8 billion %. This amount of magnitude is generally termed as Hyperinflation (Haugen and Musser, 2011).
Fourthly, we consider the situation where stagflation occurs. Here the term “stagflation refers to such a situation where inflation along with a stagnant economic situation is observed. It is majorly a phenomenon of the third world countries. There along with the inflation a lower economic growth is also noticed in those countries (Inflation and unemployment in economies in transition, 2000).
When an economy goes through a stagnation period it is observed that the production level in the economy on an aggregate deteriorates. This is mainly the time for no economic growth or negative economic growth. It causes no new opportunity for generating employment (Jossa and Musella, 1998).
This is the worst situation observed in the economy as there is no usual tools which can cure the issue of stagnation. Generally we use the techniques to control inflation makes unemployment in the economy. Now if inflation occurs along with the already negative growth of the economy then the situation becomes worse as it is really very tough to control them together (Kim and Lin, 2012). The tools to control the stagnancy of the economy more employment should be generated. That is why capital should be accumulated in ample amount as the economy started to grow with the pace of growth of its industrial sector. Now if the industries expand, the demand for labour will create employment which is good for that stagnant economy to achieve economic growth. But if there is huge inflation, the price level deteriorates which causes to shrink the accumulated capital level of the industry (Kolb, 2008). This will cause the contraction of the economy. So we can se that the two situation inflation and stagnation are complementary to each other. So, now if they happen simultaneously the contraction of the economy occurs which challenge the policy makers to make the economy out of this stagflation (Le Bihan and Sédillot, 2000).
There are majorly two ways in which we can measure the economy’s inflation rate. At first the way we consider that how the inflation has occurred or why they have occurred. Depending upon this we can divide the ways of measurement of this inflation (Lehmann, 2011).
Inflation is majorly of two types as par their reasons. Those are –
Demand Pull Inflations and Cost Pull Inflations.
Demands pull Inflations:
When market demand for goods and services is so high compared to its supply it causes an upward pressure on the economy to push up the price from the initial level to a higher level. This is called the demand pull inflation, as the excess demand pull the price of the goods and services so that inflation occurs. This is often observed in the developing as well as developed economy. It causes the economy to face the inflationary pressure in the commodity markets (Mishkin, 2007).
It happens in the economy as the production cost of the economy increases. If the cost of inputs increases, it will cause to increase the production cost. This is majorly happened when the labour union puts intense pressure to the authority to increase their wages (Moffitt, 2014). It will cause the authority to push the economy to increase the price of the goods and services. So that why inflation occurs in the economy. It makes the products dearer to all the customers even whose wages have been increased. Though their purchasing power increases due to increase in their own income, still they suffer as the inflation caused by them lowers their purchasing power making them poorer (Novak et al., n.d.).
It has been observed in the UK that Consumer Price Index is considered to be the official measure of inflation. It is based upon Harmonized Consumer’s Price Index. It includes tax but excludes the mortgage payments. It also takes under consideration few of financial services which are generally being out of the RPI estimation (Risa, n.d.).
CPIH:
It majorly depends upon CPI. But the cost of housing payments and the payments regarding mortgages are considered as CPIH. The weight of the CPIH account is the OOH i.e. Owner Occupiers Cost. Among them the interest payments in the mortgages are major house hold expenditures which acquires a major part of the Owner Occupiers Cost (Smith, 2009).
CPIY:
This is a major tool of measuring the inflation, but it excludes the impact of the indirect taxes. For example, the Value added taxes and the excise duty is excluded from this measure (Svensson, n.d.).
CPI-CT:
It is mostly like CPIY. The only way they differ from each other, is that in case of CPI-CT the rate of the indirect taxes are assumed to be constant overtime (Tillmann, 2013).
Core Inflation:
This measure is generally used in case of food inflation. It majorly strips away the up-downs of the price level of the commodities. The basket of goods taken under consideration in case of this measure is very smaller compared to the others (Warne and Vredin, 2006).
