Mary Am

[edit] Effects [edit] Negative An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services.[17] The effect of inflation is not distributed evenly, and as a consequence there are hidden costs to some and benefits to others from this decrease in purchasing power. For example, with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments.[8] High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation.[8] Uncertainty about the future purchasing power of money discourages investment and saving.[18] And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates. With high inflation, purchasing power is redistributed from those on fixed incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation.[8] This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation. Cost-push inflation Rising inflation can prompt employees to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral.[19] In a sense, inflation begets further inflationary expectations. Hoarding People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects. Hyperinflation If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply. Allocative efficiency A change in the supply or demand for a good will normally cause its price to change, signalling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, genuine price signals get lost in the noise, so agents are slow to respond to them. The result is a loss of allocative efficiency. Shoe leather cost

High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip. Menu costs With high inflation, firms must change their prices often in order to keep up with economy wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly. Business cycles According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.[20]

[edit] Positive Labor-market adjustments Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster. Debt relief Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The “real” interest on a loan is the nominal rate minus the inflation rate. (R=n-i) For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate. Room to maneuver The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate. Tobin effect The Nobel prize winning economist James Tobin at one point had argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid

inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects. See Tobin monetary model[21]

[edit] Causes

The Bank of England, central bank of the United Kingdom, monitors causes and attempts to control inflation. Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the quantity equation of money, that relates the money supply, its velocity, and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.[citation needed] Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.[22] The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy. Inflation refers to a rise in prices that causes the purchasing power of a nation to fall. Inflation is a normal economic development as long as the annual percentage remains low; once the percentage rises over a pre-determined level, it is considered an inflation crisis. There are many causes for inflation, depending on a number of factors. For example, inflation can happen when governments print an excess of money to deal with a crisis. As a result, prices end up rising at an extremely high speed to keep up with the currency surplus. This is called the demand-pull, in which prices are forced upwards because of a high demand. Another common cause of inflation is a rise in production costs, which leads to an increase in the price of the final product. For example, if raw materials increase in price, this leads to the cost of production increasing, which in turn leads to the company increasing prices to maintain steady

profits. Rising labor costs can also lead to inflation. As workers demand wage increases, companies usually chose to pass on those costs to their customers. Inflation can also be caused by international lending and national debts. As nations borrow money, they have to deal with interests, which in the end cause prices to rise as a way of keeping up with their debts. A deep drop of the exchange rate can also result in inflation, as governments will have to deal with differences in the import/export level. Finally, inflation can be caused by federal taxes put on consumer products such as cigarettes or fuel. As the taxes rise, suppliers often pass on the burden to the consumer; the catch, however, is that once prices have increased, they rarely go back, even if the taxes are later reduced. Wars are often cause for inflation, as governments must both recoup the money spent and repay the funds borrowed from the central bank. War often affects everything from international trading to labor costs to product demand, so in the end it always produces a rise in prices. The basic causes of inflation were covered at AS level. This note considers the demand and supply-side courses in more detail including the impact of changes in the exchange rate and the prices of goods and services in the international economy. Cost Push Inflation Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. There are many reasons why costs might rise: Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on exports of these commodities or alternatively by a fall in the value of the pound in the foreign exchange markets which increases the UK price of imported inputs. A good example of cost push inflation was the decision by British Gas and other energy suppliers to raise substantially the prices for gas and electricity that it charges to domestic and industrial consumers at various points during 2005 and 2006. Rising labour costs - caused by wage increases which exceed any improvement in productivity. This cause is important in those industries which are ‘labour-intensive’. Firms may decide not to pass these higher costs onto their customers (they may be able to achieve some cost savings in other areas of the business) but in the long run, wage inflation tends to move closely with price inflation because there are limits to the extent to which any business can absorb higher wage expenses. Higher indirect taxes imposed by the government – for example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation. Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. This is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a contraction of real national output together with a rise in the general level of prices.

