Introduction
Inflation measures how expensive a particular category of goods and services has become in a certain period, usually a year. It is a rate of increase in commodities prices over a certain period. It is usually measured broadly, such as the increase in the cost of living or the overall increase in prices. On the other hand, it can be calculated more specifically, such as the prices of certain goods and services. Irrespective of the context, it is representative of how much more expensive a certain category of goods and services has become over a particular period. Inflation has both negative and positive impacts on the economy, including decreased purchasing power, reduction of unemployment, and increased spending and investments.
Causes of Inflation
Inflation is caused by various factors that include the outcomes of lax monetary policies. For instance, if the supply of money becomes larger than the economy’s size, the currency’s value goes down. In this situation, the purchasing power decreases even as prices keep increasing. The relationship between the size of the economy and the supply of money is known as the quantity theory of money.
Moreover, pressures can also exist on the demand or supply side of the economy, leading to inflation. Phenomena such as natural disasters cause supply shocks that harm production, leading to increased production costs. They might result in high oil prices, which reduces the supply rate, leading to cost-push inflation, where the disruption in supply causes price increases. A good example is the fuel and food inflation that affected the global economy in 2008 (Oner, n.d.). In this case, fuel and food prices were transferred among countries by international trade.
Demand shocks are also another factor that causes inflation. They can be stimulated by expansionary policies of a country’s central bank by lowering interest rates or when a government increases spending, leading to economic growth and a boost to overall demand. However, if the increase in demand surpasses the production capacity of an economy, it can cause a strain on resources, leading to demand-pull inflation. Policymakers need to strike the correct balance of boosting growth and demand without overly stimulating the economy to cause inflation.
Finally, the expectations of various stakeholders in an economy might also result in inflation. If corporate organizations or individuals have higher expectations of higher prices within an economy, they portray these expectations in contractual price adjustments and wage negotiations. It is a type of behavior that greatly influences how the next cycle of inflation will look after increased wages or contracts exercised as agreed. People base their expectations on what has happened in the past, leading to inflation patterns.
Problems of Inflation
Inflation is a problem because it affects the purchasing power of households and can also be disastrous to a country’s economy. A household’s nominal income does not increase at the same rate as prices. It becomes worse off because increased prices erode its purchasing power while income remains the same. It, therefore, means that the household can only afford to purchase less due to diminished purchasing power. Its standard of living is influenced by its real income, meaning that it would be low due to a stagnant income. Prices of commodities change daily and at different rates instead of wages that take much longer. In an environment characterized by inflation, prices that rise unevenly will reduce the purchasing power of some consumers, which erodes their real income.
Inflation can also create distortions in the purchasing power of payers or recipients of fixed interest rates. For example, pensioners receiving a fixed interest rate might lower purchasing power if inflation becomes higher than the fixed rate. Similarly, borrowers paying a fixed interest rate would have difficulty servicing their debt if inflation becomes higher than the fixed rate.
Impact of Inflation on the Economy
Inflation has both negative and positive effects on the economy. The most significant effect of inflation is that it reduces the currency’s purchasing power because of price hikes across the economy. When the prices of a basket of goods and services, which are difficult to substitute, rise, they decrease purchasing power.
Inflation also positively impacts the economy because it encourages people to invest and spend more. People will tend to buy goods due to impending inflation and decreased purchasing power. People will buy early before their cash loses value and stock up on goods that will not value, such as stuffing the freezer or filling up the gas tank. Increased capital investments in business circles might not have been possible under different circumstances. Some investors might buy precious metals or gold during times of inflation to neutralize its effects on their investments. Also, equities are used to shield investors against the effects of inflation.
However, the urge to invest and spend in the face of inflation stimulates more inflation that can be catastrophic. When individuals and businesses spend more to reduce the amount of time they can hold on to their currency before it depreciates, the economy is flooded with money nobody wants. It means that the supply of money exceeds, by far, its demand, making the price of money fall at a faster rate. The situation becomes catastrophic when there is a tendency to stockpile goods rather than keep money, leading to hoarding incidences, resulting in empty store shelves. People are desperate to offload their money, leading to a frenzy of spending activity when they get their pay.
Inflation is also known for pushing down the unemployment rate. The rate at which wages change is much slower in response to economic shifts. The downward wages stickiness is usually attributed as the main cause of the great depression. It increased unemployment because workers did not want pay cuts leading to mass firings. The same situation can work in the opposite direction through wages’ upward stickiness. It means that when inflation reaches a certain level, the payroll costs for employers fall, making them able to hire new employees.
Therefore, there is an inverse correlation between inflation and unemployment, referred to as the Phillips Curve. However, as unemployment falls, employers are compelled to pay new workers more because of their skills (Floyd et al., 2021). As wages become higher, consumer spending power also increases, making the economy become overheated and stimulating more inflation, a situation known as the cost-push inflation.
The History, Evolution and Importance of Inflation and Unemployment
The great inflation defined the macroeconomic events of the mid-twentieth century. It lasted for nearly twenty years and led to the abandonment of the established monetary system during the WW2 period. There were two serious energy shortages, four recessions, and the implementation of price and wage controls during this time. The great inflation also brought a positive change in the macroeconomic theory, which is used today to guide the monetary policies of central banks around the world.
In 1964, inflation was measured as more than 1% per year and stayed there for the next six years. However, it began spiking upwards from the mid-1960s to nearly 14% by 1980 (Brian, 2013). After that, it began declining and stabilized at around 3.5 % (Brian, 2013). The great inflation had its origins in policies that allowed the supply of money to be excessive. After WW2, the Employment Act of 1946 promoted maximum purchasing power, employment, and production. The Keynesian stabilization policy was used in the post-WW2 era to deal with the high unemployment rate by managing aggregate spending, taxation and spending policies (Brian, 2013). Central banks still use this policy to stabilize economic activities and manage spending. However, this policy had an erroneous assumption that there was a direct relationship between inflation and unemployment. It assumed that higher inflation rates could neutralize low unemployment rates.
Conclusion
In short, inflation should not be regarded as a negative phenomenon because it also positively impacts the economy. The major negative impact that inflation has on the economy is that it reduces a currency’s purchasing power which subsequently increases the cost of living and lowers the standard of living of households. However, it plays an important role in reducing unemployment and increasing spending and investments. These positive characteristics of inflation have a major impact on the economy and have the ability to stimulate growth. Since it stimulates spending and investments, inflation leads to economic growth more so because its negative correlation with unemployment increases the employment rate to spur growth in the economy.
References
Brian, M. (2013). The Great Inflation. Federal Reserve History. Web.
Floyd, D., Boyle, M. & Schmitt, K. (2021). 9 Common Effects of Inflation. Investopedia. Web.
Oner, C. (n.d.). Inflation: Prices on the Rise. International Monetary Fund. Web.