Inflation-Causes and Consequences

Inflation-Causes and Consequences

Causes of inflation
There are two main causes of inflation, namely rising aggregate demand and rising costs of production.

Demand-pull inflation

This types of inflation arises when aggregate demand increases faster than aggregate supply. It means that the total demand increase in the economy has surpassed total supply of goods, thereby causing prices to be raised. Aggregate demand rises if any of its components (consumption, investment, government spending and net export) rises. For example, a rise in income would increase consumption and aggregate demand since consumption is a component of aggregate demand.  Aggregate demand increases from AD1 to AD2 (Figure 1 below); the price level increases from P1 to P2 indicating that there is inflation. Other factors that can expand aggregate demand include low interest rate, consumer confidence, a fall in exchange rate and business confidence. Any of these factors will increase a component of aggregate demand.

Figure 1: Demand-pull inflation

Graph showing demand-pull inflation

Cost-push inflation

It is caused by a hike in the costs of production, e.g. energy cost, wages and salaries, raw material costs, etc. When costs rise, producers respond by increasing their prices, thereby fuelling inflation.  Suppliers will reduce their supply when costs are rising; cutting down supply in the economy will increase the general price level. In Figure 2 below, aggregate supply decreases from AS1 to AS2, thereby causing inflation by raising the price level from P1 to P2. Cost-push inflation tends to be worse than demand-pull inflation due to the effect on total output in the economy. For cost-push inflation, a reduction in aggregate supply reduces the economy’s output of goods and services (from Y1 to Y2 in Figure 2 below). Demand-pull inflation, on the other hand, expands the total output of the country (from Y1 to Y2 in Figure 1 above). This is why cost-push inflation is often referred to as bad inflation while demand-pull inflation is called good inflation.

Figure 2: Cost-push inflation

Graph showing cost-push inflation

Disadvantages of  inflation

Current account deficit
A sustained rise in the prices of goods and services make domestic products less competitive in the international market, especially when other countries have a relatively lower inflation rate. Therefore, exports will reduce causing current account deficit.

Lower  standard of living
Inflation increases prices of food and other essential products. This reduces purchasing power as products become expensive for people.  The consequence is lower living standard in the economy. 

Reduces investment
High and unstable inflation rate makes it difficult for businesses to predict costs and adjust prices accordingly. This breeds business uncertainty that discourages further investment and reduces employment opportunities in the country.

Discourages savings
Inflation reduces the value of money people have in their savings accounts unless the interest rate exceeds inflation rate. It discourages savings; less savings will reduce the availability of funds available in financial institutions to be channelled towards investment. People also spend time and money shopping for higher interest rate by moving from one financial institution to another. The cost involved in moving funds due to inflation is known as shoe-leather cost.

Rising labour costs and fiscal drag
Rising inflation rate leads to workers negotiating pay rise in order for their wages to keep pace with inflation. This increases labour costs and business profits. A pay rise “drags” people into a higher tax bracket where a progressive tax system is practised. Government tax revenue increases but pay rise is just to cushion the effect of inflation; people are not richer but they end up paying more taxes to the government.

Discourages lending
Lenders suffer in a period of inflation because  they receive money with lesser value when repayment is made by borrowers. This may encourage them to increase interest rate on loans to reduce the adverse effect of inflation when repayment is made. Higher interest rate reduces borrowing and investment.

Fixed income earners suffer
People on fixed incomes, such as pensioners, will see the value of their income reduced considerably. This affects their purchasing power and makes them poorer. 

Businesses incur additional costs adjusting to inflation
Inflation necessitates adjustment in prices by businesses in order to maintain their profit margins. They have to make changes to their price lists, catalogues, advertisements to reflect the new prices. This involves extra cost and may reduce profitability especially when the products have fairly elastic demand. These costs of making adjustment are called menu costs.

Advantages of inflation

Encourages business investment
A low and stable rate of inflation encourages people to buy now rather than postpone their purchases. Since prices are rising continuously, it is better to buy now than later. This increases demand for goods which in turn stimulate investment in order to meet up with the demand.

Creation of jobs
Jobs are created when firms increase their investment in response to high demand. More people are able to earn incomes and government spending on benefits will nosedive.

Reduces real cost of borrowing
The real cost of borrowing is interest rate minus inflation rate. If inflation rate goes up, the real interest rate goes down. For example, the interest rate a borrower actually pays is 5% (15%-10%) if nominal interest rate is 15% and inflation is 10%.That means has reduced the value of the interest rate by 10%.  This can encourage more borrowing for consumption and investment.

Leads to economic growth
Increased demand will encourage increased production, thereby increasing the output of products in the economy. In other words, more consumption and investment will promote economic growth.