Essence and reasons of Inflation occurrence, its types

UNIVERSITY OF INTERNATIONAL BUSINESS

“Finance and Credit” Department

 

 

Report

On the execution of educational practice

Essence and reasons of Inflation occurrence, its types

 

 

The place of the practice: “Finance and Credit” Department of the University of International Business

Student : Omargaliyeva Indira  Group: 208

 

 

 

Head from legal entity:

Practice leader:         

Mohammad Amin Sohrabian

Ph. D

 

 

 

 

 

 

Almaty, 2011

 

 

Contents

 

Introduction.............................................................................................................3

Inflation as an Economical Term..........................................................................5                                              

1.1 Definition and Meaning of Inflation……………………………………………5

Reasons of Inflation.................................................................................................7

2.1 Causes of Inflation……………………………………………………………...7

2.2 Causes of Rising Inflation in Kazakhstan……………………………………...9

2.3 Effects of Inflation………………………………………………………….....10

Types of Inflation………………………………………………...........................15                                                                                  

3.1 Keynesian Concept……………………………………………………………15

3.2 Monetarist view……………………………………………………………….16

3.3 Types of Inflation……………………………………………………………..17

3.4 Inflation Rate in Kazakhstan………………………………………………….21

Conclusion………………………………………………………………………..24   

List of used literature

 

 

 

 

 

 

 

 

 

 

Introduction

Inflation is a really important economical term in any country and worldwide, influencing each and every person in society. So Inflation happens when prices for goods and services become higher due to different circumstances. It can be positive if your salary is rising at the same time to particular part of nation or society, but frequently it is not that good scenario, as most probably it can be negative for the whole economy if it becomes unpredictable and high. No matter is it well growing, stable economy or a weak country without any production, dependant to import or so, it can happen due to any different external and internal factors or measures taken by government or even neighboring countries.

So, please do get familiar with my report, which falls into 3 big chapters covering all general information we have to know about INFLATION, starting from Chapter 1, which is inflation definition and meaning, then followed by Chapter 2, where I will be trying to describe what are the Causes and Reasons of Inflation, and a final Chapter 3 will give you detailed information on the possibly existing Types of Inflation.

There are 2 broadly known theories of Inflation:

 

• Quantity theory (buyer accepts currency valuing it as a means of payment for other goods and services at a later time)
• Quality theory (relates to the money supply, it’s velocity)

In this report you can find an interview, given by really commonly acceptable language to anyone to understand the causes of Inflation in Kazakhstan by Bulat Khussainov, who is a leading researcher of the Institute of Economics.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":

• Demand Pull Inflation
• Cost-push inflation
• Built-in Inflation

Did you know there are several types of inflation? Each type of inflation affects the economy differently. In order to understand the effects of inflation, you need to understand what inflation is and how it works.

All possible types of Inflation are briefed below, but of course you will more have an idea of 4 main types Types of Inflation. On different grounds, economists have classified inflation into various types. According to the rate inflation there are four types of inflation:

• Moderate Inflation
• Running Inflation
• Galloping Inflation
• Hyper Inflation.

I am also providing a formula how an Inflation rate can be calculated and 2 methods are: - base period and - chain measurements.

You can also find a Conclusion part, given as a brief summary to tell you shortly of all parts described in my Course Work. For your further information I will be pointing out literature and websites, so you can go through and find more detailed information, if needed, from the given list.     

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Inflation as an economical term

 

1.1   Definition and Meaning of Inflation

                                                                                                                            Definitions of INFLATION

 

The term "inflation" originally referred to increases in the amount of money in circulation, and some economists still use the word in this way. However, most economists today call an increase in the money supply monetary inflation, to distinguish it from rising prices, which may also for clarity be called 'price inflation'. Economists generally agree that monetary inflation is one of the main causes of price inflation.

Other economic concepts related to inflation include: deflation – a fall in the general price level; disinflation – a decrease in the rate of inflation; hyperinflation – an out-of-control inflationary spiral; stagflation – a combination of inflation, slow economic growth and high unemployment; and reflation – an attempt to raise the general level of prices to counteract deflationary pressures.

Since there are many possible measures of the price level, there are many possible measures of price inflation. Most frequently, the term "inflation" refers to a rise in a broad price index representing the overall price level for goods and services in the economy. The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflation are some examples of broad price indices. However, "inflation" may also be used to describe a rising price level within a narrower set of assets, goods or services within the economy, such as commodities (including food, fuel, metals), financial assets (such as stocks, bonds and real estate), services (such as entertainment and health care), or labor. The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Core Inflation is a measure of inflation for a subset of consumer prices that excludes food and energy prices, which rise and fall more than other prices in the short term. The Federal Reserve Board pays particular attention to the core inflation rate to get a better estimate of long-term future inflation trends overall.

