Evaluate the causes of inflation, the dangers it poses and the policies to reduce inflation
Evaluate the causes of inflation and measures to reduce it?
The essay will identify the concept of inflation which is relating to macroeconomics. The discussion will be on what causes inflation and how it impacts different variables of an economy such as consumers and businesses everyday using current examples to illustrate the effect of inflation and what most governments do to tackle it.
What is inflation?
Inflation can be termed as the rise of general prices and associated fall in the value of money. Generally speaking, anything that drives up prices can be said to be inflationary while anything that drives down prices is said to be deflationary. These shifts can also be down to the demand side or aggregate supply side. However, the common feeling is that inflation is not a big problem until it either becomes high or starts to rise or both (Valdez and Molineux 2010).
Figure 1: Inflation in the UK 2000-2010
Many countries have high levels of inflation depending on how their economy is doing. For example in 2008, the UK experienced its highest level of inflation for more than 10 years peaking at 5%, which was primarily down to a spike in high oil prices when crude oil prices peaked at around £100 a barrel. In fact between 2007 and 2009, world oil prices fluctuated immensely along with food prices, causing fuel led inflation that required a lot of governments to intervene with policies to help reduce or limit oil price fluctuations. However, in 2009 inflation fell as a result of the recession and fall in consumer demand (Kojima 2009).
TWO CAUSES OF INFLATION
Economists tend to classify the causes of inflation as either demand-pull or cost-push causes as discussed below;
1) Demand-pull inflation
Boom in exports: Inflation can be caused by increased exports due to excessive demand for a countries goods and products not being matched by the ability to supply those products causing demand to exceed supply thus driving up prices. This can happen especially when the government allows businesses to have too much money to spend, which is often a result of cutting taxes or low interest rates. This type of inflation tends to occur when economies are in the boom cycle with production and resource use at full capacity causing resources and labour to become scarce, which drives up prices of wages and pretty much everything as shown in figure 2 (Valdez and Molineux 2010).
Figure 2: Demand-pull inflation
2) Cost-push inflation
Wage rises: During the boom cycle in economies, firms will face increasing costs due to rising wages or raw materials as happened in the UK in 2008 when the high prices of oil led to high inflation as illustrated previously.
Imported inflation: One of the most common causes of inflation is imports when “open” economies such as the UK which import vast quantities of goods, products and raw materials become susceptible. This happens when those imported products have rising prices while the exchange rate keeps falling which means more pounds are required to buy foreign currency (Schiller 2008).
Expectations: Inflation can also be caused by people’s expectations of rising costs and prices which will actually fuel the inflationary process. When the UK government introduced plans to increase VAT from 17% to 22%, many union leaders argued for wage increases for workers. Many observers asserted that the wage increases coupled with a 5% monthly rise in petrol prices, gas and electricity price hikes and general food price hikes would cause headline inflation rate spikes of up to about 4.2%. The UK also witnessed a rush in consumers to make major purchases to try and beat the increase in VAT and avoid paying higher prices (Guardian 2011).
WHY DO WE WORRY ABOUT INFLATION?
Everyone worries about inflation because it can have damaging consequences on everyone from consumers, employees, private businesses to the public sector.
Effect of inflation on consumers
For consumers, inflation tends to mean higher cost of goods for everyday items as inflation tends to drive up prices of commodities. This happened in 2008-2009 when the cost of oil reached £100 a barrel at one point pushing up food prices, transport and many products. For many people, if this increase in prices is not matched by an increase in wages, it leads to lower standards of living and the consequences of this can spiral into political and social unrest. Empirical observation has led me to argue that much of the political unrest witnessed in many Arab countries has its roots in high prices of food and consumer products coupled with high inflation, and unemployment forming a potent and dangerous mix that caused political destabilisation popularly known as the Arab Spring.
Effect of inflation on employees
For employees, inflation tends to precede a fall in wages as government policy to curb inflation tends to cause money supply to reduce as we shall see in some of the solutions to inflation in later sections.
