INFLATION

A sustained rise in the prices of commodities that leads to a fall in the purchasing power of a nation is called inflation. Although inflation is part of the normal economic phenomena of any country, any increase in inflation above a predetermined level is a cause of concern. (Or) The measure of price increases within a set of goods and services over a period of time is known as inflation. The most common gauge of inflation is known as the CPI, or consumer price index, which measure the price increases (decreases) of basic consumer goods and services. The GDP deflator is another very important measure of inflation as it measures the price changes in goods that are produced domestically. In effect, inflation decreases the value of your money and makes it more expensive to buy goods and services.

CAUSES OF INFLATION
There are a few different reasons that can account for the inflation in our goods and services; let's review a few of them.
y

Demand-pull inflation refers to the idea that the economy actual demands more goods and services than available. This shortage of supply enables sellers to raise prices until an equilibrium is put in place between supply and demand. The cost-push theory , also known as "supply shock inflation", suggests that shortages or shocks to the available supply of a certain good or product will cause a ripple effect through the economy by raising prices through the supply chain from the producer to the consumer. You can readily see this in oil markets. When OPEC reduces oil supply, prices are artificially driven up and result in higher prices at the pump.

Money supply plays a large role in inflationary pressure as well. Monetarist economists believe that if the federal reserve does not control the money supply adequately, it may actually grow at a rate faster than that of the potential output in the economy, or real GDP. The belief is that this will drive up prices and hence, inflation. Low interest rates correspond with a high levels of money supply and allow for more investment in big business and new ideas which eventually leads to unsustainable levels of inflation as cheap money is available. The credit crisis 2007 is a very good example of this at work. Inflation can artificially be created through a circular increase in wage earners demands and then the subsequent increase in producer costs which will drive up the prices of their goods and services. This will then translate back into higher prices for the wage earners or consumers. As demands go higher from each side, inflation will continue to rise.

EFFECTS OF INFLATION
The effects of inflation can be brutal for the elderly who are looking to retire on a fixed income. The dollars that they expect to retire with will be worth less and less as time goes on and inflation goes higher. When the balance between supply and demand spirals out of control, buyers will change their spending habits as they meet their purchasing thresholds and producers will suffer and be forced to cut output. This can be readily tied to higher unemployementbrates When extremes arise in the supply/demand structure, imbalances are created. The mortagage crisis a great example of this. Home prices were increasing at a very rapid rate from 2002 to 2005 and got to the point where the prices became too high, forcing buyers to step aside. This lack of demand forced sellers to drop prices back to a point where there is demand. As I write this article, this equilibrium has still not come into the real estate market.

This is due to many factors, as you will read in our mortgage crisis article, but the extreme acceleration of inflation in home prices is directly correlated to the pullback we are seeing. A similar example can be seen in the internet euphoria in the stock market back in 1998 to 2000. This rapid acceleration in stock prices eventually became unsustainable and led to a disastrous fall. The point that is being made is that if inflation is not contained and rises at an unsustainable rate; the stronger the impact on the other side. There is a saying; "the bigger they are, the harder they fall".

Degrees of Inflation There are different degrees of inflation. It includes mild inflation, strato-inflation and hyper-inflation. Mild inflation is a slow rise in price level of no more than 5 percent per annum. It is associated with a low level of unemployment and is during the upswing phase of a trade cycle. Such creeping inflation has beneficial effects on an economy. It is a sign of a buoyant economy or an expanding economy, implying the generation of jobs, output and growth. For strato-inflation, the inflation rate ranges from about 10 percent to several hundred per cent. Many developing countries particularly those in Latin America experienced this. Hyper-inflation is a very rapidly accelerating inflation which is also know as runaway inflation or galloping inflation. This usually leads to the breakdown of the country's monetary system as the existing currency may have to be withdrawn and a new one introduced. In 1923, the inflation rate in Germany averaged 322 percent per month with the highest inflation rate at 29 000 percent in October. Hyperinflation usually occurs during or soon after a war when a government turns to the printing press to create money to pay its debts. It is usually short-lived and should not be regarded as typical of inflation.

Types of Inflation Wage Inflation: Wage inflation is also called as demand-pull or excess demand inflation Cost-push Inflation: As the name suggests, if there is increase in the cost of production of goods and services, there is likely to be a forceful increase in the prices of finished goods and services. Pricing Power Inflation: Pricing power inflation is more often called as administered price inflation. Sectoral Inflation: This is the fourth major type of inflation. The sectoral inflation takes place when there is an increase in the price of the goods and services produced by a certain sector of industries. Cost and consequences of inflation Inflation can favour borrowers at the expense of savers because inflation erodes the real value of existing debts Inflation can disrupt business planning and lead to low capital investment Cause of higher unemployement in long term because of lack of competitiveness Inflation associated with higher interest rates reduces economic growth and leads to recession Which government policies are most effective in reducing inflation? Most governments now give a high priority to keeping control of inflation. It has become one of the dominant objectives of macroeconomic policy. Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the rate of growth of aggregate supply (AS). The main anti-inflation controls available to a government are: 1. Fiscal Policy: If the government believes that AD is too high, it may reduce its own spending on public and merit goods or welfare payments. Or it can choose to raise direct taxes, leading to a reduction in disposable income. Normally when the government wants to tighten fiscal policy to control inflation, it

will seek to cut spending or raise tax revenues so that government borrowing (the budget deficit) is reduced. This helps to take money out of the circular flow of income and spending 2. Monetary Policy:A tightening of monetary policy involves higher interest rates to reduce consumer and investment spending. Monetary policy is now in the hand of the Bank of England it decides on interest rates each month. 3. Supply side economic policies: Supply side policies include those that seek to increaseproductivity, competition and innovation all of which can maintain lower prices. The most appropriate way to control inflation in the short term is for the British government and the Bank of England to keep control of aggregate demand to a level consistent with our productive capacity. The consensus among economists is that AD is probably better controlled through the use of monetary policy rather than an overreliance on using fiscal policy as an instrument of demandmanagement. But in the long run, it is the growth of a countrys supply-side productive potential that gives an economy the flexibility to grow without suffering from acceleration in cost and price inflation.