 
Inflation happens when prices of goods and services rise. This is usually an indication that the economy is growing and that consumers are spending money. Inflation can be good for you if your wages increase at the same time and rate as prices increase. It simply means there is plenty of give and take in the money supply as consumers consume and producers produce, paying their workers as they produce more products. Inflation while workers' incomes decrease is damaging for the economy in the long run because consumers stop spending to save money, causing vendors to be stuck with extra inventory and overpriced goods and services. This usually ends in a correction of the market as money supply and demand reconcile.

Antonymous-Deflation 
Deflation occurs when the prices of goods and services fall, the exact opposite of inflation. Deflation can increase the purchasing power of the dollar if wages do not fall at the same rate prices fall. However, deflation is usually an indication that the economy is lagging and that consumers are not spending. It can also be an indication that the market is correcting itself after a time of inflation.

 

Meaning of INFLATION

Inflation is commonly understood as a situation of substantial and rapid general increase in the price level and consequent fall the value of money over a period of time. Inflation means persistent rise in the general level of prices. Inflation is a long term operating dynamic process. By and large, inflation is also a monetary phenomenon. It is usually characterized by an overflow of money and credit. In fact, the root cause of inflation is the expansion of money supply beyond the normal absorbing capacity of the economy. The behavior of general prices is measured through price indices. The trend of price indices reveals the course of inflation or deflation in the economy. Crowther defines inflation as “a state in which the value of money is falling, ie., prices are rising”. Professor Samuelson defines “Inflation occurs when the general level of prices and costs is rising”.

 

 

 

 

 

 

 

 

 

 

 

 

Reasons of Inflation

 

1. Causes of Inflation

 

Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: Quality theories of inflation and Quantity theories of inflation.

The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer.

The quantity theory of inflation rests on the quantity equation of money, which relates the money supply, its velocity, and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.

Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates. The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.

Monetary Theory of Inflation in economics is known as the Quantity Theory of Money. The quantity theory of money studies the positive relationship between the Quantity of money and the Nominal Value of the expenditures. This can be also expressed as the maintenance of the positive relationship of overall prices.

 

Equation of the Quantity Theory of Money

The Quantity Theory of Money follows the equation of M.V= P.T where m stands for the supply of money, V represents the velocity of circulation, P stands for price level and T represents Transactions or output. According to the assumption of the monetarists V and T are constant and the growth of money supply is directly proportional to each other. Sometimes in an economy excess money is generated and this money might also get translated into inflation. There are different ways to translate this money. One of the common ways is when individuals spend their excess money directly in purchasing goods and services. Inflation is directly influenced by this factor by raising aggregate demand. This instance leads to imported inflation and finally culminates into cost-push inflation.

 

Principles of Quantity Theory of Money

The quantity theory of money follows certain principles. The principles are:

The source of inflation is the increase in money supply

The demand of money is a stable function of interest rates, nominal income etc.

The supply of money is external

The real interest rate is determined by time, productivity of capital.

The inflow of money does not carry much importance in the long run

 

However, in the present days a school of economists think that the theory has lost much of its applicability. But it is still an important theory on which the analysis of inflation is based.

 

Inflation can be caused by federal taxes put on consumer products such as cigarettes or fuel. As the taxes rise, suppliers often pass on the burden to the consumer, the catch, however, is that once prices have increased, they rarely go back, even if the taxes are later reduced. So, what can be done about this and what will the disadvantages of such a step can be?

Make no mistake, there is only one causes of inflation and everything else happens as a result of that one major cause. In other words, everything else that happens becomes inflationary but not the cause of inflation. Rising prices are inflationary for sure, but not the cause of inflation. Only the manufacture of more money than the total available yesterday causes inflation. Rising prices are a reaction to this extra money in a system. Manufacturing money out of thin air eventually puts more money in the ordinary person’s pocket yet this endless production of extra paper money done by the central banks, does not require any extra effort on behalf of the worker so he ends up with more money in his pocket to buy “things” at no extra cost to him. That sounds nice but with more money to buy things, the money becomes worth less and to compare the “things” go up in price or else they would become cheaper for no real reason. The value of money is determined by dividing the number of “things” available by the total amount of money available. As the amount of money available increases, the value of “things” would go down if the system did not compensate by putting the value of those “things” up, hence an inflationary reaction to the extra amount of money available. This is not a complicated operation but rather hard to explain when money and the value of money are talked about. The value of money is different than the total amount of money available. The value of money rises of falls with the total amount of money available. If the central bank manufactures, out of thin air, more money than yesterday’s total, then the value of money would go down, which would be seen as prices of “things” going up to compensate for the extra amount of money available.       

