inflation report today

inflation report today

The Impact of Inflation on the Economy

1. Introduction

Inflation is the term used to describe a wide variety of price increases throughout an economy, all of which are, to a varying degree, monetary phenomena. In general, economists make a distinction between demand-pull and cost-push inflation. The former is the most common and occurs when economic agents try to purchase more goods and services than available at the current price level. This causes scarcity and so prices are bid up. Keynesians tend to place emphasis on the former and argue that it is caused by any factor which increases aggregate demand. Monetarists believe that inflation is caused solely by an increase in the money supply. This will be discussed further in section 6. Cost-push inflation happens when there is a decrease in aggregate supply, this can be caused by a variety of factors, for example a natural disaster can make production more expensive; alternatively, workers may push up wages in the hope of higher revenue. The outcome is that production becomes more expensive and therefore the price level rises. All inflation has a direct effect on the distribution of income because the various price changes are not simultaneous. This leads to a redistribution of real income and wealth, away from those on fixed incomes and savings, towards factors of production, entrepreneurs, and speculators. Inflation helps some groups at the expense of others. In terms of an increase in inflation, all groups are generally worse off. This is because with rising prices, businessmen and entrepreneurs are misled into expanding production, the price rises mentioned before are mistaken for increases in real demand and output so more resources are allocated to the specific good or service. This would not be a problem if the price increases were general. However, when the mistaken price increases are for specific goods or services, this will lead to an increase in the production of those goods and services. Following from this, resources are allocated away from other goods and services into this area of mistaken price increase.

2. Understanding Inflation

To conclude, inflation leads to a fall in the value of money. The cost of inflation and the unemployment rate have a stable relationship, and inflation is a global phenomenon.

Inflation also has quite a few negative effects on the economy and people. If the rate of inflation is greater than the rate of increase in national income, there will be a fall in the standard of living. This is because people will be able to afford fewer goods and services. High inflation creates uncertainty about the future and can cause damage to investment. This is because firms and individuals will be more likely to save their money rather than spend it if they think the goods or services will cost more in the future. A reduction in consumer spending and investment will cause aggregate demand to fall. This fall in aggregate demand, along with the uncertainty, will lead to lower economic growth and higher unemployment. Both higher unemployment and lower growth will lead to an increase in inequality in the distribution of income. The biggest problem inflation can cause an economy is a reduction in international competitiveness. This is because if inflation is higher in the UK than in other countries, UK goods and services will cost relatively more compared to other countries. This will lead to a fall in exports and an increase in imports. This will further reduce aggregate demand, cause unemployment, and lower economic growth.

The different effects inflation can have on people and the economy as a whole. These effects of inflation can be both positive and negative. Positive effects of inflation include the following: if wages increase as a result of inflation, this will move individuals into higher PAYE tax brackets and so they will pay more tax. If people have savings in a bank and the interest on their savings is less than the rate of inflation, the real value of their savings will decrease.

The classical theory of inflation was first developed by economists in the 18th century. The quantity theory of money was particularly popular. Inflation is an increase in the general price level of goods and services in an economy over a period of time. It also means a sustained increase in the aggregate or general price level in an economy. Inflation means there is a fall in the purchasing value of money.

3. Effects of Inflation on the Economy

Inflation has an automatic and regressive effect on the tax system. Due to the fact that the tax system is based on nominal incomes and capital gains, individuals will be pushed into higher tax brackets even though their real income has not increased. Therefore, the effective tax rate will increase. Similarly, firms will realise increased capital gains due to inventory appreciation, but these are typically taxed as nominal profits. The increase in their effective tax rate will cause a further decrease in real output. At the level of commodity taxes, the inflation-induced change in relative prices will cause distortion in the pattern of demand, but this effect is less significant than the changes in income and capital taxes.

The major effect of inflation is its impact on the decisions of households and firms. They realise that the economy is in a disequilibrium with some prices rising more rapidly than others and must judge whether this trend will continue. It becomes more of a challenge to evaluate the relative importance of price changes and actual changes in market conditions of supply and demand. The result will be increased speculative activity, in particular speculative hoarding of goods whose prices are expected to rise more rapidly in the future and disinvestment in financial assets to buy tangible goods. Both will cause a further increase in prices of goods and a decrease in demand for financial assets, thereby exacerbating the original inflationary situation. Step by step, inflation distorts relative prices and distorts the information in market signals, so market systems are less effective in rationing and allocating resources.

