Inflation is a rise in the general price level
and is reported in rates of change. Essentially what this means is
that the value of your money is going down and it takes more money to
buy things. Therefore a 4% inflation rate means that the price level
for that given year has risen 4% from a certain measuring year
(currently 1982 is used). The inflation rate is determined by finding
the difference between price levels for the current year and previous
given year. The answer is then divided by the given year and then
multiplied by 100. To measure the price level, economists select a
variety of goods and construct a price index such as the consumer
price index (CPI). By using the CPI, which measures the price
changes, the inflation rate can be calculated. This is done by
dividing the CPI by the beginning price level and then multiplying
the result by 100.
Causes of Inflation
There are several reasons as to why an economy
can experience inflation. One explanation is the demand-pull theory, which
states that all sectors in the economy try to buy more than the
economy can produce. Shortages are then created and merchants lose
business. To compensate, some merchants raise their prices. Others
don’t offer discounts or sales. In the end, the price level rises.
A second explanation involves the deficit of
the federal government. If the Federal Reserve System expands the
money supply to keep the interest rate down, the federal deficit can
contribute to inflation. If the debt is not monetized, some borrowers
will be crowded out if interest rates rise. This results in the
federal deficit having more of an impact on output and employment
than on the price level.
A third reason involves the cost-push theory
which states that labor groups cause inflation. If a strong union
wins a large wage contract, it forces producers to raise their prices
in order to compensate for the increase in salaries they have to pay.
The fourth explanation is the wage-price spiral which states that no
single group is to blame for inflation. Higher prices force workers
to ask for higher wages. If they get their way, then producers try to
recover with higher prices. Basically, if either side tries to
increase its position with a larger price hike, the rate of inflation
continues to rise.
Finally, another reason for inflation is
excessive monetary growth. When any extra money is created, it will
increase some group’s buying power. When this money is spent, it will
cause a demand-pull effect that drives up prices. For inflation to
continue, the money supply must grow faster than the real GDP.
Effects of Inflation
The most immediate effects of inflation are the
decreased purchasing power of the dollar and its depreciation.
Depreciation is especially hard on retired people with fixed incomes
because their money buys a little less each month. Those not on fixed
incomes are more able to cope because they can simply increase their
fees. A second destablizling effect is that inflation can cause
consumers and investors to changer their speeding habits. When
inflation occurs, people tend to spend less meaning that factories
have to lay off workers because of a decline in orders. A third
destabilizing effect of inflation is that some people choose to
speculate heavily in an attempt to take advantage of the higher price
level. Because some of the purchases are high-risk investments,
spending is diverted from the normal channels and some structural
unemployment may take place. Finally, inflation alters the
distribution of income. Lenders are generally hurt more than
borrowers during long inflationary periods which means that loans
made earlier are repaid later in inflated dollars.