2. Causes of Rising Inflation in Kazakhstan

 

What are the reasons for the inflation currently in Kazakhstan? What role have external factors played in this inflationary pressure? Could the government or the National Bank have prevented it? What is to be done now? In order to find out, The Exclusive interviewed several famous Kazakh economists. Below are their unedited answers.

Comments by Bulat Khusainov, the leading researcher of the Institute of Economics

• Certainly, Kazakhstan is not the only country that faces price increases on commodity goods, particularly in the food market. This phenomenon is happening in other CIS countries. The causes of such inflation are not monetary in nature. The reasons are in the structure of our industry, in the technological backwardness and, more importantly, in the lack of competition and extreme monopolization.

The inflation index can be compared to “the average temperature” of patients in a hospital. Great Britain and Russia have produced a special calculator, which enables us to count our own inflation. However, the inflation that is estimated with the consumer price index does not accurately reflect the real cost of living.

Why are we in this situation today?

• Here are some numbers. If one analyses prices for consumer goods and services in Kazakhstan since 1995, one can see that by the end of 2003 the index has increased by a factor of two or three. This inflation has three components: food commodities, non-food commodities and services. The third component has increased more than six fold. This is often caused by the prevailing practice of prepayment for services rendered. The example from our present day reality is mobile telephone service. In their business model they employ a one step payment system. If each mobile user daily pays one dollar for services that have not been made yet (there are about 5 million users in Kazakhstan), you can calculate how much money was charged for a service not yet rendered. A similar scenario happens in many sectors of the economy and will persist in the country until a sufficient number of competing companies-operators exist in the market place.

People in Kazakhstan are primarily concerned with the price increase for bread. Kazakhstan does not import crops, we export them. Our grain production exceeds our consumption. Total grain production is approximately 22 000 000 tons, while the internal consumption is about 4 000 000 tons, including seed banks and grain reserves. Therefore, the claims of some officials that the price increase is explained by worldwide growth in the price of agricultural commodities are not reasonable. References to global pricing and world grain reduction are meant for the naive. Certainly, bakers have increased their prices as a result of growth in tariffs and duties; however, it is not the only factor causing price increases.

Regarding other foodstuffs, their prices have grown as many of them are now imported. Do you recall a sudden increase in exchange rates that occurred in August? At the same moment, new customs regulations were introduced. According to the new regulations, to import commodities and services, the exporting party needs to present an export declaration. This is irrational. Nevertheless, a considerable volume of currency of the country’s four important banks was detained at the border for three or four days. The exchange rates fluctuated drastically, provoking panic. This, naturally, caused an increase in prices, even in our local market of Almaty, named Zelenyi Bazaar.

The inflation indexes we use, do not factor in the increase of the prices for real estate and the primary and secondary housing markets. According to official statistics, land prices in 2006 have grown 300% in the republic and 500% in Almaty. The prices for new apartments have grown 1,6- 1,7 times. In my opinion, it is not the inflation that needs to be calculated, but the cost of living with the help of a relevant index. Last year our statisticians roughly estimated the increase in the cost of living in Kazakhstan. We used the lowest rates for the housing and land. According to our estimations, the cost of living in the Republic has increased 1,5 times, and 1,75 in Almaty. In this estimation, we considered the real state price change, which is not taken into account in the inflation rate measured by the consumer price index (as per MFA method).

What can we do now?

• We can create more competition and decrease the import of foodstuffs. There is a threshold of imports of foodstuff, it is equal to 30 % of the total volume of consumption. We have passed this threshold long ago.

The mortgage crisis in the US chronologically coincided with the incompetent decision of the customs authorities; these factors led to the delay of cash inflow into the market. We have created an artificial economy, which does not obey classical or neo-classical economic theory.

3. Effects of Inflation

 

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 general price level rises, each unit of currency buys fewer goods and services, consequently, inflation is also 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.

Inflation's effects on an economy are manifold and can be simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation may discourage investment and savings, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include a mitigation of economic recessions and debt relief by reducing the real level of debt.

