Inflation means a sustained rise in average prices over time.
It is a key indicator of economic performance in the sense price stability is preferred. In other words, inflation is considered as bad for society and business as follows:
First, there will be erosion of living standards because (a) those who get fixed incomes are worse off in real terms; (b) value of savings goes down if nominal interest rates paid by the banks to the depositors are less than the rate of inflation; (c) there will be redistribution of wealth from lenders to the borrowers—borrowers are better off in terms of paying much less in real terms if the borrowed rate of interest is less than the rate of inflation, whereas lenders are worse off if the interest rates paid by the banks are less than inflation rates thereby resulting in negative real interest rates.
Secondly, inflation creates uncertainity for consumers and businesses if it is unanticipated. Consumers face uncertainity about future real incomes and may cut back on their spending and save more. For businesses, new investment programmes suffer and potential profits may fall due to rising prices of final goods in conjunction with rising prices of raw materials and labour. Consequently, they may downsize which in turn can create additional costs in terms of redundancy payments, etc.
Thirdly, there can be additional problems for businesses. For example, mail order firms incur rising costs of producing new editions of catalogues. They can lose international competitiveness of their exports and face increased competition in domestic markets from imports. And this can cause balance of payments deficit for the country.
Causes of inflation
Economists do not agree on exact causes. There are demand-sided arguments and there are supply-sided arguments.
There can be demand-pull inflation.
The Keynesians who were popular during 1930s to 1960s, explain this in terms of non-monetary demand pull. This means that as aggregate demand increases, output prices increase, and beyond full capacity production, only prices increase. Aggregate demand can increase more than aggregate supply due to increased investment programmes of businesses; increased consumer demand due to tax cuts and feel-good factor (i.e. rising consumer confidence); increased government expenditure on education, health, infrastructure, etc. on the basis of deficit financing; and increased demand for exports from overseas customers. If imports are resorted to satisfy excess demand, balance of payments can worsen.
The Monetarists, who were popular during the 1960s to 1980s, explain demand pull inflation in terms of monetary demand pull. If money supply in terms of notes and coins in circulation as also bank accounts(deposits) and bank loans and overdrafts grows faster than expected growth of real GDP, demand for goods and services increases and consequently, prices increase whether the economy is at full employment or not.
According to the economists offering these arguments, inflation can be cost-push in terms of rising labour costs and rawmaterial costs (including imported oil). When prices rise due to rising input costs, trade unions demand high wages. Businesses in turn increase their prices. Thus there can be a wage-price spiral upwards. As input costs rise, businesses reduce demand for inputs and thereby there will be fall in aggregate supply in conjunction with increased prices.
There can be both demand pull and cost push inflation. For example, if the government expenditure increases through deficit financing, aggregate demand rises and prices rise. This can stimulate the trade unions to demand high wages.
Policies to combat inflation
There are demand management policies and supply management policies.
On the demand side, the Keynesians propose fiscal policy adjustments in terms of increased taxation and cutting down expenditure through deficit financing and undertaking new expenditure through borrowing (i.e. public debt)) which is non-inflationary. The Monetarists argue for contractionary monetary policy. That is they want to bring down aggregate demand by increasing the base bank rate and the various short-term interest rates to reduce economic activity. Over time, monetary solutions have become more popular than the Keynesian solutions in terms of flexibility of intervention.
On the supply side, aggregate supply is supposed to be increased by making input and output markets more competitive. Input markets need to be made flexible. This means labour flexibility via eliminating trade unions. Labour productivity can be increased through better training and retraining of labour. Tax cuts can be used to induce workers and employers to work harder, longer and more willingly.