In this part of the paper the subject of the discussion will be the history and various causes of inflation. We will talk about the history of inflation, the factors which influence it, the mechanism of inflation and its effects, as well as the way government policies deal with inflationary pressures.
History of inflation
In the first step, it is important to discuss the history of inflation and the reasons for its existence. For centuries the problem of money supply increase appeared all over the world. Therefore, countries used to change the type of currency quite often. Thus, initially many countries used golden coins as their major currency, however later on governments mixed gold with some other metals, such as copper, steel and lead, in order to form new coins. Government reissued those coins to the public without diluting their value. Hence, with the same quantity of gold government could make more coins than before without decreasing their value, therefore country’s money supply increased. With the increase in money supply in the market the comparative value of money went down. As a result consumers had to pay extra for purchasing goods. Thus, conversion of gold coins into mixed-metal coins between 15 and 17 centuries led to inflation in the economies of many countries.
Already in the 19th century economists recognized three different factors, which could create inflation. Firstly, the change in the cost of production could stimulate inflation. Secondly, the change in the cost of production could affect the cost of metal used for making coins. Thirdly, currency depreciation occurred due to high currency supply.
During the American Civil War banknotes were introduced to replace coins. At that time inflation was directly related to currency depreciation. Since the quantity of banknotes available for redemptions exceeded the amount of metal, currency was devaluated.
Inflation crises
In 1992 the major inflation problems occurred in Western Europe. The major inflation hit was also known as ERM (European Exchange Rate Mechanism) crisis. During that period prices for almost all goods increased by a factor of six. The main cause of inflation was a sudden arrival of huge quantity of gold and silver in Spain. The metal spread very quickly and started to create inflationary pressure. Some other demographic aspects such as the population growth also contributed to the inflation, however the arrival of the gold and silver was the major reason for inflation. In 1993 inflation again hit the Western European system, which resulted in the increase of the exchange rate level and in the devaluation of franc.
In 1994 a major crisis hit the countries in Latin America. The consequences of this crisis were detrimental for the affected countries. Mexico’s growth slowed down significantly, while Argentina faced the problem of unemployment. All countries experienced huge account deficits, while prices and costs went out of control. In Mexico the government relaxed some monetary regulations in order to win the elections, however as a result of this policy the country was left without its reserves of foreign currencies Therefore, it was unable to pay the debt, which was supposed to be paid in dollars. In order to stabilize the rate of inflation the government increased interest rates by almost 80 percent. This fact reduced the domestic demand and significantly decreased the GDP of Mexico. Argentina also faced the crisis due to the policy of equalizing their currency to dollar. As a result the reserve of foreign currency decreased, while the inflow of local currency increased, thus stimulating inflation even further. Therefore, Argentina had to modify its exchange rate policies in order to come back to normal.
In 1995 crisis occurred in Asia. Thailand, Indonesia, and South Asian countries suffered most during this crisis, however other countries such as Malaysia, Philippines, Laos and Hong Kong were also affected. The nature of the crisis was somewhat similar to the one in Latin America. In Thailand the crisis had the same mechanism as the one in Mexico, while the Malaysian crisis resembled the one in Argentina. The crisis first occurred in Thailand, where the government increased the value of the currency and made it equal the US dollar. The country lost all its foreign exchange reserves and almost went bankrupt. Other Asian countries were also impacted by this crises.
Types and causes of inflation
There are various opinions given by economists on the potential causes of inflation, however the commonly agreed reasons of inflation are an increase in the quantity of money in the market and a decrease in the supply of goods.
Demand Pull Inflation is caused by various factors. According to the demand pull theory, when money flow is high in the market, the purchasing power of consumers increases, which results in higher demand for goods. However, if the supply of goods does not meet the demand, inflation is inevitable. Demand pull inflation is likely to happen in the economies, where resources are fully utilized and the short-run aggregate supply is rigid. In such cases an increase in aggregated demand results in the growth of commodity prices. There could be various reasons for an increase in aggregated demand. Moreover, there is a possibility that at a given time more than one factor come up together to augment it .
