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Inflation Essay

Economies and especially the more wholesome global economy have been going through phases that would be expected in an individual economy. The general trend of any given economy is marked by an indifferent performance phase called trough where the growth is usually static. Improved economic conditions will result into recovery that will be in operation until an optimum is reached. Capacity constraints then come into place and cut down on the rate of growth and push it down back into the static stage.

The period between the optimum and the static phase is called recession. This phase is mostly characterized by inflation. At the moment inflation rates in the world are rising thus prompting us to ask ourselves whether the world economy is in a recession. It is with this thought in mind that this paper delves in to the inflation topic discussing its history, causes, implications and remedy. Overview What is happening at the moment in the global economy is that there has been an increase in the general prices of commodities.

Food commodities have become scarce and petroleum as one of the most valued commodities in the world market is in its highest price ever hitting a record $125 per gallon this month. Other countries in the world have declared the food crisis in their countries as critical as food commodities continue to be scarce. Types of inflation Keynes and other monetarists agreed that inflation was the general increase in prices of commodities without an increase in the real value of money realized through an increase in real wages. Several factors have been brought forward to explain this phenomenon. – Demand pull inflation – Cost push inflation – Built in inflation (Sayers 2006) Demand pull inflation As earlier said the peak of a recovery or good economic performance period is marked by increased production of national output and demand. Further increase in demand without increasing production capabilities results into uncalled and unreasonable increase in the general prices of commodities. After enjoying a good run in the last five years the global economy is coming into terms with the effects of increased demand and purchasing power without addressing production factors.

This greater demand will make firms employ more people in order to output more. Due to capacity constraints, this increase in output will eventually become very small as to fully satisfy the market that the price of the goods will rise. This is what demand pull inflation tries to explain. The increase in demand does not always happen after an economy reaches its optimum but may however happen in other cases such as: Depreciation of the domestic currency in the foreign exchange market- As a result of this, imports become relatively expensive while exports become relatively cheap.

Thus domestic consumers follow the law of demand by purchasing less of the imports and foreigners buying more of the exports, and then aggregate demand will increase considerably. If there is capacity constraint then prices will be moved upwards. Fall in direct taxation- Cutting taxes whether direct or indirect is the same as increasing the supply of money in any given economy. Lesser taxes put more money in the hands of the households who are now more capable of purchasing a real larger amount of goods.

When the fall in taxes and depreciation of the domestic currency combine the real GDP may exceed potential GDP. As shown above other measures that are aimed at increasing money supply drastically without economic reasons for doing so are risking creating inflation. This according to monetarists is the major cause of inflation. The excessive money circulating in the economy as a result will be more than enough to carry out transactions. Positive future economic projections- Households are keen on making their investments and savings pay more in future.

It therefore happens that households will create a high money demand that may result in increased prices as a result of reduced money in circulation. Cost push inflation Another name used to describe this term is supply shock inflation. It usually occurs in the supply side of the income-output equation. What happens is that firms try to increase price levels of their commodities to meet rising high costs of inflation. As observed by Hazzllit (2007) some factors that have been identified as to cause this type of inflation are;

High costs of labor- Wage increments and especially minimum wages specifically adjusted by governments, impact a lot on firms as they are usually not planned. Labor intensive firms will try their best in absorbing the increment but in the long run may be forced to pass the increased production costs to their customers by increasing the prices of their products. It thus happen that labor cost adjustments are closely followed by price adjustments. High costs of imported raw materials- Countries that are more dependent on imports as their main raw materials for their industries are more prone to this than other countries.

Oil as a major economy driver has in recent times reached its highest price ever driving production costs in the world very high at the same time resulting to the general increase in prices in the world market (Barnett et al 2002). As a result there has been an increase in general prices in Australia and the world at large. Increased taxation levels by government- A government may decide to impose higher taxation levels for a particular basket of goods or it may be applied on all products and services. When this happens there is going to be in creased prices as producers will pass the burden to the consumers.

As a result there is going to be a shift in aggregate supply in the short run as a result of reduced demand. However, the extent of this effect is determined by the price elasticity of demand and supply ceteris paribus. Spiraling inflation This is the worst kind of inflation also known as built in inflation or run away inflation. It occurs as the result of rising costs that cause rising prices which again raise costs of production. Greed and future expectations, for the most part, causes this kind of inflation.

The last time that world economy and especially the US suffered the effects of spiraling inflation was after the 1973 Arab oil embargo. The result of that unfortunate situation caused the failure of thousands of businesses and a prolonged record rate of unemployment within our society. The Republicans in government by then called it recession, meaning that the economy was still expanding though at a decreasing rate. Others preferred to call it a depression meaning that the growth in the economy was supposed to be negative. However a precise description of the situation then was hard to come by as the issue was highly politicized.

The end result was lasting price increases of as much as 1,000%, or ten times the cost for the same product. Gasoline was thirty cents per gallon before and escalated to over $3. 00 per gallon. As a very essential economy driver in the economy, the cost of living went considerably up marked by increased general prices. Capitalism that is partly signified by greed enables the existence of a conflicting scenario where workers are ever seeking higher nominal wages from their employers and the employers are bargaining for lower wage levels.

In the end of it all workers and employers do not really get to agree on the level of real wages. Instead, workers attempt to protect their real wages (or to attain a target real wage) and employers their production costs. Thus, if workers anticipate price inflation or have experienced price inflation in the past they will push for higher money wages. Again, as workers gain more real wages their consumption on luxury goods increase. However, if real wages goes down, consumption on the same will decrease creating an excess supply in the market.

