What is really Inflation?
5/22/2012 2:01:49 PM -
Since Dr Mahamadu Bawumia presented his state of the economy couple of weeks ago, one point has come out very clear to me.
The point being that some economists do not have a solid definition for inflation. The traditional definition and that is primarily used by the Austrian school of economics is that inflation is an increase in the money supply.
Many orthodox economists, particularly from the Keynesian school, prefer to define inflation as a rise in prices.
A rise in prices is merely a symptom of inflation much like wet streets are a symptom of rain. But to confuse wet streets for rain is to confuse cause and effect. But these orthodox economists confuse lots of things; particularly their students.
Are we in inflation? The average person is beginning to feel the negative effects of inflation on the economy in their own life. Commodities are approaching record high prices and these costs are filtering through to consumable goods.
Technically, 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 same bundle or basket of things. Therefore, an 8.8 per cent inflation rate means that the price level for that given year has risen 8.8 per cent from a certain measuring or base year.
There are two major types of inflation; core inflation and inflation in the broader sense. Core inflation is a measure of average. In this case a very carefully selected group of goods' (in economics it is called 'basket of goods') change in consumer prices over a period of time is observed, and then those consumer prices are averaged. Consumer prices are simply what people pay for the product (there is also an industrial price and inflation measuring supplier price changes). The most widely used periods over which inflation is measured are: one month, quarterly, semi-annual, and annual.
Core inflation means only the very basic products’ prices are monitored, such as, garri, “pure water”, bread, transportation fares, rents, for example. When there is a mild inflation, it is an indicator that the economy is booming, as the price of products goes up, yet people are still buying them.
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 do not offer discounts or sales. In the end, the price level rises.
A second explanation involves the deficit of the government. If the central bank expands the money supply to keep the interest rate down, the 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 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.
The most immediate effects of inflation are the decreased purchasing power of the currency 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 destabilising effect is that inflation can cause consumers and investors to change their spending habits. When inflation occurs, people tend to spend less meaning that producers have to lay off workers because of a decline in orders.
A third destabilising 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 mean that loans made earlier are repaid later in inflated currency.
Probably the most significant effect of inflation is its effect on the revenues of the government. When inflation is higher than previously thought and planned with, the revenues of the government increases, which is good as the budget balance of the government improves.
The reason why revenues of the government increases when inflation increases is because the government has higher tax revenues. For example, a company sells its products and services at higher prices, which increases the total income of the company, which in turn increases the gross (before tax) profits of the company (provided that all other factors influencing profits remain constant). Higher before tax profits result in higher taxes paid to the government.
Inflation also slows the economy, thus serving as a natural economy balancer, as well as a crucial indicator. The reason why growing inflation moderates economic growth, and also potential overheating of the economy, is because, when prices increase, people, as well as companies buy less and less from their suppliers. This function of inflation decreases the needs of central bank base rates' hikes, which in itself has many negative side effects (like increasing the interest payment obligations of governments).
Most often, inflation and exchange rate of a country move more or less parallel. This means that if inflation increases, and the official statistical office of a country publishes the figures of the speeding up of inflation, the exchange rate of the currency against the dollar is also expected to, and in reality it really does more often than not, depreciate.
The reason why exchange rates are so important is because they affect the competitiveness of the export sector. The importance of exporting lies in the inflow of additional funds into the economy. For example, if the country has, say, 40 billion dollars of national economic output, 1 billion more means that companies have 1 billion more to spend within the country, and also the government has more tax income which it can spend on social programmes. This means that inflation, in this aspect also, is a significant indicator.
Inflation, on the other hand, can also be quite destructive. For example, a slowdown in inflation makes importers' products cheaper, whereas domestic manufacturers' product prices remain the same. A sudden slowdown in inflation causes lower imported product prices, meaning two things. First, because of the lower import prices, more people will by imports opposed to domestically manufactured products. This hurts domestic production, which in turn may result in rising unemployment (domestic producers’ fire employees to keep up with shrinking sales revenue)
Another problem with rising inflation arises when inflation starts to increase excessively. For example, when inflation surpasses10 percent it has two effects. People will start spending more, hurting companies, especially those companies that are domestic companies and are selling their products domestically. Also the real value of savings of both people and organisations decrease, having a negative effect on fixed deposits, and other fixed rate investment instruments.
In conclusion, inflation which measures the rate of prices changes does have both positive and negative effects. Mild inflation tends to have, generally, positive effect on the economy, whiles, high inflation do have negative effects on the populace by lowering their powering power, businesses by rendering them uncompetitive, the government by reducing its tax revenues, and the general economy.
The writer is an economic consultant and former Assistant Professor of Finance and Economics at Alabama State University, Montgomery, Alabama. Rockvile2009@yahoo.com