Effect of inflation on business
For the private enterprises, inflation tends to signal a fall in consumer spending as during inflationary times, people save more (perhaps due to uncertainty) which is why inflation leads to a fall in sales for businesses. If this is coupled with rising wages and costs of raw materials like oil, UK businesses will not only lose international competitiveness, especially if they are competing with overseas firms from countries with low inflation, they may be forced to raise prices or accept lower profit margins (Valdez and Molineux 2010).
HOW CAN INFLATION BE PREVENTED?
The solutions to tackling inflation are as varied as the problems it causes and this is because there are two main schools of thought on how to prevent inflation and each has its own standard solutions although in real life, governments will employ a mixture of both to fight inflation
Keynesian solutions to preventing inflation
Keynesian economists use the policy of demand management to tackle inflation. This means that the government will need to stimulate/reflate the economy during recession and deflate the economy during inflationary times. Therefore Keynesians tend to recommend deflationary policies to dampen down the level of economic activity during inflation with the following solutions;
Increasing taxation: Because fiscal policy is derived from Keynesian economics, many governments will use higher taxes to discourage spending. This is a Keynesian fiscal policy designed to reduce the level of aggregate demand in the economy as a way of dealing with high inflation levels. In the long run, consumers and businesses will cut back on spending which was causing the inflation and revert back to a low aggregate demand level after deflationary measures have been implemented as shown in figure 3 below (Schiller 2008).
Increasing interest rates to encourage saving: This is the most common keynesian method employed by the UK government often choosing to raise interest rates. The Bank of England raising the base rate reduces the possibility of demand-pull inflation happening. This discourages consumers from spending and start saving attracted by high interest rates. This also stops consumers from purchasing on credit since interest rates are high making it expensive. For businesses, this will mean reduction in investment as the cost of borrowing is high and sales low causing inflationary pressures to decline (Valdez and Molineux 2010).
Reducing the level of government expenditure: Keynesians also want governments to reduce their level of expenditure on services such as education which is another way of saying, let the government implement austerity measures as way of dealing with inflationary tendencies (Schiller 2008)
Monetarist solutions to preventing inflation
Monetarist economists tackle the problem of inflation using monetarist policies. The thing to note is that the real key to monetarist policy though is the control of monetary and money supply growth. In this way, the monetarists would be able to maintain low inflation. Some of the policies that monetarist economists use to tackle inflation include;
Open market operations such as buying and selling securities, funding such as when government converts short-term securities into long-term, monetary base control which includes limiting the stock of cash that an economy can have and interest rate control (Schiller 2008)
The essay set out to examine what caused inflation, the dangers it poses and the policies and ways that can be implemented to limit or reduce inflation. While there are variations of how to deal and control inflation such as Keynesian and Monetarist, the central aim of both policies is still much the same, to try and control inflation. The only difference is how to go about doing it. But whatever policy is followed, inflation is a number one priority for governments because if left to rise unchecked, it can wreak havoc on consumers, businesses and potentially set in motion events that have destabilised entire governments before in the past. On the other hand, having low inflation can benefit not only consumers who will enjoy cheaper prices but this can trigger off higher consumption which is good for businesses.
In the end, this shows why inflation is such a critical component of macroeconomic policy.
Valdez. S & Molyneux. P. (2010) "An introduction to global financial markets” 6th Edition, Palgrave Macmillan.
Schiller B (2008) “Economics” 11th Edition, McGraw Hill Publishing
Kojima Masami (2009) “Government Response to Oil Price Volatility” World Bank Report
Guardian (2011) "Inflation pushed up by VAT rise" [Online] at
http://www.guardian.co.uk/business/2011/feb/15/cost-of-living-vat-rise [Accessed 17 March 2014]
BBC Website (2012) Economy tracker: Inflation since 2000, [Online] at
http://www.bbc.co.uk/news/10612209 [Accessed 17 March 2014]
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