Inflation Homework Help

Inflation is that situation in the economy when the prices of goods rise higher than the general price level in the economy. When the prices rise, the units of currency can buy lesser goods than they could before. Thus, Inflation reduces the purchasing power of money in the hands of the people. This is a real loss in the value of the medium of exchange in the economy. Inflation has both positive and negative effects on the economy’s functioning.

How to calculate Inflation in the economy?

Inflation is a change in the prices of the commodity. Thus, to measure inflation the index method is used. There are several indices used to calculate the Inflation in the economy like Consumer Price Index, Retail Price Index, and Wholesale Price Index etc. The inflation is measured by the percentage change in the prices in the index over a period of time. The Retail Price Index is used widely in the UK and in the USA the widely used method is Consumer Price Index. According to the latest reports; the Inflation Rate in the USA for 2017 is 2.13

There are many other indices used to calculate Inflation Rate in the economy. Some of them are:

• Producer Price Indices: Producer Price Indices is used to track or measure the changes in the average price charged by the producer from its domestic consumption. The producers keep track of the prices they charge for their products. The Producer Price Indices is different from the Consumer Price Indices. The Produce Price Indices does not take into consideration the subsidies, the addition of profits at the other intermediate stages by the agents, taxes etc.; which are taken into consideration while computing Consumer Price Indices. The PPI majorly calculates the pressure put by the prices of Raw Materials on the production cost. IN USA, PPI used to be known as Wholesale Price Index.

• Commodity Price Indices: This indexing method is used to calculate the price changes of selected commodities only. The selected commodities are used as a sample to know about the price index prevailing.

• Core Price Indices: There are several products on the market that highly price sensitive. Their price volatility is highly effective. These are the products like oil, fuel etc. Therefore, in Core Price indices; such products are not included because of their sensitivity. These are excluded from the Consumer Price Indices for a reliable index.

Other common measures of inflation are:

• GDP deflator: This is one of the best indicators of calculating the Inflation Rate in the economy. The GDP Deflator is calculated by the following method:

• Regional inflation: Several Government Institutes or Offices build up the record at the regional level about the changes in the prices. These records are studied to determine the overall inflation trend prevailing in the nation.

• Historical inflation: An analysis of the historical information is done to arrive at a conclusion about the inflation rates prevailing. The trends are studied by the experts and researchers and conclusions are drawn by them.

• Asset price inflation: It is a unique method to calculate the inflation in the economy using the prices of the assets. A change in the value of assets is taken to be the direct determinant of inflation in the country.

Factors that cause Inflation:

The Economists have defined three forces that cause Inflation:

1. Cost-Push Inflation: The cost-push inflation refers to the inflation that is caused due to the rise in the cost of production of goods. This rise in the cost will force the prices of goods to rise and hence charge more from the customer. The higher the rate of cost of production will be, the more the price of the goods will be.
   
   This cost is generally increased due to:
   
   a) Rise in the wages demanded by the laborers. It is directly attributable to the cost of goods. Thus it increases the final price of goods; giving a rise to Inflation.
   
   b) Rise in the prices of Raw Material: The raw materials are the initial input for any manufacturing process. The rise in Raw material’s prices leads to a rise in the prices of the final goods. Hence resulting in the inflation of the economy.
   
   

2. Demand- Pull Inflation: This kind of inflation takes place due to the increasing demand for the product. When the demand for the product rises; the demand curve shifts upward. If the supply side also shifts upward equally, there will be no effect on the prices. But in case the supply cannot be increased; it will lead to a rise in the prices and thus causing inflation. This increased demand will cause the Aggregate Demand to rise. This rise could be because of the increase in personal expenditure, exports, government expenditure, increase consumption etc.

3. Monetary Inflation: Monetary inflation is just like the Demand-pull inflation. This kind of inflation is caused due to the rapid increase in the demand due to the increase in the money supply to the people. With more purchasing power in hand, people demand more. The supply cannot match the demand and hence the prices rise and the purchasing power of the money falls.

Positive Effects of Inflation:

There are several positive effects of Inflation. Some of them are:

1. Inflation can boost growth: Inflation can highly help in giving a boost to the growth in the economy. Due to the recession in the economy, the economy staggers and there is huge unemployment. To overcome that situation many economists target a higher rate of inflation so that the economy can have chances of growth. This is a controversial view but it is being used in the practical application

2. Inflation adjusts relative wages: It is believed that a moderate inflation rate can help in adjusting the relative wages in the economy. With the increase in the inflation rate, the wages of the employees can be increased relatively.

3. Inflation adjusts relative prices: Inflation largely helps in adjusting the relative prices of the products. In countries having low inflation rates; the competition is missing out. They have to cut their relative prices to enhance the competition. Thus inflation is necessary.

4. Adjustment of Interest Rates: Inflation reduces the real burden of public and private debt, keeping nominal interest rates above zero so that central banks can adjust interest rates to stabilize the economy, and reducing unemployment due to nominal wage rigidity.

Negative Effects of Inflation:

• Low investment: A high rate of inflation instills a sense of confusion and uncertainty among the investor. The high inflation rates create the fear of losing the money. Thus, the people invest low in the market so as to save themselves from the losses.

• Lower Exports: The sellers are not able to meet the demand in the domestic market due to which the prices of the commodities rise. In such a situation they are unwilling to export their products to the international market. They already get a huge margin by charging high from the domestic market. Thus the country loses on the International Competition. This is a huge blow to any economy.

• Incurring of Menu Costs: The businesses have to revise the whole prices of their products due to inflation. They occur heavy expense or costs on re-engineering or renewing their business structures or menu costs. Thus it brings new costs to the business.

• The burden on the Public: the ultimate burden of the inflation is shifted onto the consumers who ultimately have to pay the hefty amount to purchase goods. This is unjust as to the customers as they have to bear the cost. In many instances, they take loans from the market and go bankrupt to pay it back.

• Effect on savings: Inflation acts as a huge blow to the savings of the people. The middle- class people have to depend upon their savings to cope with the inflation. This reduces their savings and leaves them in an insecure position without any backup.

• Vicious Cycle: The hyperinflation can act as a vicious cycle. All the steps to curb inflation can go out of control and be rendered as a waste. The people will be left with debts; thus making the whole economy crippled.

• Cost to curb inflation: The government incurs huge costs to curb inflation. The government has to undertake several measures such as monetary policy, fiscal policy, credit policy etc. This is a huge cost to the government.

• Soak the pensioners: The inflation puts the old people on a setback who survive on the pension. The old people become unable to survive on the little pension they get. They are rendered helpless with the low level of pension and without any other monetary backup.

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