Inflation measures the average price change in a basket of commodities and services over time. Inflation refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc.
Inflation is indicative of the decrease in the purchasing power of a unit of a country’s currency.
Inflation occurs when spending on goods and services outstrips production. Prices can rise because of supply constraints that increase the cost of producing goods and offering services, or because consumers, enjoying the benefits of a booming economy, spend their excess cash faster than producers can increase production. Inflation is often the result of some combination of these two scenarios.
Effects of Inflation
Erodes Purchasing Power: An overall rise in prices over time reduces the purchasing power of consumers, since a fixed amount of money will afford progressively less consumption.
Hurts the Poor Disproportionately: Lower-income consumers tend to spend a higher proportion of their income overall and on necessities than those with higher incomes, and so have less of a cushion against the loss of purchasing power inherent in inflation. This is what economists mean when they note that lower incomes correlate with a higher marginal propensity to consume.
When High, Feeds on Itself: But when the inflation rate sharply accelerates and stays high, expectations of future inflation will eventually begin to rise accordingly. As those expectations rise, workers start demanding larger wage increases and employers pass on those costs by raising prices on output, setting off a wage-price spiral.
Raises Interest Rates: Governments and central banks have a powerful incentive to keep inflation in check. Policymakers can raise the minimum interest rate, driving borrowing costs across the economy higher by constraining money supply.
Lowers Debt Service Costs: While new borrowers are likely to face higher interest rates when inflation rises, those with fixed-rate mortgages and other loans get the benefit of repaying these with inflated money, lowering their debt service costs after adjusting for inflation.
Lifts Growth, Employment in the Short Term: In the short term, higher inflation can lead to faster economic growth. Elevated inflation discourages saving, since it erodes the purchasing power of the savings over time. That prospect can encourage consumers to spend and businesses to invest. As a result, unemployment often declines at first as inflation climbs. Historical observations of the inverse correlation between unemployment and inflation led to the development of the Phillips curve expressing the relationship.
Can Cause Painful Recessions: The trouble with the trade-off between inflation and unemployment, is that prolonged acceptance of higher inflation to protect jobs may cause inflation expectations to rise to the point where they set off an inflationary spiral of price hikes and pay increases, as happened in the U.S. during the stagflation of the 1970s. [Stagflation is the simultaneous appearance in an economy of slow growth, high unemployment, and rising prices]
Hurts Bonds, Growth Stocks: Normally, bonds are lower-risk investments providing regular interest income at a fixed rate. Inflation, and especially high inflation, impairs the value of bonds by lowering the present value of that income. Growth stocks, which tend to be more expensive, are notoriously allergic to inflation, which discounts the present value of their future cash flows more heavily, just as it does for high-duration bonds.
Boosts Real Estate: Real estate has historically served as an inflation hedge, since landlords can protect themselves against inflation by raising rents, even as inflation erodes the real cost of fixed-rate mortgages.
In theory, there are a variety of tools to control inflation including:
Monetary policy – Higher interest rates reduce demand in the economy, leading to lower economic growth and lower inflation.
Control of money supply – Monetarists argue there is a close link between the money supply and inflation, therefore controlling money supply can control inflation.
Supply-side policies – policies to increase the competitiveness and efficiency of the economy, putting downward pressure on long-term costs.
Fiscal policy – a higher rate of income tax could reduce spending, demand and inflationary pressures.
Wage/price controls – trying to control wages and prices could, in theory, help to reduce inflationary pressures. However, they are rarely used because they are not usually effective.
Monetary Policy and Controlling Inflation:
In a period of rapid economic growth, demand in the economy could be growing faster than its capacity to meet it. This leads to inflationary pressures as firms respond to shortages by putting up the price. We can term this demand-pull inflation.
In response to inflation, the Central bank could increase interest rates.
Higher interest rates make borrowing more expensive and saving more attractive.
Homeowners will have to pay increased mortgage payments, leading to less disposable income to spend.
Therefore households will have less ability and incentive to spend
Also firms will be deterred from borrowing to fund investment, leading to lower business investment.
