Inflation Inflation is a type of instability which can compromise economic growth and bedevil policy makers. It can mask true change in the economy and make the value of currency decline to the point of worthlessness. It can destroy confidence in one’s government and in oneself.

Inflation Definition: A rise in the price level (the compilation of the prices of all goods and services in the economy in the form of a price index) over time. Generally inflation is measured from month to month and also year over year which is the more important measurement. Change in price level is usually measured in producer and consumer indices.

How to figure inflation Inflation is figured as the rate of increase expressed as a percentage in the general price level from one year to the next. The rule of 70 can be used to approximate how long it will take inflation to double the price level or halve the value of the currency. For example: if price level rises at an average of 3% then in about 23 years price level will double. If inflation is 10% then price level will double in 7 years. Simply divide the percentage change average into 70 to get doubling time. This works for any percentage change you want to assess for doubling time including money that you may have invested in banks.

Deflation Deflation is a decrease in the general price level over time. Deflation is almost always accompanied by recession or depression in the modern era. It may also be the result of increased productivity or the acquisition of new resources which both lower the per unit cost of production. However, deflation increases the value of the currency, lowers real wages, and tends to be not liked by governments which prefer inflation since deflation lowers revenues.

Causes of inflation Demand Pull inflation: Is the result of excessive total spending in the economy. Increases in total spending do not increase the price level when spending in in Range 1 and the UE rate is high. As the economy nears the FE output in Range 2 some inflation begins to reduce the gain in real GDP.

Causes of Inflation If and when an economy enters Range 3 all increase is the result of price level change and none of the increase is the result of output increase. This is because the economy is already operating at or above full employment and has no way to produce more goods and services. As too many people are employed and too many resources are used to produce what can be produced,…

Causes of Inflation …competition for factors of production pushes up the costs and results in producers increasing all price levels to keep profits. As prices increase labor will demand higher wages which in turn sets off another round of price increases. The danger of demand pull inflation is that is will cause a wage/price spiral and become hyperinflation.

Cost Push Inflation This is also known as supply side inflation. Price level rises as per unit production costs increase: some possible causes of cost push inflation could be union strength in negotiating wage rises or supply shocks which occur when raw material resource prices increase without warning

Difficulties in interpretation It may not be easy to distinguish between the two types of inflation especially if you are going to design a policy or process to contain or reduce it. However, cost push inflation will usually die out in the recession which accompanies it as demand by producers for the raw materials decrease reducing price pressure on producers and if total spending doesn’t increase.

difficulties So what this means is if government attempts to fight the recession caused by supply shocks with stimulus spending, this can amplify the cost push inflation and deepen the recession.

Anticipated Inflation Anticipated inflation is that which is accounted for by economists, lenders, and government. That is, it is EXPECTED inflation, and as such is usually incorporated into interest rates and other areas prior to its advent. Generally, lenders do not lose out to anticipated inflation nor do revenue seekers in government, nor do producers or consumers who are able to prepare.

Effects of inflation However, even with anticipated inflation there are consequences. Redistributive effects: Fixed income groups will lose real income as their nominal income will not rise with inflation Savers will be hurt by UNANTICIPATED inflation because interest rates will not reflect any “inflation” premium”. Inflation premium is the amount interest rates are raised to cover anticipated inflation.

Effects of inflation cont. Debtors (borrowers) can be helped by inflation. It reduces the value of dollars they are paying back without changing the nominal amount they owe. Creditors will be hurt by inflation if they have not anticipated it by adding an inflation premium to their lending rates. Generally, the effects of inflation fall disproportionately on lower income earners.

NEW CONCEPT !!!!!!!!! Interest rate come in two varieties: Nominal Interest rate: small i subscript n Real interest rate: small i subscript r The real interest rate is equal to the nominal interest rate minus inflation. Since interest rates drive Ig, real interest rates are important to how GDP grows and, perhaps, in the business cycle.

Contrariness and inflation Deflation will have many of the opposite effects of inflation. However, this is not the merry picnic you might expect. Generally, deflation is accompanied by recession or abnormally slow growth. Because price level falls even growth in output may bring lower real GDP and lower real GDP per capita in certain situations.

Contrariness cont. Inflation is an arbitrary master. It will affect people differently depending on their personal situation. There is no one quick fix for inflation. In the US the most effective brake on inflation has been to induce a recession through use of high interest rates to kill spending and investment in capital goods. While this will kill inflation it also kills growth.

Output and inflation If cost push inflation occurs it may cause output (production) and employment to decline Mild inflation (up to 3%) is generally considered under control and in fact governments like mild inflation. However, it may undermine real income growth and real output growth. And it does depreciate the value of the currency.

Dangers of inflation Development of hyper inflation must always be watched for. This out of control spiral has occurred in the past especially in post war situations. Weimar Germany is the best known example although Hungary after WWI is also instructive: the price level rose to 828 octillion (1 followed by 28 zeros) pengős to one prewar pengő. More recent examples can be found in Zimbabwe and other small nations.

One final look at instability Does the stock market cause or indicate instability in the capitalist economy? Yes and no. Consumer spending rises when people’s assets increase in value and decreases as assets decrease in value. This is a small effect normally. Also there is some effect on Ig as well. If stock share prices move up, more people will invest in the company giving it more capital for investment purposes. The reverse is true if it falls in value. These are tenuous causes to be sure.