The first reason for a decrease in aggregate demand is a decline in exchange rates. A decline in exchange rate means a reduction of the currency value, which directly impacts the cost of imports. Since the value of currency is low, companies need to pay higher amount for the materials/goods they are importing. On the other hand, companies receive less for the goods they exports. In such a situation, consumption of imported goods decreases due to higher cost, while exports increase, thus raising aggregated demand. In strong economies prices of goods increase in such cases.
The second factor, which reduces aggregate demand is a decrease in taxation.. When governments decrease direct taxes imposed on consumers, consumer purchasing power increases, thus raising market demand. A drop in indirect taxes decreases prices of goods, thus consumers can purchase more goods with the same amount of money. A decrease in both direct and indirect taxes can increase aggregated demand and Gross Domestic Product to a level beyond the forecasted number.
The third reason for aggregate demand decrease is an increase of money supply in the market. When the central bank offers loans at lower interest rate, borrowing by banks and financial institutions increases, thus increasing money supply. Some economists believe that monetary operations are the main causes for inflation, especially when governments are authorized to increase money supply beyond requirements. This stimulates money circulation, thus increasing the number of transactions above the optimal level.
The fourth factor, which may explain aggregate demand decrease is a change in consumer perception of the housing rates. With lower loan rates and higher wages consumers can afford housing easier. This fact results in the increase of demand for household goods. This is not the major cause of inflation, however along with other factors it contributes to the increase of inflationary pressure.
Lastly, faster growth in economy of other countries impacts aggregate demand. Since countries, which experience high growth, increase their exports to other countries, their currency also becomes stronger. Therefore, an increase in fiscal deficit disturbs the money balance in the market.
According to the cost push theory, inflation is caused by high cost of production. Due to an increase in the cost of raw materials and labor, consumers have to pay a higher price for finished products.
Cost Push Inflation: various factors cause cost push inflation.
Firstly, a rise in cost of raw materials may become the reason for cost push inflation. Thus, countries, which are very much dependent on the exports of goods and commodities, are impacted by cost push inflation if the cost of raw materials used for the production of these exports increases. Since an increase in the cost of raw materials will raise the cost of exported goods, the demand for those goods will drop. This will lead to a decline in the export industry of that country. A very good example of cost push inflation occurred during 2005, when energy suppliers in the UK substantially increased the price for energy products, which led to inflation.
Secondly, a boost in wage charges stimulates cost push inflation. When productivity does not increase or increases slower than the cost of labor, the cost of production rises. This fact is very imperative for the industries, which are labor intensive. Companies, which find themselves in such a situation, generally pass this added cost onto consumers by increasing the price of their products. Sometimes company decides to cut the cost in other areas in order not to increase the price of their products, however this policy does not sustain for long time. Since in any labor intensive industry the number of workers is very high, even a small increase of wages becomes a major expenditure for the company. Therefore, sustaining prices at a loss or saving money in other areas becomes very difficult. Eventually, the increase in the price for the products is inevitable.
Thirdly, a rise in indirect taxes may become the reason for cost push inflation. In any industry manufacturers and suppliers heavily depend on the demand for their products and on the stable supply in the market. They operate their business on very thin margins, therefore any type of increase in taxes on the manufacturers and suppliers will directly increase the cost of production. Consumer will be ultimately affected, since they will have to pay extra for the same product. Government imposes taxes in the form of excise duty and value added tax. For example, if government increase taxes on aviation fuel, the burden will be put on the passenger by increasing flight fairs. This will result in decline in air traffic.
References
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Hall, R. E. (1982). Inflation: Causes and Effects. London: The University of Chicago, Ltd.
Riley, G. (2006, September). Tutor2u. Retrieved October 20, 2011, from www.tutor2u.net: http://tutor2u.net/economics/revision-notes/a2-macro-causes-of-inflation.html
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