It is another measure of inflation. But it majorly takes into account comparatively more bundles in case of the economy we consider for measuring the inflation rate.
It also normalize the price value of the national production of goods and services so that we can understand the real value of them and take the proper policy to increase that, as the increasing amount due to inflation is worthless, not needed for any economic decision making. What only needed is the real value of goods and services which is properly measured by Gross Domestic Product Deflator, for the economic decision making, by just sucking away the inflationary rise in the price level.
It is mainly the economic measure used earlier as an important tool for measuring inflation. RPI changes more rapidly than that of CPI. Many factors were used to be included in this measuring tool. It causes the economy to specify the economic findings to ensure the inclusion of the factors like cost of housing, the council tax, the interest payments in mortgages etc.
It is quite similar with CPI but not exactly the same with that of CPI. It is mainly the retail Price Index. But the interest payments of the mortgages are excluded in case of the RPIX.
It is the retailed Price Index too. But the geometrically calculated mean is internationally more recognized.
So we can observe above that there are ample no. of measurement tools to calculate the rate of inflation prevailing in the economy. The most important tools have been discussed here in the above analysis. Most of the existing economies of the world use the above techniques. They measure and evaluate the inflationary pressure on their own economies by the above tools taking under consideration. They take various new monetary policies to make relieve the economies from that existing inflationary pressure as they make them poorer with comparatively less increased level of national income, as it makes them poorer with the same money, but with lesser monetary values. This is majorly the problem of the developing economies of the third world countries.
There are different types of costs incurred due to the existence of the inflation. At first we divide inflation as par its occurrence. It is majorly divided as expected inflation and unexpected inflation.
The costs of expected inflation have been discussed below.
If people would anticipate that the economy will be going through the phase of inflation, it means to them that the cost of holding money is going to increase day by day in the near future. So, he will try to maximize his utility by keeping the money in th bank, as holding money in hand gives nothing, while putting it in bank will give a small amount of interest. So, they increase the no. of withdrawals thus making it more regular to visit the nearest bank so that it will cause him to get retarded the sole of his shoe. Thus the cost of growing no. of trips is called Shoe leather cost. It not only increases for a particular person but it increases for the economy as a whole. This is a very important cost of expected inflation.
It is one of the major costs incurred due to inflation. If price of the inputs increases it causes cost push inflation. If price of the goods and services increases, it results from the demand pull inflation. Both of them increase the price of the foods in the restaurants. It makes them too frequently change the catalogs of the foods as their price changes frequently. This costs are called menu cost which is the results of inflation.
Suppose the real value of a good is P/P0. When inflation occurs the price becomes P/P1 where P1> P0. So we see that though the nominal value of the good does not change, the relative price of it changes so much so that the people feel themselves poorer while availing the good after inflation.
The tax imposed on the people is not considered into the inflation. But increasing the slab of it also creates a pressure on already inflation existing economy, making the purchasing power of the people lower as to compare the economy without the inflationary pressure. It will be the people in the economy who suffers from this issue while tax is imposed on them as the slabs of the tax rate does not consider the inflationary pressure persisting on the economy.
Now we will discuss the tax burden occur in case of anticipated inflation.
Unanticipated inflation damaged the economy in various ways. One of them is arbitrarily redistributing income of the people among the economy as a whole. For example, in case of long term loan, a certain amount of inflation is anticipated this is taken under consideration. But the economy as a whole suffers for it. The reason is that the anticipation varies with the actual rate of inflation. If it creates inflation in the economy more than that is anticipated, it will make the creditor benefitted as he has to pay fewer amounts in the money value terms than that he would have to pay. If the inflation rate would not be as high as anticipated, the debtor will be beneficial as he would receive the amount more than he was supposed to receive, in value terms.
