Inflation

1. Definition

Inflation refers to a general increase in the price of goods and services, or the continuous and considerable increase in general price level.

2. Brief

The opposite of inflation is deflation, which is the general decrease in the price of goods and services. The terminology deflation is usually confused with disinflation that is the decrease in the pace of inflation, yet that does not mean prices are no longer increasing; prices are still increasing but at a decreasing rate. During inflation prices are extremely high and the currency is depreciating severely, meanwhile during deflation prices are extremely low and the domestic currency is appreciating. Inflation has an impact on both the cost of living and the cost of production, computed using the Consumer Price Index (CPI) and the Producer Price Index (PPI) caused by the demand-pull inflation and the cost-push inflation respectively. In the short-run there is an inverse correlation or a trade-off between inflation and unemployment, whereas in the long the theory is perpetuated. The condition where there is high unemployment and high inflation is called stagflation. The problem cannot be alleviated by demand management approaches (Monetary Policy and Fiscal Policy), since the problem originates from the supply-side the solution should also come from the supply-side, other than that it will cause a policy dilemma. Inflation is usually calculated heeding the cost of living hence the CPI is equated on the formula.

Measuring inflation

Inflation is calculated annually using the CPI, which measures the change in the price level at consumer level, measuring the cost of living. it used to determine whether there is an inflation or a deflation, for instance, suppose there is a continuous increase in the CPI annually, it means the cost of living is relatively expensive, which is inflation, whereas suppose there is consistent considerable decline in the CPI it means the cost of living is relatively cheaper, which is deflation.

While the CPI measures the cost of living evaluating the consumer market basket, the PPI measure the cost of production using the market basket of goods only. CPI entails the three classifications of consumer goods, which are non-durable goods; semi-durable goods; and durable goods, whereas the PPI focuses on capital and intermediate goods.

Causes of inflation

Demand-pull inflation

This is a type of inflation caused by an excessive increase in demand that surpasses the supply. Observing the fluctuations of economic activity, this inflation come to existence during prosperity when there is high employment and economic growth, and since most people have a job aggregate demand (spending) severely increases, which is an inflationary practice. This is represented by an increase in the Gross Domestic Product (GDP): where Government spending; consumption spending; and investment spending increase, plus an increase in export earnings. Evidently, an increase in aggregate demand (spending) induces an increase in price level, which is inflation. Nonetheless, during recession or depression where there is a drastic decline in the GDP, prices decreases, which is deflation. Depending on performance of the economic activity, the demand management approaches, Monetary Policy and Fiscal Policy, intervene by applying either the expansionary policies or the contractionary policies.

Cost-push inflation

Cost-push inflation is inflation caused by an increase in the cost production or the PPI. Suppose the domestic cost of production increases the prices of final goods and services will also increase. Factors influencing this are natural disasters; an increase in profit margins; an increase in wages; and a decline in productivity. These costs initiate from the supply-side and for them to be addressed there have to be a response from the supply, other than that it will cause a policy dilemma. For instance, taking into account the inverse relation between the demand for labour and wages, an increase in wages leads to unemployment and intervention from the demand management policies either expansionary or contractionary, fuels or causes even more unemployment. The situation that arises of high unemployment and inflation is called stagflation. Solving this requires for instance an increase in productivity (input-output ratio), wage stability, and reduction in excessive prices with the hope of increasing profits. The decline in production cost leads to an increase in production and employment, while reducing inflation.