What Causes Inflation To Rise? Does It Matter?
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. There is a wide range of price indices which may be used for this purpose such as the retail prices index (RPI), index of wholesale prices, a set range of commodities, or a general increase in prices including interest rates or indeed any combination of price increases the government chooses to use in the measure of inflation. To measure the inflation the percentage change in the price level is calculated, the higher the percentage the higher the increase. When compiling the RPI certain items will always receive a heavier weighting than others as the cost of a luxury car rising by 50% is unlikely to effect many people yet the 25% increase in the cost of bread will influence the spending and budgets of many more. Once the RPI has been constructed, the rate of inflation is usually calculated for the twelve-monthly periods2. The RPI the headline inflation and RPI minus mortgage interest are further influenced by changes in indirect taxes and have a pivotal role in economy as a target for policy makers as basis for indexing tax allowances and in negotiating pay claims.
Inflation can be classified in at least two ways, with respect to speed and with respect to causation and is often seen as the result of any supply and demand economy. Supply and demand are major determinates in the prices for products and services. Where supply outstrips demands the prices will fall until the level or demand increases and the market reaches equilibrium. Conversely, where demand outstrips supply then the prices will increase until the market place reaches equilibrium. In reality the markets tend to remain in a state of continuous change, but it is this levelling out the price changes reflect. Therefore inflation can result from either an increase in aggregate demand or a decrease in aggregate supply and those two sources of impulses that can trigger inflation are termed as demand-pull and cost-push inflation.
Demand-pull inflation arises from increasing aggregate demand and its main sources are increases in money supply, in government spending financed by borrowing from the banking system or increase in exports. When aggregate demand increases, real GDP and the price level rises; wages than begin to rise and short-run aggregate supply decreases, which raises the price level still further. If aggregate demand keeps increasing, the price level will continue to rise, wages will respond, aggregate demand will increase, and the price-wage inflation spiral ensues3.
The Keynesian demand-pull theory of inflation places the causes of inflation in the real ...
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Demand-pull inflation arises from increasing aggregate demand and its main sources are increases in money supply, in government spending financed by borrowing from the banking system or increase in exports. When aggregate demand increases, real GDP and the price level rises; wages than begin to rise and short-run aggregate supply decreases, which raises the price level still further. If aggregate demand keeps increasing, the price level will continue to rise, wages will respond, aggregate demand will increase, and the price-wage inflation spiral ensues3.
The Keynesian demand-pull theory of inflation places the causes of inflation in the real economy where excesses occur when combined claims on output of households, firms, the government and the overseas sector are greater than the real output that can be produced. Keynesian theory assumes that there will be a maximum level of national output, and hence real income, that can be obtained at any time, but if equilibrium national income exceeds the full employment level of income, the inability of output to expand to meet the excess demand will lead to demand-pull inflation and this excess demand gives an inflationary gap. But the ultimate cause of inflation perhaps lies with the government. In the Keynesian theory the budget deficit may also be the source of excess demand for real output. A high level of consumer demand can also be linked to the role of government as when the government pursues full employment people behave in an inflationary manner both as workers and as voters demanding wage increases in excess of productivity and adding to the pressure of demand by voting for increased public spending and budget deficit.
