What is inflation ? What are the reason to increase inflation and what are the measurement to control inflation ? How it effect the economy ?
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Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time. Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation’s currency. As prices rise, they start to impact the general cost of living for the common public and the appropriate monetary authority of the country, like the central bank, then takes the necessary measures to keep inflation within permissible limits and keep the economy running smoothly. Inflation is measured in a variety of ways depending upon the types of goods and services considered, and is the opposite of deflation which indicates a general decline occurring in prices for goods and services when the inflation rate falls below 0 percent.
What Is Inflation?
Example of Inflation
Imagine your grandma stuffed a $10 bill in her old wallet in the year 1975 and then forgot about it. Cost of gasoline during that year was around $0.5 per gallon, which means she could have then bought 20 gallons of gasoline with that $10 note. Twenty-five years later in the year 2000, the cost of gasoline was around $1.6 per gallon. If she finds the forgotten note in the year 2000 and then went on to purchase gasoline, she would have got only 6.25 gallons. Although the $10 note remained the same for its value, it lost its purchasing power by around 69 percent over the 25 year period. This simple example explains how money loses its value over time when prices rise. This phenomenon is called inflation.
However, it is not necessary that prices always rise with the passage of time. They may remain steady or even decline. For instance, the cost of wheat in the U.S. hit a record high of $11.05 per bushel during March 2008. By August 2016, it came down to $3.99 per bushel which may be attributed to a variety of factors like good weather condition leading to higher production of wheat. This means that a particular currency note, say of $100, would have got lesser quantity of wheat in 2008 and more in 2016. In this case, the purchasing power of the same $100 note increased over the period as the price of commodity declined. This phenomenon is called deflation, and is the opposite of inflation.
Causes of Inflation
Price rise is the root of inflation, though it can be attributed to different factors. In the context of causes, inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation and Built-in inflation.
Demand-pull inflation occurs when the overall demand for goods and services in an economy increases more rapidly than the economy's production capacity. It creates a demand-supply gap which higher demand and lower supply, which results in higher prices. For instance, when the oil producing nations decide to cut down on oil production, the supply diminishes. It leads to higher demand, which results in price rises and contributes to inflation. Additionally, increase in money supply in an economy also leads to inflation. With more money available to the individuals, the positive consumer sentiment leads to higher spending. This increases the demand, and leads to price rise. Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, or by devaluing (reducing the value of) the currency. In all such cases of demand increase, the money loses its purchasing power.
Theoretically, monetarism establishes the relation between inflation and money supply of an economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and especially silver flowed into the Spanish and other European economies. Since the money supply had rapidly increased, prices spiked and the value of money fell, contributing to economic collapse.
Cost-push inflation is a result of increase in the prices of production process inputs. Examples include increase in labor costs to manufacture a good or offer a service, or increase in the cost of raw material. These developments lead to higher cost for the finished product or service, and contribute to inflation.
Built-in inflation is the third cause that links to adaptive expectations. As the price of goods and services rises, labor expects and demands more costs/wages to maintain their cost of living. Their increased wages result in higher cost of goods and services, and the spiral continues as one factor induces the other and vice-versa.
What Is Inflation?
Example of Inflation
Imagine your grandma stuffed a $10 bill in her old wallet in the year 1975 and then forgot about it. Cost of gasoline during that year was around $0.5 per gallon, which means she could have then bought 20 gallons of gasoline with that $10 note. Twenty-five years later in the year 2000, the cost of gasoline was around $1.6 per gallon. If she finds the forgotten note in the year 2000 and then went on to purchase gasoline, she would have got only 6.25 gallons. Although the $10 note remained the same for its value, it lost its purchasing power by around 69 percent over the 25 year period. This simple example explains how money loses its value over time when prices rise. This phenomenon is called inflation.
However, it is not necessary that prices always rise with the passage of time. They may remain steady or even decline. For instance, the cost of wheat in the U.S. hit a record high of $11.05 per bushel during March 2008. By August 2016, it came down to $3.99 per bushel which may be attributed to a variety of factors like good weather condition leading to higher production of wheat. This means that a particular currency note, say of $100, would have got lesser quantity of wheat in 2008 and more in 2016. In this case, the purchasing power of the same $100 note increased over the period as the price of commodity declined. This phenomenon is called deflation, and is the opposite of inflation.
Causes of Inflation
Price rise is the root of inflation, though it can be attributed to different factors. In the context of causes, inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation and Built-in inflation.
Demand-pull inflation occurs when the overall demand for goods and services in an economy increases more rapidly than the economy's production capacity. It creates a demand-supply gap which higher demand and lower supply, which results in higher prices. For instance, when the oil producing nations decide to cut down on oil production, the supply diminishes. It leads to higher demand, which results in price rises and contributes to inflation. Additionally, increase in money supply in an economy also leads to inflation. With more money available to the individuals, the positive consumer sentiment leads to higher spending. This increases the demand, and leads to price rise. Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, or by devaluing (reducing the value of) the currency. In all such cases of demand increase, the money loses its purchasing power.
Theoretically, monetarism establishes the relation between inflation and money supply of an economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and especially silver flowed into the Spanish and other European economies. Since the money supply had rapidly increased, prices spiked and the value of money fell, contributing to economic collapse.
Cost-push inflation is a result of increase in the prices of production process inputs. Examples include increase in labor costs to manufacture a good or offer a service, or increase in the cost of raw material. These developments lead to higher cost for the finished product or service, and contribute to inflation.
Built-in inflation is the third cause that links to adaptive expectations. As the price of goods and services rises, labor expects and demands more costs/wages to maintain their cost of living. Their increased wages result in higher cost of goods and services, and the spiral continues as one factor induces the other and vice-versa.
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