Demand Pull Inflation Demand-pull inflation is likely when there is full employment of resources and when SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of reasons – some of which occur together at the same moment of the economic cycle •

A depreciation of the exchange rate, which has the effect of increasing the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while foreigners buy more exports, AD will rise. If the economy is already at full employment, prices are pulled upwards.

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A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond potential GDP.

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The rapid growth of the money supply – perhaps as a consequence of increased bank and building society borrowing if interest rates are low. Monetarist economists believe that the root causes of inflation are monetary – in particular when the monetary authorities permit an excessive growth of the supply of money in circulation beyond that needed to finance the volume of transactions produced in the economy.

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Rising consumer confidence and an increase in the rate of growth of house prices – both of which would lead to an increase in total household demand for goods and services

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Faster economic growth in other countries – providing a boost to UK exports overseas.

The effects of an increase in AD on the price level can be shown in the next two diagrams. Higher prices following an increase in demand lead to higher output and profits for those businesses where demand is growing. The impact on prices is greatest when SRAS is inelastic. In the first diagram the SRAS curve is drawn as non-linear. In the second, the macroeconomic equilibrium following an outward shift of AD takes the economy beyond the equilibrium at potential GDP. This causes an inflationary gap to appear which then triggers higher wage and other factor costs. The effect of this is to cause an inward shift of SRAS taking real national output back towards a macroeconomic equilibrium at Yfc but with the general price level higher than it was before.

The wage price spiral – “expectations-induced inflation” Rising expectations of inflation can often be self-fulfilling. If people expect prices to continue rising, they are unlikely to accept pay rises less than their expected inflation rate because they want to protect the real purchasing power of their incomes. For example a booming economy might see a rise in inflation from 3% to 5% due to an excess of AD. Workers will seek to negotiate higher wages and there is then a danger that this will trigger a ‘wage-price spiral’ that then requires the introduction of deflationary policies such as higher interest rates or an increase in direct taxation.

Inflation influences in the British economy

The diagram summarises some of the key influences on inflation. Reading from left to right: ○

Average earnings comprise basic pay + income from overtime payments, productivity bonuses, profit-related pay and other supplements to earned income

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Productivity measures output per person employed, or output per person hour. A rise in productivity helps to keep unit costs down. However, if earnings to people in work are rising faster than productivity, then unit labour costs will increase

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The growth of unit labour costs is a key determinant of inflation in the medium term. Additional pressure on prices comes from higher import prices, commodity prices (e.g. oil, copper and aluminium) and also the impact of indirect taxes such as VAT and excise duties.

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Prices also increase when businesses decide to increase their profit margins. They are more likely to do this during the upswing phase of the economic cycle.

Inflation April 20, 2008 by admin •

Bond Glossary

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Bonds

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Inflation

What is Inflation? 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. Flash plugin not found.

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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. •

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.

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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.

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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 of 2007 is a very good example of this at work.

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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 unemployment rates. When extremes arise in the supply/demand structure, imbalances are created. The mortgage crisis of 2007 is 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". Even moderate inflation can cause problems because it lessens the practical advantages of using money instead of having to trade. This can be better understood if you look at the four functions that economists generally attribute to money and the way that inflation affects them: •

Money is a storage of value. If you were to sell a horse for 10 gold coins, you should be able to go back and change that money in for another horse tomorrow or the next week or the next month. When money holds its value, you feel safe saving it, and instead of selling a horse, you might be in situation in which you sell real estate or any other asset.

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Inflation weakens the function of money as a storage of value, because each unit of money is worth less with the passing of time.

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Money is a standard unit of account. If you are interested in buying a sheep, you will probably not want to take the sheep as a loan with the commitment of paying off two sheep the next year. Most likely you will get a loan and pay it in monetary terms. In other words, get a loan of one gold coin to buy your sheep, with the commitment of paying two gold coins next year.

