Inflation

Inflation is a rise in the general level of prices. It is caused by an excess of demand over supply, and is related to an increase in the money supply. Single-digit inflation is usually described by economists as moderate inflation. Double or triple-digit inflation, which some countries have survived for quite long periods, is known as galloping inflation. Inflation of four or more digits, as in Germany in the early 1920s, and Argentina in the early 1980s, is known as hyperinflation. Hyperinflation is an extreme form of inflation resulting from political or economic instability.

Demand-pull and cost-push inflation that we now experience are more common forms.

If aggregate demand exceeds what a country can produce at full employment prices will rise (including wages, the prices of labour): this is demand-pull inflation.

Cost-push inflation is a rise in the average price level due to an increase in production costs. Cost-push originates from the supply side of the economy. Monopoly power significantly contributes to cost-push inflation. The monopoly power of labour unions may result in wage increases that inflate the cost of production. The power of monopoly business permits these costs to be passed on to the consumer in the form of higher prices. Once prices go up, labour realizes that its recent wage gain has been eroded, and it again raises wages. The increase in wages again causes prices to rise, and the wage-price spiral repeats itself.

Supply shock is another cause of inflation. Supply-shock inflation results from infrequent drastic changes in the production cost of fundamental products.

A widespread agricultural disaster such as a drought or freeze may increase food prices and have a widespread impact on average prices. The most visible case of supply shock was the series of OPEC increases in 1970s oil prices.

The higher price of oil increased the cost of energy, plastics, and other inputs and resulted in increased production cost in nearly every productive process in the economy. This in turn increased the price of final products and therefore average prices. But these shocks by themselves are not inflation. Inflation is a continued rise in prices. Shocks that affect supply cause a one-time change in prices that is not inflation. But these shocks may lead to inflation if they set off cost-push inflation.

Inflation can sometimes occur simply because we expect it to. If consumers believe that the prices of goods are going to rise, they may rush out now and buy before the prices go up. The increase in demand will cause prices to rise so the expectation comes true. Once people start expecting prices to rise, and act upon it by buying more, prices will rise, and expectations inflation is the result. Psychology plays an important role in a social science.

We have seen some possible ways in which inflation can be generated - demand-pull, cost-push, shocks, and expectations. Yet there is no one way of looking at inflation that always explains its occurrence. Inflation may result from a combination of causes. The solutions to inflation will in part depend upon the source of the inflationary pressure.

The opposite of inflation, when prices fall (generally for short periods), is deflation. Government policies can be inflationary (often by accident), disinflationary and reflationary. Disinflationary policies might be aimed at slowing down the price inflation or at reducing imports: they involve reducing demand by raising taxation and/or cutting government spending. Reflationary policies, on the contrary, involve revitalizing a sluggish economy by increasing consumer demand, either by cutting taxes or raising benefits, or relaxing monetary and credit restrictions.

Inflation is measured by the retail price index (RPI) in Britain and the consumer price index (CPI) in the US. These measure the cost of the “basket” of goods and services, including food, clothing, housing, fuel, transport and medical care. The individual items in price indexes are weighted, meaning that allowance is made for their relative importance in people’s spending.