Inflation Essay, Research Paper

?INFLATION?

Inflation, in economics, is used to describe an increase in the value of money; in relation to the goods and services it will buy. Inflation is the sustained rise in the aggregate level of prices measured by an index of the cost of various goods and services. Repetitive price increase cause the purchasing power of money and other financial assets with fixed values, creating serious economic uncertainty. Inflation results when actual economic pressures anticipation of future developments cause the demand for goods and services to exceed the supply available at existing prices or when available output is restricted by undecided productivity and marketplace constraints. Constant price increases were historically linked to wars, poor harvests, political upheavals, or other unique events.

Examples of inflation have occurred throughout history, but detailed records are not available to measure trends before the Middle Ages. Economics historians have identified the 16th to early 17th centuries in Europe as a period of long-term inflation. Major changes occurred during the American Revolution, when prices in the U.S. rose an average of 8.5 percent per month, and during the French Revolution, when prices in France rose at a rate of 10 percent per month. Theses relatively brief events were followed by long periods of alternating international inflations and deflations linked to specific political and economic actions. The U.S. reported average annual price changes as follows:

1790 to 1815- up 3.3 %

1815 to 1850- down 2.3 %

1850 to 1873- up 5.3 %

1873 to 1896- down 1.8 %

1896 to 1920- up 4.2 %

1920 to 1934- down 3.9 %

Consumer prices accelerated during the World War 11 era, rising at an average rate of 7.0% from 1940 to 1948, and then stabilizing from 1948 to 1965, when annual increases averaged only 1.6 percent.

There is various kind of inflation. When upward trend of prices is gradual and irregular, averaging only a few percentage points each year, inflation is not considered a serious threat to economic and social progress. It may even stimulate economic activity: The illusion of personal income growth beyond actual productivity may encourage consumption; housing investment may increase in anticipation of future price appreciation; business investment in plants and equipment may accelerate as prices rise more rapidly than cost; and personal, business, and government borrowers realize that loans will be repaid with money that has potentially less purchasing power. A greater concern growing is chronic inflation. Chronic inflation tends to become permanent moving upward to even higher levels as economic distortions and negative expectations are brought on. To accommodate chronic inflation, normal economic activities are disrupted: Consumers buy goods and services to avoid even higher prices, real estate speculation increases; businesses concentrate on short-term investments; governments rapidly expand spending in anticipation of inflated revenues; and exporting nations suffer competitive trade disadvantages forcing them to turn to protectionism currency controls. In the extreme form, chronic price increases become hyperinflation, causing the entire system to break down. During a hyperinflation the growth of money and credit becomes explosive, destroying any links to real assets and forcing a trust on complex barter arrangements. As the governments try to pay for increased spending programs by rapidly expanding the money supply, the inflationary financing of budget deficits disrupts economic, social, and political stability.

There are many causes of inflation. The demand -pull inflation occurs when aggregate demand exceeds existing supplies, forcing price increases and pulling up wages, materials, and operating and financing costs. Cost-push inflation occurs when prices rise to cover total expenses and preserve profit margins. A persistent cost-price spiral eventually develops as groups and institutions respond to each new round of increases. Deflation occurs when the spiral effects are reversed. To explain why the basic supply and demand elements change, economists have suggested three substantive theories: the available quantity of money; the aggregate level of incomes; and supply-side productivity and cost variables. Monetarists believe that changes in price levels reflect fluctuating volumes of money available, usually defined as currency and demand deposits. They argue that, to create stable prices, the money supply should increase at a stable rate matching with the economy’s real output capacity. Critics of this theory claim that changes in the money supply are a response to, rather than the cause of, price-level adjustments. The aggregate level of income theory is based on the work of the British economist John Keynes published during the 1930s. According to this approach, changes in the national income determine consumption and investment rates; thus, government fiscal spending and tax policies should be used to maintain full output and employment levels. The money supply, then, should be adjusted to finance the desired level of economic growth while avoiding financial crises and high interest rates that discourage consumption and investment. Government spending and tax policies can be used to offset inflation and deflation by adjusting supply and demand according to this theory. In the U.S., however, the growth of government spending plus ?off-budget? outlays (expenditures for a variety of programs not included in the federal budget) and government credit programs has been more rapid than the potential real growth rate since the mid-1960s. The third theory concentrates on supply-side elements that are related to the significant erosion of productivity. These elements include the long-term pace of capital investment and technological development; changes in the composition and age of the labor force; the shift away from manufacturing activities; the rapid increase of government regulations; the diversion of capital investment into nonproductive uses; the growing scarcity of certain raw materials; social and political developments that have reduced work incentives; and various economic shocks such as international monetary and trade problems, large oil price increases, and sporadic worldwide crop disasters. These supply-side issues may be important in developing monetary and fiscal policies.

The specific effects of inflation and deflation are mixed and fluctuate over time. Deflation is typically caused by depressed economic output and unemployment. Lower prices may eventually encourage improvements in consumption, investment, and foreign trade, but only if the essential causes of the original decline are corrected. Inflation primarily increases business profits, as wages and other costs lag behind price increases, leading to more capital investment and payments of dividends and interest. Personal spending may increase because of “buy now, it will cost more later” attitudes; potential real estate price appreciation may attract buyers. Domestic inflation may temporarily improve the balance of trade if the same volume of exports can be sold at higher prices. Government spending rises because many programs are explicitly, or informally, indexed to inflation rates to preserve the real value of government services and transfers of income. Officials may also anticipate paying larger budgets with tax revenues from inflated incomes. The impact of inflation on individuals depends on many variables. People with relatively fixed incomes, particularly those in low-income groups, suffer during accelerating inflation, while those with flexible bargaining power may keep pace with or even benefit from inflation. Those dependent on assets with fixed nominal values, such as savings accounts, pensions, insurance policies, and long-term debt instruments, suffer erosion of real wealth; other assets with flexible values, such as real estate, art, raw materials, and durable goods, may keep pace with or exceed the average inflation rate. Workers in the private sector strive for cost-of-living adjustments in wage contracts. Borrowers usually benefit while lenders suffer, because mortgage, personal, business, and government loans are paid with money that loses purchasing power over time and interest rates tend to lag behind the average rate of price increases.