Inflation

Inflation is always and everywhere a monetary phenomenon in the world, where inflation is defined as a sustained, inordinate and general increase in prices. A rise in inflation means that the prices are rising faster and a fall in inflation means that prices are rising slower. Thus, it can help us to measure the rate of changes in general prices. However, when there is a fall in inflation, inflation rate may be positive, as prices are rising but at a decreasing rate. Therefore, a sustained fall in prices would mean a negative inflation rate or deflation. There are two main causes of inflation, the demand pull and cost push. Where, a demand pull inflation is caused by a rise in money supply compared to a cost push inflation, which is caused by a rise in unit of production.

The consequences of inflation is either due to anticipated inflation or unanticipated inflation. Where, anticipated inflation is the rate of inflation that majority of individuals believe will occur, compared to unanticipated inflation, which is inflation that comes as a surprise to individuals in the economy. Only when inflation is unanticipated, then it will generate unexpected negative effects on households and firms. This will result in a redistribution of income, as fixed income earners can only purchase fewer goods and services than before. Unless pensions, salaries and wages are adjusted for price increases, the real income of this group of people will fall. Incomes of a fixed value such as those from insurance policies, mortgages and bonds also decline in real terms. Those who receive income derived from interests and rents whose amounts are fixed by long term contracts are also adversely hit by inflation.

However, the effect of inflation on firms depends on the cause of inflation. If inflation is demand pull, profit margins tend to widen. This is because prices of goods and services tend to rise faster than factor prices as the latter are fixed by short term or long term contracts. Thus, investment is likely to increase in a period of rising prices due to higher expectation of profit margins. In comparison, if inflation is cost push, profits earned by firms may be squeezed as firms may find it hard to pass on the full effects of rising costs in the form of higher prices to consumers. In addition, firms which cannot absorb all or part of the higher factor prices by improving productivity and efficiency may find it difficult to survive. This leads to fall in investment and hence production.

A persistent increase in prices will also lead to an increase in cost of living. If the income of a family remain constant, its living standard will be lowered, as now they will need to give up on luxury goods to pay for their basic necessities. For example, in Zimbabwe, the inflation rate is as high as 2.2 million percent in 2008. The government had to order retailers and businesses to halve their prices to alleviate the high cost of living. However, this had resulted in widespread shortages for basic necessities such as rice and flour and a strengthening of the black market in the Southern African nation.

In sum, the type of policies to be implemented depends on the causes underlying the inflation. In order, to curb a demand pull inflation, a contractionary monetary and fiscal policies can be implemented to close the inflation gap by reducing aggregate demand. Whereas, to manage cost push inflation, the government can adopt prices and incomes policies to alleviate the problem.