Inflation is a term that appears quite frequently in the news, especially when it appears that prices of goods and services are increasing day after day.
It is a rather important economic indicator that steps in almost every walk of life-from creating purchasing power to saving, investing, and even broader health of the economy. The essence here is how this inflation could be controlled-that is a question as relevant for the individual as it is for the policy-maker.
What is Inflation?
In other words, inflation is the rate at which the general price level of goods and services in an economy increases over time. Inflation goes by its occurrence; thus, each unit of currency can buy fewer goods and services. That is to say, money has a reduced purchasing power.
Ideally, inflation eats away at the real value of money, bringing forth a situation whereby more money is needed over some time to buy the same items. Inflation is normally measured in price indices such as CPI and PPI.
This tracks the prices of a representative sample of goods and services over time, so allowing a look at changes in the purchasing power and the cost of living.
In such a growing economy, moderate inflation is considered normal and, in fact, beneficial; inflation encourages spending and investing. However, persistent high inflation, that is to say, hyperinflation, destabilizes an economy, subsequently eating away at savings, it creates uncertainty, and discourages investment.
Causes of Inflation
Inflation is basically driven by two major types of forces: demand pull and cost push.
1. Demand-Pull Inflation
That is the situation when demand for goods and services is more than their supply. Imagine an economy where people are spending more on goods and services than companies are producing. This rise in demand will push up prices. A most common situation for this type of inflation is rapid growth in the economy, with a concomitant rise in disposable income among consumers, which increases the demand for products.
2. Cost-Push Inflation
Cost-push inflation is a situation that arises when the cost of production rises, and then a producer raises prices because of having a need to maintain its profit. Such a rise in the cost of production may be due to increased wages, costlier raw materials, or increased tax on the production. For instance, an increase in oil price is an example of the cause of cost-push inflation since it increases transportation and manufacturing costs, and the oil price increase affects most of the goods.
3. Built-In Inflation
This is the type of inflation where wage earners always want higher wages to sustain their lifestyle in view of increased living costs by the day. As a result, business concerns face inflation resulting from higher costs of production, matched by a resultant increase in prices because of the higher wages. The cycle is known frequently as a “wage-price spiral” that incites inflationary tendencies in an economy.
4. Money Supply and Over-issuance of Currency
Quick rate of increase in the money supply may also give rise to inflation. When the money supply issued by a country’s central bank such as the Federal Reserve for instance or the European Central Bank is increased too soon, too many moneys chase too few goods and push up the prices of the goods. Inflation does not occur uniformly.
types of Inflation
Economists classify the different ones according to severity and their effects:
Creeping Inflation
This is the slow gradual drift in prices, considered as manageable and normal in an economy that is growing.
Walking Inflation
Moderation in inflation rates starts eroding buying power and calls for some control measures.
Running Inflation
This is high inflation rate and signals the start of economic instability; there may be urgent need for control measures.
Severe inflation at times exceeds 50% per month. Rates this high can definitely leave an economy in tatters, and the value of the currency can indeed break down completely as is seen in the cases of Zimbabwe and Venezuela.
Effects of Inflation
Some inflation affects the economy. The good influence of inflation is, for instance moderate inflation to get consumers spending or investing rather than keeping cash, which becomes worthless with time, thus boosting economic growth.
There also exists the benefit of inflation to businesses whereby they can raise the prices a little to gradually clear their debts in the “cheaper” dollars. Nevertheless, high or uncertain inflation has mostly been damaging. It ‘eats away’ savings reduces purchasing power and complicates planning.
High inflation will also push up interest rates, thus reducing investment and slowing down growth in an economy. Inflation is very damaging to people who are on fixed incomes, such as retirees, because their purchasing power is decreasing.
How to Control Inflation?
Most of the central banks have controlling inflation as their primary aim. Therefore, there are different measures that help in keeping inflation within manageable levels.
These methods include:
1. Monetary Policy Adjustments
The most common method of controlling inflation is through monetary policy. Central banks can obtain effective control over inflation based upon the changes in interest rates and money supply.
• Higher interest rates: The central banks increase interest rates so that borrowing is expensive and this discourages spending and borrowing thereby reducing the amount of money in circulation in the economy, leading to lower demand and therefore lower inflation.
• Open Market Operations: Central banks can also control inflation by buying or selling government bonds. Selling bonds helps them absorb cash from the economy, thereby reducing the money supply, and subsequently help in curbing inflation. Buying bonds does the opposite that is applied mostly in cases of deflation rather than inflation.
• Reserve Requirements: Central banks may require commercial banks to hold a larger proportion of deposits as reserve, meaning that some of the capability to advance money by commercial banks is tied up to reduce the money supply or dampen inflation.
2. Fiscal Policy Measures
The government can curb inflation by adjusting spending and taxing policies through fiscal measures.
• Decreasing Government Expenditure: Decreasing government expenditure will decrease aggregate demand of the economy to check inflation. Less spending means fewer dollars chasing goods and services, and this may bring down prices.
• Increasing Taxes: Increasing tax raises the disposable income of consumers, which subsequently falls into decline. This method can be very effective in cooling an overheated economy and bringing control over demand-pull inflation.
3. Supply-Side Policies
Supply-side policies aim at increasing productivity and output in the economy; they seek to control cost-push inflation by making it easier and cheaper for firms to produce goods.
• Improving Infrastructure: One of the ways of gaining low-term production costs through investment in infrastructural activities such as transportation and energy as these result in increased goods supply from which control can be managed.
• Encouraging Competition: It is also possible that policies encouraging competition can check inflation. The greater the number of competing firms, the lesser the propensity to increase price, thus controlling inflation.
4. Wage and Price Controls
Besides the above, direct government tries to control inflation by trying to hold down wages and prices through controls over them or maximum limits over wage and price levels so that they do not spin out of control. However, history has again and again justified the fact that such a course of action results in shortages and lower quality; hence, it is adopted only as a short-term solution.
Conclusion
Modulation of inflation is one of the most important functions of an economy, and a well-moderated inflation rate is indicative of a healthy thriving economy. But if left unchecked, it leads to inefficiency in an economy, reduced purchasing power, and lower standards of living.
Hence, it is important to identify causes and types of inflation for effective control measures. Careful monetary and fiscal policy, along with supply-side reforms by policymakers, can manage inflation to create stable or even stronger growth.