The people will be suffered who gets fixed pensions. Here point to be noted that the pension is not fully sponsored by government. It is a deferred earning by the patients so he or she will suffer if the inflation occurs more than what is anticipated when he was doing jobs. It will be made sure that he will be getting lower purchasing power with that same level of deferred earnings due to this unanticipated income.
There are different policies which can be adopted by the government to control the rate of inflation persisting in the economy. But it majorly depends upon the economic condition of a particular country. It varies from country to country depending upon the nature of the development of the various countries.
By this way government want to control the money supply actually. There are majorly three ways to execute the policies.
One is to increase the interest rate by the central bank of that particular country at which banks borrow from the governments. It compels them to increase the rate at which the y lend money to the common people. It makes the supply of money lower for the economy.
There are terms named ‘reserved requirement ratio’ at which the commercial banks have to put money to the central banks. Now if central bank increases the ratio, the money for borrowing by the common people from the commercial banks eventually decreases.
If the rate of interest paid in case of bonds gets increased it makes the investors to buy those bonds. In this way the excess money are sucked away from the market to control the inflation.
There is a very crucial relation between inflation and unemployment which gets hampered by the different policies taken by the governments. The tradeoff between inflation and unemployment is generally measured by the Phillips curve. The policies taken to control the inflation induces unemployment so that we have to make balance between these two issues. That is why it is observed in the economy in the short run that a natural level of unemployment always persists. If people can anticipate the upcoming inflation then to retard the growth of unemployment is to actualize the anticipated income.
Unemployment rate = natural rate of unemployment – a (Actual inflation – expected inflation)
This is the short run relation between unemployment and inflation which has been represented in the form of equation.
References:
Armour, J. (2006). An evaluation of core inflation measures. Ottawa: Bank of Canada.
Aucremanne, L. (2001). The use of robust estimators as measures of core inflation. Amsterdam: De Nederlandsche Bank.
Bekaert, G. and Wang, X. (2010). Inflation risk and the inflation risk premium. Economic Policy, 25(64), pp.755-806.
Camba-Mendez, G. and Kapetanios, G. (2005). Forecasting euro area inflation using dynamic factor measures of underlying inflation. Journal of Forecasting, 24(7), pp.491-503.
Gagnon, J. (n.d.). Inflation Regimes and Inflation Expectations. SSRN Journal.
Granville, B. (2013). Remembering inflation. Princeton, New Jersey: Princeton University Press.
Gupta, S. and Saxegaard, M. (2009). Measures of underlying inflation in Sri Lanka. [Washington, D.C.]: International Monetary Fund.
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Inflation and unemployment in economies in transition. (2000). Economic Modelling, 17(3), p.337.
Jossa, B. and Musella, M. (1998). Inflation, unemployment, and money. Cheltenham, UK: E. Elgar.
Kim, D. and Lin, S. (2012). Inflation and Inflation Volatility Revisited. International Finance, 15(3), pp.327-345.
Kolb, R. (2008). Encyclopedia of business ethics and society. Thousand Oaks: Sage Publications.
Le Bihan, H. and Sédillot, F. (2000). Do core inflation measures help forecast inflation?. Economics Letters, 69(3), pp.261-266.
Lehmann, E. (2011). A Search Model of Unemployment and Inflation*. The Scandinavian Journal of Economics, 114(1), pp.245-266.
Lehmann, E. (2011). A Search Model of Unemployment and Inflation*. The Scandinavian Journal of Economics, 114(1), pp.245-266.
Mishkin, F. (2007). Inflation dynamics. Cambridge, Mass.: National Bureau of Economic Research.
Moffitt, R. (2014). Unemployment benefits and unemployment. IZAWOL.
Novak, J., Crone, T., Mester, L. and Khettry, N. (n.d.). Core Measures of Inflation as Predictors of Total Inflation. SSRN Journal.
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Smith, G. (2009). The missing links. [Toronto, ON]: C.D. Howe Institute.
Svensson, L. (n.d.). Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets.SSRN Journal.
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