The Causes of Inflation
Introduction
This paper has been developed to study the concept of inflation and its causes in an economy. Inflation is one of the significant concepts of economics which play a significant role in determining the growth and development of the economy. The main purpose of this paper is to identify and evaluate the causes of inflation in an economy. Moreover, this paper also evaluates the types of inflation and their advantages as well as disadvantages. This paper also highlights why it is important to study the concept of inflation or what is the importance of the concept of inflation from an economy point of view. The whole paper will revolve around the question “what are the causes of inflation.”
Inflation is a term which can be defined as a persistent rise in the prices of goods and services over a period of time in an economy . It is a quantitative measure of the rate at which the prices of the goods and services within an economy increase in a particular period of time. Inflation means a constant rise in the general price level of the goods and services . It indicates that the value of money or currency decreases during the time of inflation. A unit of a currency will purchase less amount of a product during the period of inflation as compared to the non-inflation period.
Impact of inflation
Inflation plays a significant role in determining the rate of growth of an economy. Inflation affects the growth rate of the economy by affecting several aspects of an economy. Inflation can affect the economy in a positive way as well as in a negative way. Thus, the impact (positive or negative) of inflation on the economy depends on the rate of inflation in the economy . In general, inflation affects the growth rate, employment rate, income of the individuals, government finance, production and distribution, business and trade, farmers, etc.
Inflation and growth of an economy
Inflation affects the growth rate of the economy. The impact of inflation on the growth rate of the economy can be either positive or negative. It has been found in the research that inflation (mild) is necessary for the growth and development of an economy. If the price of the goods and services varies between 2 p.c. and 3 p.c. annually, it will increase and maintain cash flow in the economy which is necessary for the growth and development of the economy. However, a high rise in the price of the good and services lowers the value of money significantly which negatively affect the economy.
Inflation and employment
Inflation increases the agreement income of the economy as the spending of the people increases during the period of inflation. As the prices of the goods and services increase the producers of the goods and services increase the supply of goods and services to earn more profit. To increase the supply of goods and services, it is necessary to increase the production of the goods and services . To increase production, more employees are required. So, they hire more people to work and produce more. Thus, due to inflation employment rate increases within the economy. But a high rate of inflation increases the rate of unemployment. The high rate of inflation creates uncertainty in the economy which may increase the rate of unemployment.
Inflation and business & trade
The volume of internal trade increases during inflation because the production of goods and services increases along with the spending of the people during inflation. Greater production of goods and services increases the supply of goods and services in the economy. The increase in aggregate income of the economy creates demand for goods and services in the market. Hence, the volume of trade increases . It is also important to note that export trade suffers during inflation as the prices of the domestic goods increase which makes the domestic product costly in the international market.
Inflation and purchasing power
During inflation, the value of money decreases significantly. A unit of currency purchases less amount of goods and services. It is also said that during inflation more money chases few goods. Thus, the purchasing power of the currency decreases during inflation.
Inflation and government finance
During inflation, the revenue of the government increases because the government receives more revenue from sales tax, income tax, excise duties, etc. On the other hand, government expenditure also increases as governments spend more on administrative and other purposes.
Inflation and farmer
Due to inflation, the prices of the agricultural products also increase which increases the income of the farmers . Thus, inflation is also a cause of the shift in the pattern of distribution of income and wealth in the economy.
Causes of inflation
There are several factors which can lead to an increase in the general price level of goods and services. However, there are two main reasons for inflation in an economy such as high demand for goods and services (demand-pull inflation) as well as high cost of the production (cost-push inflation) . If there is a high demand for a product in the market, the price of that product increases. On the other hand, if the cost of production of a product is high, the producer charges a high price for that product in order to cover the cost of the production. Therefore, these two (high demand and high cost of production) are the primary causes of the increase in the general price level of the goods and services. Apart from this, there are several other factors which can increase the general price level of the goods and services in the economy. Some of the factors are listed below;
Public spending
Public spending is one of the significant elements of the total spending of an economy. Government spending is an important determinant of aggregate demand of an economy . An increase in government spending increases the aggregate demand in the economy which further leads to an increase in the general price level.
Deficit financing
Deficit financing is one of the significant factors which lead to inflation in the economy. The government prints more money for deficit financing. Printing more money increases the cash flow in the economy. It creates inflationary pressure in the economy.
