Inflation
Inflation is defined as the general increase in the price of goods and services in an economy, usually as measured by the Consumer Price Index and the Producer Price Index. Over time, as the cost of goods and services increase, the value of a dollar will decline because a consumer will not be able to purchase as much with that same dollar as he/she previously could have.
Causes of inflation or Types of Inflation
Demand Pull Inflation – this type of inflation results from an increase in demand for goods and services in the economy. This may be as a result of an increase in the money supply. For example, when the Central Bank reduces the reserve requirement ratio or prints more money to meet demand or repurchase bonds that they previously issued, demand will increase and so too will prices.
Cost Push Inflation – this type of inflation occurs when there are increases in the cost of production or in the cost of factors of production that are used to produce other goods and services.
Imported Inflation – this is when the general price levels locally are determined by the price levels of different countries. This will mean that when we import goods with already inflated prices, these are passed on to the local consumers.
Monetary Inflation – this is inflation that results from an increase in the money supply especially when the economy is at full employment level. Increase in the money supply can result from expansionary fiscal policy and expansionary monetary policy in the form of a reduction in the reserve requirement ratio and the discount rate by the Central Bank and also by the buying of bonds from the public.
Measuring Inflation
Inflation is usually measured by the Consumer Price Index which measures prices of a basket of goods and services purchased by a typical consumer. The inflation rate is the percentage rate of change of a price index over time. For example, if in January 2007, the Consumer Price Index was 202.416, and in January 2008 it was 211.080. Using the CPI formula, the price change for the year can be calculated as follows:
$$ \Biggl ( \frac{ \text{ 211.080 - 202.416 = 4.28 %}}{202.416} \Biggr ) $$
The resulting inflation rate for this one year period is 4.28 percent, meaning the general level of prices for typical consumers rose by approximately four percent in 2007.
Measures to reduce Inflation
Measures to solve for inflation can be either from the demand side or from the supply side. From the demand side, there can be contractionary fiscal and monetary policy and from the supply side, the solution can be in the form of price controls.
Contractionary Fiscal Policy – this will require a reduction in government spending and an increase in taxation. An increase in taxation will lead to reduced consumer spending and a fall in demand for goods and services. Simultaneously a fall in government spending will lead to a fall in aggregate demand in the economy. This will have the effect of reducing price levels and inflation.
Contractionary Monetary Policy – the objective here is to reduce money supply and increase interest rates. Contractionary monetary policy can take the form of an increase in the reserve requirement ratio, a bond sale to the public or an increase in the discount rate. All of these measures will have the effect of reducing the money supply in the economy which is needed for the solution of the inflationary problem.
Deflation
Deflation is defined as a fall in the general price level. It is a negative rate of inflation. Deflation means that the value of money increases rather than decreases. Deflation can discourage spending because things will be cheaper in the future. Deflation can also increase real debt burdens – reducing the spending power of firms and consumers.
Problems with Deflation
Discourages consumer spending – with falling prices, people may delay purchases because goods and services will be cheaper in the future. Therefore, deflation brings with it declines in spending which can cause a recession or a downturn in the economy.
Real wage unemployment – deflation causes a rise in the purchasing power. When this happens, real wage will be above equilibrium wage and will cause a fall in the demand for labour which leads to unemployment.
Increase real value of debt – deflation increases the real value of money and the real value of debt. Deflation makes it more difficult for debtors or borrowers to pay off their loans. Therefore, consumers and firms have to spend a bigger percentage of disposable income on meeting loan and debt repayments.