If workers are successful in negotiating for higher real wages, there will be higher expenses to be faced by their employers in labor costs. To protect the real value of their profits (or to attain a target profit rate or rate of return on investment), employers then pass the higher costs onto consumers in the form of higher prices. This encourages workers to push for higher money wages ever as they are usually consumers also (Sayers 2001). Anticipated and unanticipated inflation When inflation is expected from year to year, it becomes easy for individuals, government and businesses to correctly predict the rate of price inflation.

This constitutes what is called anticipated inflation. When economic analysts makes us aware of pending price rises then the necessary measures to cushion ourselves are put in place. For example, employees can request for increases in money wages so as to maintain their real wages. To maintain the real value of money one may opt to shift savings into accounts offering a higher rate of interest or into assets where capital gains might outstrip general price inflation. Companies can adjust their prices; banks and other financial institutions can adjust interest rates.

Unanticipated inflation occurs when economic agents (people, businesses and governments) make errors in their inflation forecasts. Actual inflation may end up well below, or significantly above expectations. Costs and effects of inflation Competitiveness- If a country has higher inflation rates than the rest of the world it will lose price competitiveness in international markets. The relative rise in inflation will cost the country its share in the global market as imports will penetrate more easily given that they become cheaper with inflation.

If the exchange rate depreciates, this may help to restore some of the lost competitiveness. This kind of effect is common in cases of demand pull inflation. Inflation and Government The global economy has experienced major inflation phases especially after the famous oil embargo and the economic depression of the early 1930’s after the First World War and the more recent one after the cold war. These kinds of inflations were prompted by methods used to provide (in part) means for conducting the war.

One set of methods can still be replaced by another less harmful that should not necessarily lead to inflation. It is still possible to keep down the amount of money in circulation by financing the total amount necessary through taxation and loans. Increasing money supply through printing is not among the many recommended action by economists. Some economists wrongfully label inflation as a special way of taxing the households which is very misguiding. Inflation is not a method of taxation, but an alternative for taxation.

When a government imposes taxes, it does so deliberately after careful considerations and is a way of exercising full control. It can tax and distribute the burden any way it considers fair and desirable, allotting a larger share of the tax burden to those who are high in the income scale and sparingly taxing those on the lower end of the income scale. But in the case of inflation, it sets in motion a mechanism that is beyond its control. It is not the government, but the price system process that determines the effects it will have on the society.

There is another pointer to the differences between inflation and taxation in that all taxes collected flow into the treasury. But with inflation, the public treasury’s gain is less than what it costs the individual citizen, since a considerable part of that cost is drained off by the profiteers of inflation. Apart from printing money the government is also faced with another option in the face of inflation, domestic borrowing from banks. If the government borrows from the banks, the banks do not grant loans out of their own funds, or public deposits as the banks are not real lenders.

What happens is that they grant the loans out of their excess reserves, in doing so they merely expand credit for the benefit of the government. In other words, they increase the quantity of money substitutes. Controlling inflation Various methods have been proposed to curb inflation though on the greater part market dynamics are responsible for restoring the situation to an equilibrium where money demand equals money supply and these suppress excessive supply of it that bring about inflation. Mishkin (1998) proposes three methods of combating inflation. -monetary targeting -exchange-rate pegging inflation targeting

Exchange-rate pegging Economists proposes that a country’s one way of holding down inflation and keep it low is for central banks to peg their currency to that of a stable, low-inflation country. In some cases, this strategy involves pegging the exchange rate at a fixed rate to that of the other country so that its inflation rate will eventually gravitate to that of the other country, while in other cases it involves a crawling peg or target in which its currency is allowed to depreciate at a steady rate so that its inflation rate can be higher than that of the other country. Mishkin et al 1998) However, this method poses a problem in that the pegging country loses its independence in the money exchange policy formulation. Monetary targeting In many countries, exchange-rate pegging is not even an option because the country or region is too large or has no natural country to which to anchor its currency. They therefore end up adopting another strategy for controlling inflation in the name of monetary-aggregate targeting.

For example, the collapse of the fixed-exchange-rate Breton Woods regime encouraged monetary targeting by many countries, especially Germany and Switzerland starting in the mid 1970s. Inflation targeting One way of pursuing monetary targeting is to follow Milton Friedman’s suggestion for a constant-money-growth-rate rule in which the chosen monetary aggregate, is targeted to grow at a constant rate. As pointed out by Mishkin (1998), no monetary-targeting central bank or economy as such has ever adhered to strict, rules for monetary growth.

Instead, monetary targeting is quite flexible as all monetary targeters deviate significantly from their monetary-growth targets in order to be responsive to short-term objectives. One way of pursuing monetary targeting is to follow Milton Friedman’s suggestion for a constant money-growth-rate rule in which the chosen monetary aggregate, say M2, is targeted to grow at a constant rate. In practice, even among the most avid monetary targeters, a quite different approach has been used though. (Ball, 2007) .

Conclusion We can now conclusively say that the current situation in the global economy is going to face harder times in terms of inflation related problems. Unless individual governments takes the initiative and introduce effective inflation control measures there is no hope that the situation will improve in the near future. The US government as the global economy leader has already put in place measures to ease the situation on her people. Whether these projected good effects will trickle down to other nations is yet to be seen.

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