Population growth
Population growth is also a significant determinant of inflation. The growth in population creates more demand for goods and services in the economy . And as the demand for goods and services increases in the market, the price of the goods and services also increases. Thus, the economy faces inflationary pressure.
Hoarding
In most of the cases of inflation, hoarding is the major cause. Hoarders are the individuals or entities who store or stockpile the products and do not release them to the market. Due to this, the market faces a shortage of products. The supply of the product reduces significantly. Considering the constant demand for the product, it can be said that the supply of the product cannot satisfy the demand of the product . As a result, the price of the product increases in the market which creates inflationary pressure in the economy.
Genuine shortage of the factors of production
It is also a significant determinant of inflationary pressure in the economy. A shortage of the factors of production affects the level of production significantly. At certain times there may be a shortage of factors of production. The shortage of factors of production will reduce the level of production. A reduction in the level of production will decrease the supply of the product in the market. As a result, the demand for the product will exceed the supply of the product which further increases the price of the product . The price of the product increases to tackle the issue of high demand in the market. A rise in the price of the product reduces demand for that product. Apart from this, in the case of high demand the producer charges a high price to make a handsome profit.
Reduction in the rate of tax
Tax reduction also creates inflationary pressure in the economy. Reduction in the tax rate increases the disposable income of the people in the economy. As the disposable income of the people increases in the economy, their expenditure increases. More disposable income leads to more demand for goods and services in the market. More demand for goods and services leads to a rise in the prices of goods and services.
The imposition of indirect tax
Sometimes, the government imposes the indirect tax in the form of excise duties, value-added tax, etc. on the businesses. An increase in the indirect tax of the products, the total cost of the producers or the seller increases. Thus, in order to cover the increased cost, the producers charge a high price for their products. It creates inflationary pressure in the economy.
All the factors discussed above are the economic factors which create inflationary pressure in the economy. Apart from these economic factors, there are some non-economic factors which also create inflationary pressure in the economy such as flood and drought. It destroys the crop and hence the supply of agricultural products reduces significantly. And as the supply reduces, the prices increase.
From the above discussion, it is quite clear that there are two major factors which determine inflation in the economy. These factors are the demand for goods and services and the cost of production of goods and services.
Types of inflation
The type of inflation will also help in understanding the impact of inflation on the economy as different types of inflation affect the economy differently. There are four major types of inflation which are discussed below;
1) Creeping or mild inflation: if the prices of the goods and services increase at a rate of 3 percent or less annually, then it is called creeping inflation. If the prices of the product or services in an economy rise at a rate of 3 percent or less it helps the economy to boost. Creeping inflation benefit economic growth. Mild or creeping inflation creates a perception in the mind of the consumer that the prices of the product will keep on rising and hence they plan to purchase the product and hence demand increases . As demand increases, the suppliers also increase the supply to meet the demand and earn high profit. To increase the supply, they hire more employees to increase production. Thus, the overall economy grows due to creeping inflation.
2) Walking inflation: if the rate of inflation is between 3 to 10 percent, it is called walking inflation. Walking inflation is harmful to the economy because it significantly boosts the economy. People start buying the product today to avoid a much higher price tomorrow. The demands increase significantly and hence supply cannot meet the demand. Thus, the prices of the product become out of reach of most people.
3) Galloping inflation: galloping inflation is said to prevail when inflation rises more than 10 percent. This is a very critical situation for an economy in which money loses value so fast . The income of the people cannot keep up with the prices of the products and services. Due to this, the economy becomes unstable.
4) Hyperinflation: hyperinflation is a very rare situation. In this inflation, the inflation rate increases beyond 50 percent. It makes the economy unstable. Everything in the economy becomes unstable during hyperinflation. Uncertainty prevails everywhere in the economy.
Conclusion
Inflation has a significant impact on the economy. It prevails in the economy when there is a persistent rise in the general price of the products. It affects the growth of the economy positively or negatively. Mild inflation is necessary for the economy which helps the economy to grow and develop. On the other hand, walking, galloping, and hyperinflation are harmful to the economy. There are several factors which lead to inflationary pressure in the economy such as an increase in the demand for the products and cost of production. Population growth, deficit financing, tax reduction, the imposition of indirect tax, etc. also lead to inflationary pressure in the economy.
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