How Does Inflation Work?
You may have been told stories from your parents or grandparents about the price of goods back in the day being much cheaper than it is now. For example, the price of a pint of milk in 1990 would cost 25p but in 2018 it would cost 44p. The 19p rise is the result of inflation.
What Causes Inflation?
Two main causes of inflation:
Demand-Pull Inflation
As a company reaches full capacity, it will increase prices to meet the increased demand above the current full capacity. Also if fully employment occurs with labour shortages, workers can get higher wages increasing their spending power. By increasing spending power, the population can purchase more products and services increasing demand. The rise in demand may cause companies to increase prices to help the company expand at a greater rate to cope with demand.
Cost-Push Inflation
If the cost to run a business or to produce products, businesses will pass this increase in cost to consumers. If external factors such as trade unions present a united front to increase wages, the increased wages will mean companies have to contribute more to wages. The second factor is import prices. For example, if the UK pound is worth less then companies would have to pay more for the same imported goods. The third factor that contributes to cost-push inflation is the price of raw materials. An example of this is the price of oil, if the price of oil increases then it would significantly impact most goods in the economy as oil is used to produce a wide variety of products directly or indirectly.
What is Hyperinflation?
Hyperinflation is when prices rise by more than 50% per month over some time. Several factors can cause hyperinflation to occur:
Excessive Money Supply
When a country goes through a depression (period of contracting economy growth is rate is negative) or a recession (negative growth occurs more than two quarters or six months); governments often increase the money supply to encourage banks to lend to consumers and businesses to create spending and investment. However, if GDP (Gross Domestic Product) does not grow then businesses will continue to raise prices to boost profits and stay afloat. As consumers have more money they will pay higher prices leading to greater inflation of prices.
Loss of Confidence in Economy
Currency value plays an important role in the world of finance as it could affect the confidence in the currency. When the value of a currency starts dropping, citizens will start losing confidence and hoarding commodities and goods that have value. The price of basic goods such as fuel and food will become scares sending prices up. Governments are then forced to print more money, which in turn increases the problem.
How is Inflation Measured?
Countries use the Consumer Price Index that examines the average prices of a predetermined basket of consumer goods and services such as transportation, food, and medical care. The predetermined basket will vary between countries however, most countries will use this index to determine the increase or decrease in inflation and will use the figure to find out if outside help is needed to help the economy; countries try to aim for inflation increase of 2%.
Effects of Inflation
Inflation has several effects such as:
Purchasing Power
Inflation will increase the cost of goods and services. If you have £10 today and inflation increases by 10% next year, the £10 you had are now worth £1 less of its purchasing power.
Encourage Spending and Investing
As inflation is expected to increase, the consumer will want to spend and invest now before prices increase again. Often consumers would buy food, purchase shoes a size up for children and so on.
Cause More Inflation
Inflation is the result of high demands of goods, services, and resources which ultimately causes businesses to increase their prices to cope with demand and expansion costs. A price increase will cause inflation.
Examples of Inflation
Uber Fares
Uber is increasing their prices due to increased demands which means it needs more drivers. The increase of fares would hope to attract new drivers and tempt drivers back to Uber.
Second-Hand Cars
Due to the shortage of microprocessors and other materials, car manufacturers are producing fewer vehicles. This in turn has led to consumers are turning to second-hand cars. The increase in demand for second-hand cars has caused prices to increase.
Heating Bills
Over the last couple of months, rising costs of gas have been well documented due to the high demand for gas. The rising costs mean consumers will see the impact on their monthly bills and suppliers going bust due to the rising gas prices.
How to Control Inflation?
The central bank and/or the government generally control inflation and often use monetary policy. Here is the variety of tools to control inflation:
Monetary Policy
Increase interest rates to reduce demand in the economy, which will lead to lower economic growth and inflation.
Fiscal Policy
A higher rate of income tax will reduce spending and demand.
Wage Controls
Controlling wages will control the amount of purchasing power that people will have therefore decreasing demand and inflation.
Summary
Inflation plays a big part in economics and can affect wages and the cost of consumer goods and services. Learning about how inflation works and how it could affect a country’s economy has shown how controlling inflation is a fine balance of many policies that have greater consequences on a country’s economy and its citizens. Ultimately the price of goods and demand has a direct effect on inflation and needs to be monitored carefully and wages are increased accordingly.