Therefore, higher interest rates are quite effective in slowing down consumer spending and investment, leading to a lower rate of economic growth. And as economic growth slows down, so does inflation.
A higher interest rate should also lead to a higher exchange rate (higher interest rate attracts hot money flows) The appreciation in the exchange rate will also reduce inflationary pressure by:
Making imports cheaper. (There will be lower price of imported goods, such as petrol and raw materials)
Reducing demand for exports and therefore lower total demand in the economy.
Because exports are less competitive, exporting firms will have an incentive to cut costs and improve competitiveness over time.
Fiscal Policy and controlling Inflation:
To reduce inflation, the government can increase taxes (such as income tax and VAT) and cut spending. This improves the government’s budget situation and helps to reduce demand in the economy.
To combat inflation, the government could use contractionary fiscal policy. In this case, it might raise taxes and decrease government spending in an attempt to reduce the total level of spending.
Typically, when the aggregate demand exceeds the aggregate supply, an inflationary gap arises. Therefore, the Government can take these fiscal measures to control inflation:
Take steps to decrease the overall Government expenditure and transfer payments
Increase the rate of taxes causing individuals to decrease their total expenditure, leading to a decrease in demand and a drop in the money supply in the economy.
The government can also use a combination of the two to obtain a reasonable control over inflation.
Cost-push inflation (e.g. due to rising oil prices) can lead to inflation and lower growth. This is the worst of both worlds and is more difficult to control without leading to lower growth. In 2022 the world saw a rise in cost-push inflation due to rising energy prices and the end of Covid lockdown causing supply shortages.
Cost-push inflation is more difficult to reduce because it is fundamentally caused by supply problems. Raising interest rates is a blunt tool and likely to cause unacceptably lower growth. This is why Central Banks tend to tolerate a higher rate of cost-push inflation and hope it is short-lived. In the long-term we can try and tackle the supply issues, such as more flexible labour markets, stock-piling oil reserves to deal with crises and policies to increase competitiveness.
Other Policies to Reduce Inflation:
Reduce expectations: A key determinant of inflation over time is inflation expectations. If people expect inflation next year, firms will put up prices and workers will demand higher wages. This expectation tends to cause higher inflation. If the Central Bank and government can effectively reduce expectations by making credible threats to bring inflation under control, this will make their job easier.
Price controls: With inflation, we will see firms trying to increase prices as much as they can to maintain profitability and deal with rising costs. One way to try to avoid this ‘profit-push’ inflation is to introduce price controls. This is where the government sets limits on price increases.
Wage Control: If inflation is caused by wage inflation (e.g. powerful unions bargaining for higher real wages), then limiting wage growth can help to moderate inflation. Lower wage growth will reduce the costs for firms and lead to less excess demand in the economy.
Monetarism: Monetarism seeks to control inflation by controlling the money supply. Monetarists believe there is a strong link between the money supply and inflation. If you can control the growth of the money supply, then you should be able to bring inflation under control. Monetarists would stress policies such as:
Supply-Side Policies: Often inflation is caused by persistent uncompetitiveness and rising costs. Supply-side policies may enable the economy to become more competitive and help to moderate inflationary pressures. For example, more flexible labour markets may help reduce inflationary pressure. However, supply-side policies can take a long time, and cannot deal with inflation caused by rising demand.
Exchange rate policy: A country may seek to keep inflation low by joining a fixed exchange rate mechanism. The argument is that if the value of a currency is fixed (or semi-fixed) then this creates a discipline to keep inflation low. If inflation rises, the currency would become uncompetitive and start to fall. In the late 1980s, the UK joined the European Exchange Rate Mechanism (ERM) partly to bring inflation under control.
Ways to Reduce Hyperinflation – change currency: In a period of hyperinflation, conventional policies may be unsuitable. Expectations of future inflation may be hard to change. When people have lost confidence in a currency, it may be necessary to introduce a new currency or use another like the dollar (e.g. Zimbabwe hyperinflation).