Demand-pull inflation will typically have an equally diverse effect on the income distribution as cost-push. In the short run, industries experiencing an increase in demand for their products will be able to charge higher prices, therefore increasing profits. Wages will increase in these industries and in industries producing complementary goods due to the increase in demand for labour. Even in industries which are forced to lay off workers as a result of decreased demand, nominal wages may still rise. High-skilled workers, which are usually unionized and more successful in wage bargaining, are likely to see their wages rise more than low-skilled workers in this situation. The net result will be an increase in the wage differential and a decrease in the unemployment rate. This is often heralded as a desirable effect, but it may be unsustainable and not lead to any reallocation of resources.

Effects of inflation on the economy: Cost-push inflation often has a direct effect on the income distribution because different workers and industries will be able to raise their prices to different extents. Workers whose wages rise less rapidly than the rise in their prices will obviously be disadvantaged for at least the time until wages catch up in money terms with their real income at the start of the process. This tends to create a monopoly in higher-skilled labour, and there will be a decrease in the number of jobs for low and unskilled workers. This is a result of the aforementioned industries cutting back to save costs from the rise in cost of production. Technically, inflation always causes a redistribution of real income, but inflation resulting from an increase in aggregate demand may be neutral in its effect and not influence income distribution.

4. Strategies to Combat Inflation

However, deflationary fiscal policy will only work assuming the price and wage flexibility. If prices and wages are very inflexible, reducing aggregate demand may not reduce inflation, it may just lead to unemployment, as firms will cut production and lay off workers rather than lower wages, and if the reduction in aggregate demand hits the unemployed workers then this will also contribute to cost-push inflation. Unemployment is a problem during deflationary fiscal policy because the employed fear they may lose their jobs and will thereby ask for higher wage rises to compensate for the increased cost of living, this is known as inflationary wage-price spirals.

Fiscal policy involves increasing taxes and/or reducing government spending. This policy does something similar to the monetary policy of higher interest rates. By taking money out of the circular flow, aggregate demand falls and therefore demand-pull inflation is reduced. Increasing taxes and cutting down on government spending are policies which are deflationary because there will be less money in the pockets of the consumers and firms. Reducing government spending is perhaps the most effective way of cutting down inflation, but politicians are very unwilling to do so because it is not popular with large sections of the electorate.

A government embarking on an anti-inflationary strategy has several alternatives – cutting down aggregate demand and reducing cost-push inflation. These policies are listed and explained below.

5. Conclusion

Inflation can have a very significant effect on the distribution of income. However, the way in which it affects the distribution of income is quite complex and depends on the relative inflation rate between different goods and the price elasticity of supply and demand for these goods. The overall effect of inflation on the distribution of income is likely to be negative. This is because when considering the inflation rate across all goods and factors, inflation will alter the distribution of real income, i.e. income adjusted for inflation, in an arbitrary and unfair manner. This is due to the fact that price changes are not uniform for all goods and services. For example, a fixed income earner whose most expenditure goes on goods with a high inflation rate and low price elasticity of demand will experience a fall in his standard of living. This is further compounded by the fact that increased inflation rates generally lead to higher levels of unemployment.

This paper has presented a comprehensive overview of the inflation phenomenon and its various effects on the economy. It can be concluded that a moderate rate of inflation has several highly important effects on the economy. These effects result in the inflation rate having either a positive or negative effect on the economy. By careful examination of all the effects of the moderate rate of inflation on the economy, it is the contention of this paper that the negative effects experienced are more substantial. Thus, it can be stated that although positive effects to the inflation rate exist, the cost is too great making it undesirable. This is because the economy can achieve the same beneficial effects presented by the inflation rate through alternative means which involve less of a cost. This would avoid the detrimental effects caused. Therefore, the inflation rate should be reduced to a small rate instead of moderate. It was noted at the beginning of the paper that this is a topic of much relevance in today’s economic climate. Thus, further research into this area is warranted.