Inflation

What is Inflation?

​

What are the causes of Inflation?

​

What are the short and long term effects of Inflation on the economy?

​

Inflation and currency

What is inflation?

• Inflation is the rate at which the general level of prices for goods and services in an economy is rising over a period of time.

​

• When inflation occurs, each unit of currency buys fewer goods and services than it did before.

​

• Inflation is typically measured on an annual basis, and economists use various indexes, such as the Consumer Price Index (CPI), Producer Price Index (PPI) or Personal Consumption Expenditures (PCE) to track changes in prices over time.

​

What are the causes of Inflation? pt 1

• Demand-Pull Inflation: This type of inflation occurs when aggregate demand for goods and services exceeds aggregate supply. Detailed causes include:
• Increase in consumer spending due to factors like rising incomes, consumer confidence, or expansionary fiscal policies (government spending or tax cuts).
• Investment spending by businesses on capital goods and infrastructure.
• Government expenditure on projects and programs.
• Excessive growth in money supply, leading to more spending power in the economy.

​

• Built-In Inflation: Also known as wage-price inflation, this occurs when past inflation influences future inflationary expectations. Detailed causes include:
• Workers demanding higher wages to keep up with rising prices, leading to a wage-price spiral.
• Businesses raising prices in anticipation of future cost increases, such as expected rises in wages or input costs.

​

​

What are the causes of Inflation? pt 2

​

• Cost-Push Inflation: This type of inflation results from increased production costs being passed on to consumers. Detailed causes include:
• Rising wages: When workers negotiate higher wages, businesses may raise prices to cover the increased labor costs.
• Higher input costs: Prices of raw materials, energy, or imported goods can increase, leading to higher production costs and subsequently higher prices for finished goods.
• Taxes and regulations: Increased taxes or compliance costs for businesses can lead to higher prices for consumers.
• Supply chain disruptions: Natural disasters, geopolitical conflicts, or other factors that disrupt the supply chain can lead to shortages and price increases.

​

• Monetary Factors: Changes in the money supply and monetary policy decisions can impact inflation. Detailed causes include:
• Expansionary monetary policy: Central banks increasing the money supply through methods like lowering interest rates or quantitative easing can lead to inflation by boosting spending.
• Excessive money creation: If the money supply grows faster than the economy's ability to produce goods and services, it can lead to inflationary pressures.
• Currency depreciation: When the value of a currency declines relative to other currencies, it can lead to higher prices for imported goods and contribute to inflation.

​

How can monetary policy control and affect inflation? pt1

• Interest Rate Adjustments:
• Central banks can use changes in interest rates as a primary tool to control inflation. When central banks raise interest rates, borrowing becomes more expensive, leading to reduced consumer spending and business investment. This decrease in spending helps to slow down economic activity and reduces inflationary pressures.
• Conversely, when central banks lower interest rates, borrowing becomes cheaper, stimulating spending and investment, which can help boost economic growth and alleviate deflationary pressures.

​

• Open Market Operations (OMOs):
• Central banks conduct open market operations by buying or selling government securities (such as bonds) on the open market. When central banks purchase securities, they inject money into the banking system, increasing the money supply and potentially stimulating economic activity.
• Conversely, when they sell securities, they withdraw money from the banking system, reducing the money supply and curbing inflationary pressures.

​

• Reserve Requirements:
• Central banks can adjust reserve requirements, which are the minimum amounts of reserves that commercial banks are required to hold. By increasing reserve requirements, central banks reduce the amount of money that banks can lend out, thereby decreasing the money supply and dampening inflationary pressures.
• Conversely, lowering reserve requirements can stimulate lending and increase the money supply to support economic growth.

​

How can monetary policy control and affect inflation? pt2

​

• Forward Guidance:
• Central banks can provide forward guidance to influence market expectations about future monetary policy actions. By communicating their intentions regarding future interest rate changes or other policy measures, central banks can influence borrowing and spending decisions, which in turn can impact inflationary pressures.

