Inflation is a persistent, substantial increase in the general level of prices. When the general price level rises, each unit of currency buys fewer goods and services.

Causes of Inflation

Monetary phenomena

This occurs because of an increase in money supply : printing of more notes. Thus money in circulation becomes much greater than is required. As a result, prices end up rising at an extremely high speed to keep up with the currency surplus. This results in the rapid decline in the value of the currency and the purchasing power of the people reduces drastically.

Demand - pull inflation

This situation arises when aggregate demand is more than aggregate supply.

This excess demand cannot be fulfilled because of full employment of resources. This inability to fulfill demand causes a shortage in the market and therefore prices rise, causing inflation.

It can also happen when the economy is at less than full employment and is unable to respond to a rise in demand because of inefficiencies in supply, for example outdated machinery and shortage of skilled labour.

Cost - push inflation

This occurs because of rise in prices of factors of production (rent, wage, interest). Because of the increase in costs of production the prices of goods and services increase causing cost-push inflation.

Imported inflation

Inflation due to an increase in the price of imports. As the price of imports increase, prices of domestic goods using imports as raw materials also increase, causing an increase in the general prices of all goods and services. Imported inflation may be caused by foreign price increases or depreciation of a country's exchange rate.

Advantages of inflation

Business Growth   Controlled growth of Inflation, can become part of business growth, simply because savings are often invested, because of

the net loss if they are kept in Bank.

During times of controlled Inflation, people in the past tended to spend, as they feared prices could rise, saving on buying now, rather then paying more later.   Falling Debt Values   Higher Inflation eats away at the real value of a currency. This could mean that the actual value of debts decrease, benefiting indebted businesses and private individuals.

Higher Stock Values   Stocks bought at an earlier value, could rise in price and sold off at a higher price bringing higher profitability.

Rising asset Values   Values of fixed assets could rise, making some Companies more financially secure. Traditionally higher Inflation often leads to higher prices, therefore fixed assets in theory should rise in value.

Disadvantages of Inflation

Inflation causes a fall in investment

If inflation starts to rise it tends to become unstable. This means that it can alter greatly from one year to the next. Business managers find it impossible to

work out the future costs and revenues of any investment project they may be planning. Faced with this uncertainty they may decide to put off the investment and this can have a serious effect on production and employment.

Inflation may cause industrial unrest

Inflation reduces the purchasing power of wages. Workers may ask for wage rises not only to keep up with past inflation, but also to cover them against inflation they expect in the near future. If the employers give them the wage rises, it can push up the costs of production, push

up prices, and make the workers’ fears about inflation come true. If employers try to resist the wage demands they could face industrial action.

People on fixed incomes suffer

Pensioners and others on incomes that do not keep pace with inflation will find the real purchasing power of their incomes falling.

Balance of payment problems

If prices of goods and services rise faster than those of other trading countries, then the country’s exports will become

less competitive in prices. On the other hand, imports from abroad will become more attractive than the comparatively expensive home goods. So exports may fall in value, and imports rise in value, so that the current account of the balance of payments deteriorates.Savings may be discouraged: with inflation, the future purchasing power of money saved may be reduced. The rate of interest savers receive is often lower than the rate of inflation. This may discourage saving, so that there is less money available for investment in the economy.

Confusion and Uncertainty

When inflation is high people are uncertain what to spend their money on. Also, when inflation is high firms may be less willing to invest because they are uncertain about future profits and costs. This uncertainty and confusion can lead to lower rates of economic growth over the long term.

Shoe leather costs

To save on losing interest in a bank people will hold less cash and make more trips to the bank.

Income redistribution

Inflation will typically make borrowers better off and lenders worse off. Inflation reduces the

value of savings, especially if the saving is not index linked. However it does depends on the real rate of interest. E.g. if a saver gets a higher rate of interest than the inflation rate he will not lose out.

Boom and Bust economic Cycles

High inflationary growth is unsustainable and is usually followed by a recession. By keeping inflation low it enables a long period of economic growth. Sustainable, low inflationary, economic growth is highly desirable.

Cost of reducing inflation

High inflation is deemed unacceptable therefore governments feel it is best to reduce it. This will involve higher interest rates to reduce spending and investment. This reduction in Aggregate Demand will lead to a decline in economic growth and unemployment.

Fiscal Drag

The amount of tax we pay will increase if there is inflation. This is because with rising wages more people will slip into the top income tax brackets.

The real incomes of people fall.

Types of inflation

Creeping inflation

Mild inflation is a slow rise in price level of no more than 5 percent per annum. It is associated with a low level of unemployment and is during the upswing phase of a trade cycle. Such creeping inflation has beneficial effects on an economy. It is a sign of a buoyant economy or an expanding economy, implying the generation of jobs, output and growth.

Suppressed inflation

Also called inflation. Inflation controlled through income and price controlling policies. Existing inflation disguised by government price controls or other interferences in the economy such as subsidies. Such suppression, nevertheless, can only be temporary because no governmental measure can completely contain accelerating inflation in the long run.

Hyper Inflation

Also known as galloping or runaway inflation.Extremely rapid or out of control inflation.

It is the highest, fastest rate of inflation which grows year by year. It is undesirable, more than 10%.

Deflation

Deflation is a fall in the price level of the economy. It means there will be a negative inflation rate.