3 Real Reasons for Rising Prices:
Demand-pull inflation is the most common. It’s simply when demand for a good or service increases so much that it outstrips supply. If sellers maintain the price, they will sell out. They soon realize now have the luxury of raising prices, creating inflation.
Many circumstances can lead to demand-pull inflation. A growing economy can create some inflation as people feel confident about the future and spend more. As long as inflation stays within limits, this could actually benefit economic growth. That’s because it creates an expectation of inflation, which can contribute to further demand-pull inflation. As people expect further inflation, they make their purchases sooner to avoid further price increases. The Federal Reserve has set an inflation target to manage the public’s expectation of inflation.
A second cause of inflation is cost-push inflation. This isn’t as common as demand-pull inflation, because it only occurs when there is a shortage of supply combined with enough demand to allow the producer to raise prices. Wage inflation can contribute to cost-push inflation. This is usually caused by strong labor unions.
Expansion of the Money Supply
A third cause of inflation is an over-expansion of the money supply. The money supply is not just cash, but also credit, loans and mortgages. When loans are cheap, then there will be too much money chasing too few goods, creating inflation. The prices of just about everything will increase, even though neither demand nor supply has changed.
Policies to Reduce Inflation:
- Supply Side Policies
Supply side policies aim to increase long term competitiveness and productivity. For example, privatization and deregulation were hoped to make firms more productive. Therefore, in the long run supply side policies can help reduce inflationary pressures. However, supply side policies work very much in the long term. They cannot be used to reduce sudden increases in the inflation rate.
- Making imports cheaper.
- Reducing demand for exports and
- Increasing incentive for exporters to cut costs
- Fiscal Policy
This is another demand side policy, similar in effect to Monetary Policy. Fiscal policy involves the government changing tax and spending levels in order to influence the level of Aggregate Demand. To reduce inflationary pressures the government can increase tax and reduce government spending. This will reduce AD.
- Wage Control
Wage growth is a key factor in determining inflation, if wages increase quickly it will cause high inflation.
ADVANTAGES AND DISADVANTAGES OF INFLATION:
Inflation occurs when there is a sustained increase in the general price level. Traditionally high inflation rates are considered to be damaging to an economy. High inflation creates uncertainty and can wipe away the value of savings.
However, most Central Banks target an inflation rate of 2%, suggesting that low inflation can have various advantages to the economy. Some economists even argue we should target a higher inflation rate during periods of economic stagnation.
The Advantages of Inflation:
- Deflation (a fall in prices – negative inflation) is very harmful. During a prolonged period of deflation and very low inflation. When prices are falling people are reluctant to spendMONEY because they are concerned that prices will be cheaper in the future, therefore, they keep delaying purchases. Also, deflation increases the real value of DEBT and reduces the disposable income of individuals who are struggling to pay off their DEBT. When people take on a debt like a mortgage, they generally expect an inflation rate of 2% to help erode the value of debt over time. If this inflation rate of 2% fails to materialize, their debt burden will be greater than expected.
- Moderate inflation enables adjustment of wages.It is argued a moderate rate of inflation makes it easier to adjust relative wages. For example, it may be difficult to cut nominal wages (workers resent and resist nominal wage cut). But, if average wages are rising due to moderate inflation, it is easier to increase the wages of productive workers wages; unproductive workers can have their wages frozen – which is effectively a real wage cut. If we had zero inflation, we could end up with more real wage unemployment, with firms unable to cut wages to attract workers.
- Inflation enables adjustment of relative prices.Similar to the last point, moderate inflation makes it easier to adjust relative prices.
- Inflation can boost growth. At times of very low inflation the economy may be stuck in a recession. Arguably targeting a higher rate of inflation can enable a boost in economic growth. This view is controversial. Notall economists would support targeting a higher inflation rate. However, some would target higher inflation, if the economy was stuck in a prolonged recession. This has corresponded to very weak economic growth and very high
Disadvantages of Inflation:
- Inflation is usually considered to be a problem when the inflation rate rises above 2%. The higher the inflation, the more serious the problem it is. In extreme circumstances hyperinflation can wipe away peoples savings and cause great instability.
- Inflationary growth tends to be unsustainable leading to a damaging period of boom and bust economic cycles.
- Inflation tends to discourageINVESTMENT and long-term economic growth. This is because of the uncertainty and confusion that is more likely to occur during periods of high inflation. Low inflation is said to encourage greater stability and encourage firms to take risks and INVEST.
- Inflation can make an economy uncompetitive. For example, a relatively higher rate of inflation in Italy can make Italian exports uncompetitive.
- Reduce value of savings. Inflation leads to a fall in the value ofMONEY. Therefore servers does not save money they prefer spending.