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The progressive loss of the value of money during a period of inflation makes the borrowers to be less willing to use the money as standard differed payments. Suppose that a friend asks you to loan him $100, and commits to paying you $120 within a year. This seems like a good deal – after all this is an interest weigh of twenty percent. But if the prices are increasing rapidly and the value of money is decreasing, how much will you be able to buy with those $120?

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Inflation makes people be less willing to loan out money. They fear that once the loans are paid off, the money they receive will not have the same buying value then the money loaned. This uncertainty can cause a devastating effect over the development of new businesses, that to finance their businesses are based a good amount on loans.

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Money is a means of exchange. Money is a means of exchange between buyers and sellers because it can be directly changed for anything else, which makes buying and selling a lot easier. In an economy of trade, an apple producer that wants to buy chocolate might see himself first forced to buy oranges and then exchange the oranges for the chocolate, because it is possible that the chocolate salesperson only wants oranges. Money however, eliminates this type of problem.

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But if inflation is high enough, money is no longer an effective means of exchange. During hyperinflations, frequently the economies go back to trading and this way, the buyers and sellers do not have to worry for the loss of the value of money. For example, in a healthy economy the apples sales man can sell them for money and then change this money in for chocolate. But during hyperinflation, while he is selling the apples for money and buys the chocolate, the price of the chocolate could have increased so much that he is not longer able to buy chocolate. During a hyperinflation, the economies have to go to tricky trades.

Another result of inflation is that it produces a similar effect to a significant increase of taxes. This may seem strange, because we normally consider the government charge taxes taking part of the people’s money from them, no by printing more money. But a tax is basically anything that transfers private property to the government. The alternation of the money or printing of more money can have this effect. Suppose that the government wants to buy a new van that is going to cost $20,000 for the national library. The right way to do this would be to use $20,000 from the income taxes to buy it. A sneaky way of doing it would be to print up the $20,000 of new money. By printing and spending new money, the government has turned $20,000 of private property, which in this case is the van, into public property. So this means that printing new money works exactly like a tax. Since printing new money generates inflation, this type of tax is generally known as an inflationary tax. An inflationary tax is not only sneaky, but also unjustly affects the poor because they spend almost all of their income on goods and services that go up considerable during inflation. In comparison, since the rich are able to save a high proportion of their income instead of spending almost everything they receive, an inflationary tax affects them proportionately less. The rich can protect themselves from a great part of the damage caused by inflation by inverting their savings into assets, such as root property, whose prices increase during inflation. Effects of Inflation: Inflation affects both the economy of a country and its social conditions, as well as the political and moral lives of its inhabitants. However, the economic effects of Inflation are stated and described below:

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Price inflation has immense effect on the Time Value of Money (TVM). This acts as a principal component of the rates of interest, which forms the basis of all TVM calculations. The real or estimated changes occurring in the rates of inflation lead to changes in the rates of interest as well.

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Inflation exerts impact on the treasury of a nation as well. In United States of America, Treasury Inflation-protected Securities (TIPS) ensures safety to the American government, assuring the public that they will get back their money. However, the rates of interest charged by TIPS are less compared to the standard Treasury notes.

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The most immediate effect of inflation is the decrease in the purchasing power of dollar and its depreciation. Inflation influences the investments of a country. The Inflation-protected Securities (IPSs) may act as a guard against the loss in the purchasing power of the fixed-income investments (like fixed allowances and bonds), which may occur during inflation.

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Inflation changes the allocation of income. This exerts maximum effect on the lenders than the borrowers at the time of persisting inflation, because the loans sanctioned previously are paid back later in the form of inflated dollars.

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Inflation leads to a handful of the consumers in making extensive speculation, to derive advantage of the high price levels. Since some of the purchases are

high-risk investments, they result in diversion of the expenditures from regular channels, giving birth to a few structural unemployments.

