Inflation is defined as a persistent increase in the average price level in the economy. 1 This increase in the average price level causes a decline in the real value of money in the economy thus reducing consumer’s purchasing power. Economists have put forward three different types of inflation: excess monetary growth, cost-push inflation and demand-pull inflation.
The core theory regarding inflation relates to the supply of money. Monetarists believe that increases in money supply leads to higher aggregate demand, thus shifting the aggregate demand curve from AD 1 to AD2 causing the price level to rise from P1 to P2.
Demand- pull inflation is also the result of an increase in aggregate demand and can occur when the economy is near or reached full employment. An increase in aggregate demand to a level due to a change in any of the determents raises the average price level as the economy reaches full employment.
In contrast cost-push inflation is the result of increased costs in the factors of production such as wages and raw materials. The results of these changes are that firms cannot produce the same quantity as before and therefore the short-run aggregate supply curve shifts to the left from SRAS1 to SRAS2, thus causing the price level to rise from P to P1.
One of the government’s macroeconomic goals is a low and stable rate of inflation as there are many consequences of high levels of inflation. High levels of inflation rates are often followed by recessions when demand plummets.
Inflation affects people differently. The most obvious consequence associated with inflation is the consumers’ loss of purchasing power. Consumers who have fixed income experience a loss of purchasing power because as the average price level increases consumers real income falls. This means consumers can now purchase less than before with the same amount of money. Often when workers become aware of inflation they become unsatisfied with their current wages and request a raise in wages to cover inflation. Workers who are unsatisfied with their wages become less efficient or can strike. Less efficient workers and days lost through strikes have major implications on firms’ ability to supply goods and therefore firms will often grant their workers a raise in wages. This will increase costs of production and can cause a spiral of inflation with higher prices and higher wages.
Savers are also losers due to high levels of inflation. Savers are negatively affected by inflation as they experience a reduced purchasing power of their income and their savings. Thus high levels of inflation result in savers receiving repayments of liquidity that is of less value then the deposits, which were originally made. Therefore inflation discourages saving, which results in less savings available to used be for investment resulting in reduced economic growth.
Inflation also has negative consequences on firms in the international market. Firstly, if inflation is more severe in selected countries those countries will experience leakages of liquidity to imports from lower-inflation countries. Imports from lower-inflation countries will have prices that are lower and more attractive to consumers thus increasing expenditure on imports and reducing the revenues of domestic firms whose demand has been reduced. Furthermore inflation affects a country’s exports. Firms producing products in countries experiencing high levels of inflation will also experience increased costs of factors of production thus firms have to raise their prices to account for these extra costs. On the international market these products will have less competitive prices compared to lower-inflation countries resulting in a decrease in demand as consumers favour lower prices. Thus decreased demand results in a loss of revenue for firms.
Although there are many losers of inflation there are also people who benefit from high levels of inflation. Borrows are winners during inflationary times as the real value of the debt they are repaying is reduced and with increased wages the repayments as a percentage of their wages is less.
Asset-price inflation is the tendency for a particular asset to rise in price in price in respect of the general price level. Homeowners interested in selling their property or moving into a smaller property benefit from inflation as during inflationary the value of assets increases making it peak time to sell houses as sellers can sell their property for much higher then they had purchased it. Thus people who own assets are winners to high inflation. Eventually however a point comes where demand will fall either because prices are so high or interest rates are at a level that people are discouraged from borrowing and can lead to a crash in the property market. This results in a collapse in economic investment and demand..
Overall though inflation will only have short-term winners and central banks will look to control inflation. The normal policy would be to increase interest rates for savers (encourage savings) and borrowers (reduce demand for borrowings) and controlling the money supply in the economy. Governments will also try to control wages through wage agreements with workers unions
Deflation is the opposite of inflation and is defined as a persistent fall in the average level of prices in the economy.2 Deflation is regularly seen negatively as it suggests a fall in aggregate demand leading to a fall in the average price level further resulting in an increase in unemployment. Alternatively deflation can be caused by increased productivity of firms in producing goods, which increases the supply of goods without an increase in demand. If the supply increases but demand remains the same, the average price level will decrease to reach the market equilibrium in which demand equals supply.
In terms of winners and losers it is the opposite of inflation Deflation can have short-term winners as consumers have increased purchasing power. This is because as the average price level falls peoples wages go further. Although it does have to be considered that during deflationary periods wages are reduced and more people become unemployed therefore making increased purchasing power only a short-term benefit. Deflation does benefits savers who have an interest rate higher then the rate of deflation as the real value of their savings increases. Also, people who own bonds/gilts with higher interest rates then the rate of deflation will also benefit.
In contrast deflation negatively effects many people. As deflation is a fall in the average level of prices and a decrease in aggregate demand firms have to lower their costs to sustain previous revenue. Wages account for a large portion of firms costs and therefore during deflationary periods firms often lay off workers. This creates one of the biggest problems with deflation, increased unemployment. Increase unemployment further leads to a decrease in aggregate demand as the unemployed have no income but reply on transfer payments from the government through unemployment benefit. Deflation therefore indirectly effects governments as increased unemployment leads to increased government spending to support the unemployed while also spending money on large projects to create jobs.
Borrowers are also losers in deflation. Deflation negatively effects borrowers because their repayments now represent a larger amount of purchasing power than when the debt originally occurred. They might also find that the asset purchased through the borrowing is also worth less – a double impact. Deflation therefore discourages borrowers thus leading to reduced investment. During deflationary periods the Central banks drop rates to encourage borrowing but even the current UK interest rate of 0.5% is not encouraging borrowers as investment is risky.
Economists continually debate inflation/deflation and its causes and effects and it is generally accepted that a low steady level of inflation is right for an economy. When either goes above or below this level central banks and governments act to bring it back in line. The many failures in history from the Great Depression to the current Global economic crisis show that the causes and effects of economic policy are not fully understood. There are many other factors such as the general confidence of people in the economy that have impacts and these are not always forecasted.
1 Blink, Jocelyn, and Ian Dorton. Economics Course Companion. 1st ed. Oxford: Oxford University Press, 2007. Print.
2 Blink, Jocelyn, and Ian Dorton. Economics Course Companion. 1st ed. Oxford: Oxford University Press, 2007. Print.