Keynesians also believe that inflation causes an increase in the money supply, because if the general price level is rising, firms and individuals will borrow more to meet the higher costs and prices, and the resulting higher bank lending will increase the money supply. 4
Cost-push inflation can result from any factor that decreases aggregate supply, and the main factors are increasing wage rates and increasing prices of key raw materials. These sources of decreasing aggregate supply bring increasing costs that lower real GDP and increase the price level. An increase in the money supply to restore full employment increases aggregate demand, which results in a yet higher price level and higher real GDP. If the original source of cost-push inflation repeats, costs rise again and the short-run aggregate supply curve shifts leftward again, the price level rises even higher and the inflation proceeds at a rate determined by the cost-push force. 5The cost-push or structuralist theory of inflation locate the cause of inflation in structural and institutional conditions on the supply side of the economy, particularly in the labour market and the wage bearing process. Cost-push theories argue that the growth of monopoly power in both labour market and goods market is responsible for inflation6 and assume that in the labour market wages are determined through the process of collective bargaining, while in the goods market prices are raised when monopolistic firms add a standard profit margin to their costs when setting prices causing costs of production to rise independently of demand. 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. A raise in the money supply will increase aggregate demand, which in a short run will increase output and employment. This causes money wage to rise, increasing firms' production costs and provoking price increases. At the same time expectations of further price increases are created causing the wage-price spiral. The adjustment process can cause both unemployment and the rate of inflation to increase because of the role of expectations in the inflationary process and the catching up process as workers endeavour to obtain compensation for past losses in real wages due to unexpected increase in the rate of inflation.9
In order to consider the extent to which inflation is a monetary phenomenon the causes and consequences of inflation must be taken into account. Many factors can cause the price level to rise. On the demand side expenditure changes of an autonomous increase in investment and government spending and the monetary changes of an increase in supply of money, or a decrease in the demand of money. On the supply side anything that increases costs of production will cause the price level to rise. Those causes however suggest that temporary burst of inflation need not be a monetary phenomenon and it need not be accompanied by monetary expansion. However the rise in prices must eventually come to a halt unless monetary expansion occurs, which suggests that sustained inflation must be a monetary phenomenon, because if a rise in prices is to go on continuously, it must be accompanied by continuing increase in the supply of money regardless of the cause that set in motion.
While considering the consequences on an inflation it should be noted that in the short run, a demand-shock inflation tends to be accommodated by an increase in national income above its potential level and the supply-shock inflation by a decrease in national income below its potential level, which may suggest that in the short term inflation is not a purely monetary phenomenon. But if all adjustments are fully made shifts in aggregated demand and supply leave national income unchanged and only affect the price level, which would suggest that in the long run inflation is a purely monetary phenomenon.10
Inflation can have consequences in addition to simply the increases in
prices. It will add uncertainty to an economy as the forecasts of income and
expenditure will be less certain to organisations and individuals. This can
result in an unwillingness to spend and as a consequence the growth in the
economy may be stifled and long-term economic growth can be reduced.
Income distribution will also be effected. Inflation redistributes income away from those in a weak bargaining position, and to those who can use their economic power to gain large pay, rent or profit increases. 11 Many individuals may be in jobs, which will receive pay rises in line with a measure of inflation, however there are also many who are reliant on a fixed income such as pensioners. As prices increase these people will effectively be on a decreasing income. Inflation redistributes wealth to those with assets and away from those with savings, tends to encourage borrowing and discourage lending, because debtors gain and creditors lose. There can also be a transfer of income from taxpayers to the government if fiscal drag occurs, which pulls taxpayers into higher tax bracket when their money increase.
Inflation can also affect the import export business as the price if goods
in one country may be increasing at a greater pace than in its competitors.
If the price of goods has increased in the home country then the imported
good may gain a larger market share as their prices are becoming
proportionally lower. In addition the attractiveness of the home countries
goods as exports will decline, as they are more expensive in the importing
nation. It is for this reason that revaluation of a nations currency may be
used as a tool in order to prevent the possible resulting trade and
employment catastrophe as with reduced demand for goods there will be lower employment levels as there will less production needed. This can then enter a downward spiral, which may result in a recession. Then there may be the further effect of this trade impact on the balance of payments figure.
The effects as could be seen radiate to many other aspects of the economy rather than just price. Perhaps the most important is that of unemployment. It has long been recognised that there is a direct correlation between inflation and unemployment, but as must be remembered correlation does not prove causation. However there can be an influence on demand, which will result in the loss of jobs, and it was A.W. Phillips who undertook a long-term examination of unemployment and inflation. In a study, which utilised the statistical figures from the 1860's to the 1950's, he demonstrated that inflation is required in an economy. He developed what is known as the Philips curve which illustrated that inflation and unemployment cannot be reduced to zero, as a choice has to be made where either inflation or unemployment have to be accepted. 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.
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
0 Lipsey, G. p498
1 Sloman, J. p545
2 Powell, R p353