• costs and effects of inflation • • •

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There is widespread agreement that high and volatile inflation can be damaging both to individual businesses and consumers and also to the economy as a whole. However, economists disagree about the relative seriousness of inflation. The revision notes below cover some of the main economic and social costs associated with persistent inflation in goods and services. Effect on UK competitiveness - if the UK has higher inflation than the rest of the world it will lose price competitiveness in international markets. This assumes a given exchange rate. If the exchange rate depreciates, this may help to restore some of the lost competitiveness. Consider the chart above which shows the annual average increase in consumer prices for the UK, the United States and Euroland during the last four decades. Inflation in Britain has been relatively higher than in other major competitor countries - although the chart also indicates a movement towards inflation convergence during the 1990s

This rise in relative inflation leads to a fall in the world share of UK exports and a rise in import penetration. Ultimately, this will lead to a fall in the rate of economic growth and the level of employment. The problems of a wage-price spiral – price rises can lead to higher wage demands as workers try to maintain their real standard of living. Higher wages over and above any gains in labour productivity causes an increase in unit labour costs. To maintain their profit margins they increase prices. The process could start all over again and inflation may get out of control. Higher inflation causes an upward spike in inflationary expectations that are then incorporated into wage bargaining. It can take some time for these expectations to be controlled. Higher inflation expectations can cause an outward shift in the Phillips Curve. Inflation can also cause a reduction in the real value of savings - especially if real interest rates are negative. This means the rate of interest does not fully compensate for the increase in the general price level. In contrast, borrowers see the real value of their debt diminish. Inflation, therefore, favours borrowers at the expense of savers. Consumers and businesses on fixed incomes will lose out. Many pensioners are on fixed pensions so inflation reduces the real value of their income year on year. The state pension is normally uprated each year in line with average inflation so that the real value of the pension is not reduced. However it is unlikely that pensioners have the same spending patterns as those used to create the weights from which the RPI figure is calculated. For example in November 1999, the state pension was up-rated by just 1.1% - the headline rate of inflation for that month. Inflation usually leads to higher nominal interest rates that should have a deflationary effect on GDP. Inflation can also cause a disruption of business planning – uncertainty about the future makes planning difficult and this may have an adverse effect on the level of planned capital investment.

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Budgeting becomes a problem as firms become unsure about what will happen to their costs. If inflation is high and volatile, firms may demand a higher nominal rate of return on planned investment projects before they will go ahead with the capital spending. These hurdle rates may cause projects to be cancelled or postponed until economic conditions improve. A low rate of new capital investment clearly damages long-run economic growth and productivity. Cost-push inflation usually leads to a slower growth of company profits which can then feed through into business investment decisions. Inflation distorts the operation of the price mechanism and can result in an inefficient allocation of resources. When inflation is volatile, consumers and firms are unlikely to have sufficient information on relative price levels to make informed choices about which products to supply and purchase. Two further costs of inflation are often mentioned in the textbooks: Shoe leather costs - when prices are unstable there will be an increase in search times to discover more about prices. Inflation increases the opportunity cost of holding money, so people make more visits to their banks and building societies (wearing out their shoe leather!). Menu costs - extra costs to firms of changing price information. This can be important for companies who rely on bulky catalogues to send price information to customers. (Note there are also significant menu costs associated with any future transition to the European Single Currency) Anticipated and unanticipated inflation

When inflation is volatile from year to year, it becomes difficult for individuals and businesses to correctly predict the rate of price inflation that will happen in the near future. When people are able to make accurate predictions of inflation, they can anticipate what is likely to happen and take steps to protect themselves. For example, people can bid for increases in money wages so as to maintain their real wages. Savings can be shifted into accounts offering a higher rate of interest, or into assets where capital gains might outstrip general price inflation. Companies can adjust their prices; lenders can adjust interest rates. Unanticipated inflation occurs when economic agents (people, businesses and governments) make errors in their inflation forecasts. Actual inflation may end up well below, or significantly above expectations.