What Causes Inflation To Rise? Does It Matter?

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Introduction

WHAT CAUSES INFLATION TO RISE? DOES IT MATTER? The term inflation is a well known for the effect it has on wages and prices. It is a common perception that inflation is a negative aspect in the economy, however, it is also necessary to remember that although inflation can be a destructive force it is also a requirement in any economy as zero inflation with normally represent zero or negative growth. To understand the effects of inflation and the costs that it might impose on individuals and the society as a whole it is first necessary to understand its causes. Inflation is usually defined as a continuing or persistent tendency for general price level to rise so it could be said that in effect the rate of inflation measures the change in the purchasing power of money1. The important aspects of this definition are concepts continually and general as it refers to rise in the average price level over a period of time. Inflation is a monetary phenomenon where the price level and therefore the value of money that is changing, not the price of particular product and secondly it is an ongoing process, not a one off event. Since inflation refers to changes in the average level of prices, measurement involves consideration of movements in an index referring to the average level of prices.

Middle

Demand-pull and cost-push inflation can occur together, since wage and price rises can be caused both by increases in aggregate demand and by independent causes pushing up costs. The monetarist view is that inflation is due to excessive monetary expansion. Milton Friedman thus summed up this view 'Inflation is always and everywhere a monetary phenomenon in the sense that it is and can only be produced by a more rapid increase in the quantity of money than output'.7 Many of them argue that excess demand or rising costs are symptoms of inflation and not the causes and the theory also holds that there is a strong direct connection between the supply of money and total spending. This means that if the money supply is allowed to grow at a faster rate than the output of goods and services, real GNP, the inevitable effect will be inflation - nominal GNP will be increasing faster than real GNP8. The monetarist theory is based on the quantity theory of money, which holds that changes in the value of money could be explained by changes in the supply of money. Monetarists assume that V (velocity of circulation) and T (total volume of transactions) are constant so that a change in the money supply has a direct and proportionate effect on the price level.

Conclusion

However, this curve is unable to totally rationalise or explain why unemployment and inflation will rise at the same time, it could illustrate and provide statistical support for both the Keynesian theories of inflation, but it could not decide between the two. It was Milton Friedman who developed the theory to account for this in the 'expectations augmented' Philips curve. Further development of monetarist inflation theory followed to include rationale expectations where inflation is no longer treated as being purely a monetary phenomenon. Instead, the behaviour of workers and firms in the real economy, determined significantly by their expectations of future inflation and reactions to current and past inflation, form an important part of the inflation process.12 Inflation cannot be totally controlled, indeed it may be unwise to do so, but it is a strong determinant of the health of an economy. To high is destructive, and to low indicates stagnation. However it is an economic factor, which should be understood in order to be able to project and comprehend the way in which economies work. 1 Griffith & Wall, p501 2 Griffith & Wall, p503 3 Parkin. M, p404 4 Stanlake, G.F. Grant, S.J. p422 5 Parkin. M, p404 6 Powell, R. p346 7 Vane, H.R. Thompson J.L. p127 8 Stanlake, G.F. Grant, S.J. p421 9 Vane, H.R. Thompson J.L. p135 10 Lipsey, G. p498 11 Sloman, J. p545 12 Powell, R p353

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