​

• Quantitative Easing (QE):
• In times of economic crisis or deflationary pressures, central banks may resort to quantitative easing, which involves purchasing large quantities of financial assets (such as government bonds or mortgage-backed securities) from the market. This injection of liquidity into the financial system aims to lower long-term interest rates, stimulate lending, and boost economic activity, thereby preventing deflation and supporting inflationary targets.

​

• Inflation Targeting:
• Many central banks adopt inflation targeting frameworks, where they set explicit targets for inflation and adjust monetary policy to achieve those targets. By signaling a commitment to maintaining low and stable inflation over the medium to long term, central banks can anchor inflation expectations and help prevent inflationary spirals.

​

What are the effects of rising inflation on the economy? pt1

• Reduced Purchasing Power:
• Rising inflation erodes the purchasing power of money, meaning that each unit of currency buys fewer goods and services over time. As prices increase, consumers may find their real incomes decreasing, leading to a decrease in their standard of living.

​

• Uncertainty and Economic Distortions:
• High or unpredictable inflation can create uncertainty in the economy, making it difficult for businesses to plan and make long-term investments. This uncertainty can lead to economic distortions, as businesses may delay investments or hold excess cash to hedge against inflation risk.

​

• Interest Rate Increases:
• Central banks often respond to rising inflation by increasing interest rates to curb spending and reduce inflationary pressures. Higher interest rates can increase the cost of borrowing for consumers and businesses, leading to reduced investment and consumer spending, which can slow down economic growth.

​

What are the effects of rising inflation on the economy? pt1

​

• Income Redistribution:
• Inflation can redistribute income and wealth within the economy. Debtors benefit from inflation because they can repay their debts with money that is less valuable than when they borrowed it. Conversely, creditors suffer because the real value of the money they are repaid decreases.

​

• Wage-Price Spiral:
• Rising inflation can lead to wage-price spirals, where workers demand higher wages to keep up with rising prices, and businesses raise prices to cover increased labor costs. This cycle can perpetuate inflationary pressures and contribute to further price increases.

​

What are the effects of declining inflation on the economy? pt1

​

• Deflationary Spiral:
• Deflation, or a sustained decline in the general price level, can lead to a deflationary spiral, where falling prices result in lower consumer spending and business investment. This can lead to further price declines, creating a self-reinforcing cycle of economic contraction.

​

• Increased Real Debt Burden:
• Deflation increases the real burden of debt because the value of money increases over time. Debtors may find it more difficult to repay their debts as the purchasing power of their incomes declines.

​

• Delayed Spending:
• Consumers may delay purchases in anticipation of further price declines during deflationary periods, leading to decreased consumer demand and economic stagnation.

​

What are the effects of declining inflation on the economy? pt2

​

• Asset Price Deflation:
• Deflation can lead to declines in asset prices, such as real estate and stocks, which can negatively impact household wealth and financial stability.

​

• Interest Rate Challenges:
• Central banks may face challenges in stimulating economic activity during deflationary periods, as nominal interest rates approach zero and monetary policy becomes less effective.

​

How does inflation affect the currency?

• Currency Depreciation:
• Inflation often leads to a depreciation of the currency's value relative to other currencies. When a country experiences higher inflation rates compared to its trading partners, its currency becomes less attractive to investors and traders. As a result, the demand for the currency declines, causing its value to fall in foreign exchange markets.

​

• Impact on Trade Balance:
• Inflation can affect a country's trade balance by influencing its competitiveness in international markets. If inflation rates are higher in one country than in its trading partners, its exports may become more expensive relative to those of other countries, leading to a decrease in demand for its goods and services.

​

• Investor Confidence:
• High or unstable inflation rates can undermine investor confidence in a currency and its economy. Investors may seek alternative currencies or assets that offer more stable purchasing power, leading to capital outflows and a decline in the currency's value.