6. Inflation by lo2taonline


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									AAST-GSB- MBA "Investments"

Inflation is defined as an increase in the average level of prices in the economy caused by the
interaction of the supply of money with aggregate output and interest rates, while deflation
would be a decrease in the average level of prices.

Causes of inflation
The causes of inflation are easiest explained by looking at aggregate supply and demand. As
shown by the diagram below, any change in either Aggregate Supply (AS) or Aggregate
Demand (AD) will cause a change in the price level.

If aggregate demand increases to AD1 or aggregate supply decreases to AS2, the price level
increases- this is inflation. If both happen together the inflation is even worse. If the inflation is
caused by an increase in demand, then it is known as demand-pull inflation. The growth in
demand literally pulls up prices. However, if the inflation is caused

by a change in aggregate supply, then it is usually known as cost-push inflation. In practice, the
two are often linked together as increases in demand may cause labor shortages, which in turn
push up wages. Firms, who have to pay the higher wages, are then forced to put their prices up
to maintain their margins.

Why Inflation is a Problem?
In many ways the problem with inflation is not the higher prices, deflation can actually be just
as damaging as inflation. But the way it can creep up suddenly creating a big stir and causing us
to lose our balance. In another way, as long as we properly anticipate inflation, we can prepare
and absorb much of its shock. Problems occur when inflation is greater than we predicted when
it is unanticipated. When the actual inflation rate is greater than the anticipated (planned for)
rate, several problems may arise.

A. The problem with inflation is one of redistribution inflation makes some people worse off,
but it makes others better off.

MBA "Investments"                                                            Ashraf Shamseldin
AAST-GSB- MBA "Investments"

B. Also the costs of inflation go beyond redistribution, and have negative implications for the
economy as a whole. If inflation is low, the effects may be small. But in periods of high
inflation, known as hyperinflation, the negative effects will cripple an economy.

C. Another problem caused by unanticipated inflation is for workers on fixed contracts. If a
labor union makes a long-term agreement for salary increases based on the projected inflation
rate, then the real wage may actually decline if the inflation rate shifts up. The definition of the
real wage is: Real wage = nominal wage -inflation rate

D. Other Consequences of Inflation
There are several other economic impacts to consider as a consequence of high inflation.
Inflation has an impact on the output and employment decisions by firms that are altered by
high inflation. Some possibilities include:

The economic impact of inflation
During periods of high inflation, it was always found that inflation is economic enemy number
one. What's so dangerous and costly about inflation? During periods of inflation all prices and
wages do not move at the same rate; that is, changes in relative prices occur. As a result of the
different relative prices, two definite effects of inflation are:
* A redistribution of income and wealth among different groups.
* Distortions in the relative prices and outputs of different goods, or sometimes in output and
employment for the economy as a whole.

Impacts on income and wealth distribution:
Inflation affects the distribution of income and wealth primarily because of differences in the
assets and liabilities that people hold.

In economics, inflation is a rise in the general level of prices of goods and services in an
economy over a period of time. When the price level rises, each unit of currency buys fewer
goods and services; consequently, annual inflation is also an erosion in the purchasing power of
money -a loss of real value in the internal medium of exchange and unit of account in the
economy. A chief measure of price inflation is the inflation rate, the annualized percentage
change in a general price index (normally the Consumer Price Index) over time.

Inflation's effects on an economy are manifold and mainly negative1. Negative effects of
inflation include a decrease in the real value of money over time; uncertainty about future
inflation may discourage investment and saving, or may lead to reductions in investment of
productive capital and increase savings in non-producing assets, e.g. selling stocks and buying
gold. This can reduce overall economic productivity rates, as the capital required to reorganize
or retool companies becomes more elusive or expensive. High inflation may lead to shortages
of goods if consumers begin hoarding as a result of their concern that prices will increase in the

 It can also be simultaneously positive as some economists believe. Positive effects include a mitigation of
economic recessions, and debt relief by reducing the real level of debt

MBA "Investments"                                                                      Ashraf Shamseldin
AAST-GSB- MBA "Investments"

High rates of inflation and hyperinflation can be caused by an excessive growth of the money
supply. However, the consensus view is that a long sustained period of inflation is caused by
money supply growing faster than the rate of economic growth. The task of keeping the rate of
inflation low and stable is usually given to monetary authorities. Generally, these monetary
authorities are the central banks that control the size of the money supply through the setting of
interest rates, through open market operations, and through the setting of banking reserve

Measurement of the inflation rate
Inflation is usually estimated by calculating the inflation rate of a price index, usually the
Consumer Price Index (CPI). The Consumer Price Index measures prices of a selection of
goods and services purchased by a "typical consumer". A price index, in turn, measures the
level of prices of goods and services at any point of time and therefore the inflation rate is the
percentage rate of change of a price index over time. Formally, it is defined as the rate of
change in the price level. Thus, an inflation rate of 5 percent per annum means that the price
level is increasing at the rate of 5 percent.

The number of items included in a price index vary depending on the objective of the index.
Usually three kinds of price indexes are periodically reported by government sources. They all
have their particular advantages and uses. The first index is called the consumer price index
(CPI), which measures the average retail prices paid by consumers for goods and services
bought by them. Several thousand items are included in this index. The second price index used
to measure the inflation rate is called the producer price index (PPI). It is a much broader
measure than the CPI because it measures the wholesale prices of approximately 3,000 items.
The items included in this index are those that are typically used by producers (manufacturers
and businesses) and thus contain many raw materials and semi finished goods. The third
measure of inflation is the called the implicit price deflator (IPD). This index measures the
prices of all goods and services included in the calculation of the current output of goods and
services in the economy, known as gross domestic product. It is the broadest measure of the
price level. The three measures of the inflation rate are most likely to move in the same
direction, even though not to the same extent.

Price Deflator

The CAPM can be used as a tool to help us in the calculation of the inflation as follows:-
Calculations of rates of return can be made in nominal terms or in real terms, that is, after
allowing for the effects of inflation. Rates of return in nominal terms can be derived from real
rates of return by assuming a future rate of inflation and using the following formula:
Nominal rate of return = (1 + real rate) x (1 + inflation) -1

Since future rates of inflation, particularly over long periods, cannot be predicted with any great
degree of accuracy, the use of nominal rates introduces additional uncertainty.

MBA "Investments"                                                         Ashraf Shamseldin

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