Inflation is the continuous increase in the general price levels of commodities in the economy over a period. It is identified with the market fall of the value of money in a particular economy. This recurring price increase erodes the purchasing power of money creating economic distortions and uncertainty (Sargent 2002). Inflation may also be described as a sudden increase in supply of money in a given economy. This results to each unit of currency buying fewer commodities thus a reduction in the purchasing power per unit of money. It can also be viewed as an increase in the supply of money at a rate that is higher than the rate of production in the country's economy. When this price increase is gradual and irregular, it leads to creeping inflation. This is healthy for the economy. It stimulates the economy encouraging social and economic progress. It also makes it easier to adjust relative prices such as salaries employees receive.
While mild and gradual inflation is considered to be an indicator of a healthy economy, inflation above this slow rate has a negative impact in the economy. Taxes imposed to citizens increases with increases in supply of money to the economy. This makes people become more willing to spend because of two main reasons: to purchase commodities before they increase in price and to avoid paying tax on holding currencies. This results to the increase in demand for different commodities thus raising their prices as dictated by price mechanism. This strengthens the rate of inflation and increases the velocity of money; a process referred to as a vicious cycle and is difficult to harness, leading to hyperinflation (Laubach, Mishk, 2001).
High inflation rates and hyperinflation lead to bad economic times. As prices rise, the purchasing power of a currency unit decreases thus leading to an increase in uncertainty. This encourages purchasing greasing the vicious cycle while at the same time discouraging savings and investments. Unequal redistribution of money will result. People who receive fixed incomes will continue receiving the same amount which in turn reduces their purchasing power while those on flexible incomes will be able to adjust to inflation. Money will thus be redistributed from those with fixed incomes to those with flexible income. If the inflation rate is higher compared to that abroad, it will lead to deficits in balance of payment resulting from international trade.
Unless it has gone far out of hand, inflation is a controllable. Several approaches can be used to control this. The federal reserve of the U.S counters inflation rates by different fiscal and monetary policies. Fiscal policies come in the form of federal budgeting policies and taxation. However, most market watchers look at financial policies to stabilize the economy. In the US, The Federal Reserve Board's Open Market Committee FOMC is in charge of implementing monetary policies (Sargent 2002). They are charged with the responsibility of limiting or increasing the amount of money circulating in the economy. They make money easier to come by thus encouraging spending to spur economic growth or make it harder to come by when growth rates reach unsustainable levels.
In general, Central Banks in all economies fight inflation by setting high interest rates and reducing the supply of money in the economy. Income policies/ wage and price control policies can be introduced to fight inflation rates. This process all the same has negative effects including distortion of the overall functioning of the economy as it encourages shortages and decrease in quality of commodities.
There are several ways used to measure inflation. Consumer Price Index (CPI) is widely used. This approach measures the average prices of a fixed basket of goods and services. This basket of goods reflects what a typical family buys to achieve some desired standard of living in a given period. In the USA, the base set is currently 1982-1984. This base period is adjusted after a given number of years. The Bureau of Labor Statistics (BLS) compiles it on a monthly basis. They weigh each item in the basket according to its total household expenditure share in the base period in order to reflect changes in the index periodically to represent the current household cost of living (Sargent 2002). The items are grouped into eight categories which include: housing, apparel, education and communication medical care and transportation. The three main CPI used are: CPI for all urban consumers, Chained CPI for all urban consumers and CPI for urban wage earners and clerical workers.
Producer Price Indexes (PPI) is another method of measuring inflation by the federal government. It measures average changes in price domestic producers receive for their output using weights attached to their output. It covers virtually all industries. It is compiled monthly by the BLS.
Personal Consumption expenditure (PCE) is another method of measuring inflation. The Bureau of Economic Analysis computes it on a monthly basis from the National Income and Products Account NIPA.
Inflation has different economic costs. It has a huge impact on savers, as they lose confidence in money as a real value of saving. It may also lead to higher demand of wages as people anticipate to maintain their current living conditions. Inflation also has an impact on a country's competitiveness and unemployment rate. When a country experiences higher inflation rate than another, it leads to loss in competitiveness worsening their performance in trade. This results to increase in unemployment rate.
Business planning and investment can be disrupted by inflation. Budgeting is made hard due to uncertainties created by rise in prices and costs.Inflation has a couple of other positive consequences associated with it. A stable low rate can allow organizations to raise their revenues, prices and profits and their workers can anticipate an increase in their wages as result (Laubach, Mishk, 2001).
Low stable inflation can also help reduce the real value of outstanding debts. A good example is mortgage beneficiaries who benefit from inflation to reduce the real burden on their mortgage.
Fluctuation in exchange rates can also have effects on inflation. Fall in value of the domestic currency against other currencies causes higher import prices. Rising of labor costs that are greater than the improvement in productivity also results into inflation.
It is difficult to forecast inflation. Some of the reasons behind this include: volatile energy prices, change in value of currency in relation to other foreign currencies, change in indirect government taxes, volatile food prices and uncertain growth of demand
Inflation is a natural phenomenon that a healthy economy must experience. Too high inflation rates and zero inflation rates are, however, harmful to the economy. The government is the entity vested with the responsibility of controlling inflation. When it fails to control it, such negligence will be equated to stealing from its people (Sargent 2002).
Reference:
Laubach, T. Mishk, F. (2001). Inflation Targeting: Lessons from the International Experience. New Jersey. Princeton University Press.
Sargent, T. (2002). The Conquest of American Inflation Princeton paperbacks. New Jersey. Princeton University Press, 2002
