What is inflation?
Inflation can be defined as a sustained and continuous increase in general price level. This brings about a fall in the value of money. For it to be said that an economy is in an inflationary period, two things must happen.
- General level of prices must be on the increase. Inflation is not measured by the increase in one price relative to another one, but by the increase in collective prices ie the general price level.
- The rise in prices must be sustained and continue over a period of time.
When inflation occurs, the purchasing power of consumers reduce and the disposable income of consumers can buy only fewer goods than it could previously.
Causes of Inflation
Firstly we need to ask ourselves the question what determines the value of money?.
The value of money is simply determined by supply and demand. The number one variable that determines the value of money is the average level of prices in the economy. Money is a medium of exchange and we are required by law to accept it in exchange for goods and services. The higher prices are, the more money the typical transaction requires and the more money people will choose to hold.
Higher prices are usually caused by the availability of money in the economy. When too much money is in the economy, sellers of goods and services would also want to raise prices to earn more. There must then be a limitation of the money supply to check inflation; a balance in the quantity of money supplied by the Federal Reserve and the quantity of money demanded by the people can be a sustainable way of checking inflation in an economy.
With this view, a rapid increase in the money supply plays an active role in inflation. Inflation may occur as a result of mistaken policies of the federal reserves or excess money creation. Also in the case of rising unemployment through activities that will produce a fall in real output, the federal reserve may try to increase demand and encourage production of more goods and services by easing the growth of money supply. This then increases the price levels.
A Fall in the real output of a country may be caused by labor union’s clamoring for an increase in real wages, input costs and also a weaker foreign exchange rate. For example, in Nigeria a devaluation of the currency would cause a rise in general price levels because she is an import dependent country, and the demand for her goods by foreign countries is less than the demand for foreign goods by Nigerians. So it boils down to the market forces of demand and supply. Goods demanded from foreign countries by nigerians, are settled in the currency of the foreign country, and goods bought from Nigeria by foreign countries are settled in the local currency which is Naira.
To settle Nigeria in the local currency, the foreign buyer demands Naira from the CBN or the parallel Market in exchange for his own currency (pounds, euros, dollars). Meanwhile, to settle imports to Nigeria from foreigners, Nigerians demand for foreign currency (Pounds, euros, dollars) in exchange for their Naira. The value to be paid is then dependent on the supply and demand of our currency in relation to other currencies.
If more of dollars for example is demanded by Nigerians in order to settle imports from America, and little naira is demanded by Americans in exchange for dollars in order to settle imports from Nigeria, then the value of dollars to naira would rise because of a lack of demand for the naira. The market forces of demand and supply determine the floating exchange rate; but other factors such as interest rate decisions, unemployment rates, GDP, production and more play an active role in the determination of the exchange rate.
Countries can also decide to peg exchange rates (more like what Nigeria is currently doing). The Central bank of Nigeria (CBN) is pegging the exchange rate of dollars to naira at $1 to (#197 – #199). The thing about pegging exchange rates is that the interbank rates would be stable and may be reset on particular dates known as revaluation dates. It should be noted that most times, the rates have no control over the parallel market.
Types of Inflation
The main two main types of inflation are
- Demand Pull Inflation
- Cost Push Inflation
Demand Pull inflation: This occurs when there is an exceptionally high demand for goods and services relative to the small supply; it inevitably results in a price increase. Demand pull inflation is when the aggregate total demand for goods and services are continually on the increase while aggregate supply remains unchanged or at a rate far less than the increase in demand.
Factors that support an increase in aggregate demand and by so doing demand pull inflation include: a rising disposable income and an exploding population. Foreigners can also contribute to demand pull inflation when their demand for goods and services places a strain on the limited production and supply.
Cost Push Inflation: This type of inflation is caused by an increase in the cost of production which pushes up the general price level of goods and services. Cost push inflation can occur as a result of an increased labor cost (which in turn is added to the price of the goods and services), an increase in the profit margins set by producers, an increase in taxation of sales by the government, and an increase in raw materials needed to produce goods.
Apart from these two, there are many more types of inflation. They include:
- Hyperinflation: This is when inflation rate reaches more than 50% each month. It is very rare but has happened before on few occasions. For example the hyper-inflationary period in Zimbabwe during the 2000’s when billionaires could not afford a meal. Another example is Germany during the 1920’s.
- Creeping inflation: This is when inflation rate rises less than 3 or 4% in a year.
- Stagflation: This is when high levels of inflation is coupled with high unemployment rates. The economy becomes stagnant but there is still price inflation.
- Galloping inflation: This is when inflation rises between 10 % or more. Money loses value fast and fixed income earners and creditors suffer most.
Costs of Inflation to the economy
- Shoeleather Cost: They represent the resources that are wasted when people change their behavior to avoid holding money. Back in the day, it was known as the actual expense of replacing shoes that might get worn our as a result of making too many trips to the bank. Of course this term should not be taken literally. Shoe leather cost is actually the time and inconvenience you must sacrifice to keep less money at hand than you would if there is no inflation.
- Menu Costs: It is the cost of price adjustment by firms. Menu costs are costs of changing prices of already established products or services. They include the cost of deciding on new prices, cost of printing new price lists and catalogs, the cost of sending these new price lists and catalogs to dealers and customers, the cost of informing customers about the price change, and the cost of dealing with customer’s annoyance over the price changes. Menu costs occur periodically in firms even with minimal levels of inflation; but with high levels of inflation, menu cost soars and it would be impracticable for firms to wait periodically before adjusting prices.
- Money Illusion: Inflation creates an illusion. The illusion is when people interpret nominal changes in wages or prices as real changes. For example, workers are clamoring for a 10% increase in wages, but cost of living and prices of most goods rise by a similar percent. The worker may think he is earning more but with an increase in the cost of living and foodstuffs by a similar amount, the wage still maintains the same purchasing power. This means that nothing has changed in real terms.
- Wealth redistribution: During inflation, debtors gain and creditors lose. Take for example you borrow $500,000 from the bank to start a business and the loan has an interest rate of 8%. In a situation whereby inflation rises above the interest rate, let’s say 12% ; inflation would devalue the future payment to the bank. This means that you would be better off but the bank would be worse off. So inflation redistributes wealth from lenders to borrowers.
- Price confusion: In the law of demand and supply, firms take rising prices as an incentive to produce more and falling prices as a signal to produce less. In periods of inflation, if firms cannot identify that rising prices is as a result of inflation resources may be redirected in the economy.
Olivier Blanchard., David R Johnson., Macroeconomics (6th edition)