InflationConsequences and Policy Options

By

Qambrani Shoaib Anwer

WHAT IS INFLATION?Simply put, inflation is a situation in the economy where, there is more money chasing less of goods and services. In other words, it means there is more supply/availability of money in the economy and there are less of goods and services to buy with that increased money. Thus goods and services command a higher price than actual as more people are willing to pay a higher value to buy the same goods. In this inflationary situation, there is no real growth in the output of the economy per se. It’s simply more money chasing few goods and services.

THE BASIC TYPES OF INFLATION

1. Demand-Pull Inflation Demand-pull inflation places responsibility for inflation squarely on the shoulders of increases in aggregate demand. This type of inflation results when the four macroeconomic sectors (household, business, government, and foreign) collectively try to purchase more output that the economy is capable of producing.

In terms of the simple production possibilities analysis, demand-pull inflation results when the economy bumps against, and tries to go beyond, the production possibilities frontier. Then end result is inflation.

In the more elaborate aggregate market analysis, demand-pull inflation results when aggregate demand increases beyond aggregate supply creating economy-wide shortages. As with market shortages, the price (or price level) rises. Then end result is inflation.

2. Cost-Push Inflation Cost-push inflation places responsibility for inflation directly on the shoulders of decreases in aggregate supply that result from increases in production cost. This type of inflation occurs when the cost of using any of the four factors of production (labor, capital, land, or entrepreneurship) increases.

In terms of the production possibilities analysis, this means that the production possibilities frontier is shrinking closer to the origin, causing it to bump down against the aggregate demand. Then end result is inflation.

In the aggregate market analysis, aggregate supply decreases to less than aggregate demand creating economy-wide shortages. As with any market shortages, the price (price level) rises. Then end result is inflation.

The Inflation Rate and the Price LevelThe inflation rate is the percentage change in the price level. The formula for the annual inflation is

Current year’s Last year’s Price level Price level

Inflation rate Last year’s price level

WHAT ARE THE WAYS OF MEASURİNG INFLATION? Consumer Price Index (CPI) -- This measures the consumer prices of a basket of commodities in different cities.Wholesale Price Index (WPI) -- This measures the different prices of a basket of commodities in the wholesale markets. The basket is broadly made up of Primary products, Fuel products, and manufactured products.GDP Deflator --This is used to adjust measure of gross domestic product for inflation.

CAUSES OF INFLATIONInflation may be caused by an increase in the quantity of money in circulation. This has been seen most graphically when governments have financed spending in a crisis by printing money excessively, often leading to hyperinflation where prices rise at extremely high rates. Another cause can be a rapid decline in the demand for money as happened in Europe during the black plague.

The money supply is also thought to play a role in determining levels of more moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics by contrast typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation.

A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggested that price stability was a trade off against employment. Therefore some level of inflation could be considered desirable in order to minimize unemployment. The Philips curve model described the Pakistan experience well in the 2008, but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 2010.

Another Keynesian concept is the natural gross domestic product, a level of GDP where the economy is at its optimal level of production. If GDP exceeds its natural level, inflation will accelerate as suppliers increase their prices. If GDP falls below its natural level, inflation will decelerate as suppliers attempt to fill excess capacity.

Is Inflation Good For The Economy? Yes and No. Yes because Inflation helps producers realize better margins. This incites them to do better and produce more. No because it reduces the buying power of the consumer in real terms.

INFLATION

refers to a situation in the economy where there Is a general and sustained increased in prices, and is measured in terms of indices such as the CPI.

Types and Causes Policy OptionsDemand-pull inflation (shifting AD) Increased AD (anything that changes CIGXM)

o Reduction in exchange rateso Reduction in taxeso Reduction in i/r (hence Im)o Rising consumer confidenceo Faster economic growth externally

Changes in money supplyo Money supply growing faster that outputo Increased bank borrowing

Cost-push inflation (shifting AS) Higher costs

o Wage-push inflationo Profits-push inflation - firms passing on costs

to consumers by raising priceso Supply-side inflation - rise in prices of

imported raw materialso Higher import/export prices o Increase in the level of indirect taxeso Structural inflation due to structural rigidities

(like labour immobility)

Contractionary demand management policies. Generally used for Dd-pull inflation.

Fiscal policyT Im, C ADG AD

Monetary policyi/r Im, C ADSsM i/r etc

Supply side policiesMarket policiesManpower policies:- Improve efficiency of labour markets such that unN- Better matching of workers to jobsPro-competition policies:Reduce the monopoly/market power of unions/business, such they unable to push up W rates ahead of average productivity increases. (e.g. antitrust laws)Wage-Price policies- Wage guideposts- Price guideposts- Wage-price freezeSupply side economics- Increase AS e.g., via increasing technological capabilities

ConflictsNote that regulating inflation should always be a government’s first priority as it may lead to a major economic collapse as well as the implementation of currency reforms.Meeting other policy objectives often conflicts with decreasing inflation – e.g. increasing employment, economic growth etc.:Phillips’ Curve: Trade off between unemployment and inflation?Stagflation, slumpflation

ConsequencesInternal External

Short

run

Case 1: Demand-pull inflationNegligible change in output, unemployment and NY - economy at Yf. GPL increases.Consequently, SOL falls.

Case 2: Cost-push inflationoutput, unemployment and NY all fallConsequently, SOL falls

BOP – CP, relative prices of exports quantity of exports current account worsens feedback mechanism problem worsens especially when inflation is cost-push, may alleviate demand-pull inflation**Cheaper M lower Dd for local goods X-M AE

FDI – FDI will probably (due to inflation being a sign that the economy is unstable), but depends on the degree of inflation

BOP worsens – pressure on xcr to depreciate.

Long

run

Lower level of investmentsModerate/high inflation business confidence Im rate of EG limited (PPC does not shift out as much)Mild inflation stimulates EG and builds business confidence as it is a sign of a healthy economy Im PPC shifts outward

Savings decrease, consequently, EG is limitedThe value of money falls as people would rather consume at the present time SsM available for Im i/r Im EG is limited

Redistribution of incomeWage price spiralPrices Dd for higher W W prices etc.Function of money breaks down- Money as a medium of exchange, serves as a store of value. Under severe inflation, these functions break down. Regression of the economy into one that deals with barter trade. Consequently, the price mechanism is distorted (under hyperinflation) and can no longer rationally allocate resources.