Inflation: Introduction, Types & Causes

By: Watsala Shakya

An Introduction to Inflation

Inflation is an inevitable part of growth of any economy. Economically speaking, inflation is when the purchasing power of a currency declines overtime. In simpler terms, inflation is when prices of commodities in the overall economy rises, which subsequently raises the cost of living in a county. While, it sounds like crime against humanity, it’s not. Instead it acts as a measure of the health of the economy. While typically prices rise overtime, in some instances they can also fall, such incidents are known as deflation, which we will be talking about later in this article.

In general senses, the occurrence of inflation can be seen in the prices of commodities over the years, for instance the bus fare in the province of Bagmati was Rs. 3 for students in the 90s. Fast forward a decade later, the fare hiked to Rs. 10 for students, and at present the fare has hiked up to Rs 13 for students. In the same sense, 10 years ago a monthly salary of Rs 20,000 was enough to support a family, today the amount is barely enough to pay rent and get food. Money loses value. In extreme cases of inflation, a currency loses its value completely due to which the economy has to resort to using foreign currencies, in particular the global currency, the US dollar. Such extremes cases has been seen in Venezuela, Zimbabwe, among others, while in Brazil, the government reinvested its currency to combat super inflation.

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The Good and Bad of Inflation

While it may seem the household income does not rise as inflation does, which ultimately makes it difficult for households to have a disposable income and in other cases, reduces their purchasing power. Hence, real income falls. Here real income is another term of saying the standard of living, and in the case of inflation saying real income declines means that the standard of living in an economy declines as well. While this might be one way to perceive it, in reality the price changes at different speeds. Some prices of commodities may change every single day for instance, wages; some may be adjusted to remain constant with the help of contracts, such as salary. In inflationary environments, prices rise inevitably and as a result the decline of purchasing power is an inevitable phenomenon as well.

Inflation may seem to have only vices, in reality it is a by-product of growth in GDP. While one does not need to be an economist to know the growth in GDP indicates a healthy economy. It tells us about the size of an economy and tells us how the economy is performing in the real world. The growth in GDP indicates employment is increasing, which means assumptions of companies hiring more workers is assumed. As more people get jobs, more people have more money in their pockets, hence they will have more money to inject into the economy to keep the healthy cycle of economy going. In worst cases, when GDP shrinks, as it did in many countries during the recent global economic crisis, employment often declines, which initiates recession of a period of slump in the economy. Therefore, inflation in the economy signifies growth in the economy.

However, if the growth of GDP, which also subsequently accelerates inflation, is left unchecked, the impacts could be devastating, and could bring hyperinflation into picture. While incontrollable rise in commodities is stated, hyperinflation can render a currency useless and crumble the whole economy, while dragging other economies around it.

Inflation can distort reality, it can distort the purchasing power for recipients and payers of fixed interest rates, and this is because while interest rates remain unchanged, the value of money fluctuates. For instances, a pensioner might receive a 3% increase yearly on their pension, but if the inflation is 8%, the purchasing power of the pensioner falls. Another instance of a mortgage payer shows that if they had borrowed at a fixed rate of 10%, they would benefit from the 8% inflation rate, while assuming the payer’s income keeps up with the inflation. This is due to the real interest rate, which is the difference between the nominal rate and inflation rate. The payer would find servicing the debt to be easier if the inflation is higher, while hoping their income keeps up with the inflation.

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Types Of Inflation

There are three categorizations of inflation that is widely recognized: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.

1. Demand-Pull Inflation

This type of inflation usually occurs when the demand for commodities is higher to the supply. The gap creates in demand and supply, or the shortage, causes the price of commodities to rise. An interesting fact of demand pull inflation is an otherwise rather nice thing, which people are getting richer and have more money to spend. The government can sometimes cause inflation by lowering taxes everyone loves tax breaks because they raise disposable income to navigate the spending in the economy and the money that flows in the economy. However, in the long-term raising demand can also cause price rises which negates some of the initial boost of the tax break. Similarly, a decline in interest rates may cause short-term pleasure and long-term inflationary pressure if interest rates on loans or mortgages fall we might be tempted to take out a loan buy the new car, and hence money supply in the economy rises.

In most cases, Demand-Pull inflation indicates the rise of the standard of living among the people of an economy, as it indicates the spending capacity of the people has increased. Keynesian economic theory believes the increase in employment leads to increase in the overall demand of commodities, in order to meet the demand supply has to be increased for which means companies will hire more people to meet those demands. As a result people have more money to spend and hence the cycle continues. Eventually, supply meets up to the demand.

5 Major Causes of Demand Pull Inflation

a) Growing Economy

In a growing economy, the consumers of that economy are confident to spend more for which they are more willing to take debts; it is almost a characteristic of growing economies for instance, USA and South Korea, among others. This leads to a slow increase in demand overtime, which means the prices of commodities.

b) Increasing Export Demands

An abrupt increase in export indicated demand has risen due which many economies choose to undervalue their currencies so that their demand for export remains in the global market. The currency is hence depreciated and the impact of inflation is seen more clearly.

c) Government Expenditure

In cases where the government goes on a spending spree, prices go up. This is because more money is injected into the economy, when this happens people have more money to spend, the government creates more jobs, more people are employed, household income goes up, which means consumption demand rises, along with it prices soar.

d) Forecasts of Inflation

If companies expect prices of commodities to rise, they will raise their prices as well. Slowly, all companies follow the trend which leads to an increase in prices in the economy.

e) High Money Supply

An expansion in the money supply in the economy while the number of commodities available for purchase in the economy remains constant pushes the prices of those commodities upwards. This increases the overall prices of commodities in the economy.

2. Cost-Push inflation

Cost-Push inflation is when the costs of conducting businesses rise, the cost is then passed onto customers. For instance, if the cost of raw materials or inventory uses in production rises, the cost of final product also increases, due to which producers charge higher for the commodity. In essence, this type of inflation occurs when producers pass the cost they have incurred to consumers. This type of inflation can erode the purchasing power of consumers, as their wages or income may not be able to keep up with the increasing.

Causes of Cost-push Inflation

There can be a lot of reasons for these rises firstly raw materials. Especially oil, it might get more expensive for a very nice reason because a lot of countries are developing and doing well.

Secondly, the workers might ask for a raise and may succeed either because they’ve organized themselves well politically or because schools and colleges haven’t been training enough workers in the skills that company’s needs.

Thirdly land rents might be increasing because not enough factories and offices have been built which tends to come down to political failures around building permits the result of all this is that businesses then push their extra on to the consumer by raising prices; they do not want to it’s a scary move but they have no choice. They would go out of business otherwise.

3. Built-In Inflation

This type of inflation is caused by expectations for the future. When prediction of future inflations are made, prices are raised. As a result, wages have to be increased in order to afford the increased cost of living. When the cost of wages increase, the cost of production increases, which then impacts the price of the commodity and hence the cycle continues.

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