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in 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.

Today, most mainstream economists favor a low steady rate of inflation. Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy. 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.

An increase in the general level of prices implies a decrease in the purchasing power of the currency. The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money. For example, with inflation, lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments.

An increase in the price level (inflation) erodes the real value of money (the functional currency) and other items with an underlying monetary nature (e.g. loans and bonds). However, inflation has no effect on the real value of non-monetary items, (e.g. goods and commodities, gold, real estate).

 

 

 

NEGATIVE

High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation. Uncertainty about the future purchasing power of money discourages investment and saving. And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates unless the tax brackets are indexed to inflation.

With high inflation, purchasing power is redistributed from those on fixed nominal incomes, such as some pensioners whose pensions are not indexed to the price level, towards those with variable incomes whose earnings may better keep pace with the inflation. This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, higher inflation in one economy than another will cause the first economy's exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.

Hoarding            

People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.

Hyperinflation       

If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply goods. Hyperinflation can lead to the abandonment of the use of the country's currency, leading to the inefficiencies of barter.

 

Allocative Efficiency

A change in the supply or demand for a good will normally cause its relative price to change, signaling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, price changes due to genuine relative price signals are difficult to distinguish from price changes due to general inflation, so agents are slow to respond to them. The result is a loss of allocative efficiency.

 

Shoe leather cost

High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.

 

Menu costs

With high inflation, firms must change their prices often in order to keep up with economy - wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly.

 

Business cycles

According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.

 

POSITIVE

Labor-market adjustments

Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster.

 

Debt relief

Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The “real” interest on a loan is the nominal rate minus the inflation rate. (R=n-i) For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate.

 

Room to maneuver

The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.

 

Tobin effect

The Nobel prize winning economist James Tobin at one point argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least a higher steady state level of income. This is because inflation lowers the real return on monetary assets relative to real assets, such as physical capital. To avoid this effect of inflation, investors would switch from holding their assets as money (or a similar, susceptible-to-inflation, form) to investing in real capital projects.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Types of Inflation

3.1   Keynesians Concept

A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively, often leading to hyperinflation, a condition where prices can double in a month or less. Another cause can be a rapid decline in the demand for money, as happened in Europe during the Black Plague.

The money supply is also thought to play a major role in determining moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics, by contrast, typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians the money supply is only one determinant of aggregate demand. Some economists consider this a “hocus pocus” approach: They disagree with the notion that central banks control the money supply, arguing that central banks have little control because the money supply adapts to the demand for bank credit issued by commercial banks. This is the theory of endogenous money. Advocated strongly by post-Keynesians as far back as the 1960s, it has today become a central focus of Taylor rule advocates. But this position is not universally accepted. Banks create money by making loans. But the aggregate volume of these loans diminishes as real interest rates increase. Thus, it is quite likely that central banks influence the money supply by making money cheaper or more expensive, and thus increasing or decreasing its production. A fundamental concept of Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and 
employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment. The Phillips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation experienced in the 1970s.

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal working of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.

Another Keynesian concept is the potential output (sometimes called the "natural gross domestic product"), a level of GDP, where the economy is at its optimal level of production given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-employment unemployment rate). IF GDP exceeds its potential (ad unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.

However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under British Prime Minister Margaret Thatcher might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed (also see unemployment), unable to find jobs that fit their skills. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.

 

2. Monetarist view

 

Monetarists believe the most significant factor influencing inflation or deflation is how fast the money supply grows or shrinks. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation. According to the famous monetarist economist Milton Friedman, "Inflation is always and everywhere a monetary phenomenon.» Some monetarists, however, will qualify this by making an exception for very short-term circumstances.

 

Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that any change the amount of money in a system will change the price level. This theory begins with the equation of exchange:

 

M*V=P*Q

 

Where

M is the nominal quantity of money.

V is the velocity of money in final expenditures;

P is the general price level;

Q is an index of the real value of final expenditures;

In this formula, the general price level is related to the level of real economic activity (Q), the quantity of money (M) and the velocity of money (V). The formula is an identity because the velocity of money (V) is defined to be the ratio of final nominal expenditure (P*Q) to the quantity of money (M).

 

Monetarists assume that the velocity of money is unaffected by monetary policy and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With exogenous velocity (that is, velocity being determined externally and not being influenced by monetary policy), the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not exogenous in the short run, and so the formula does not necessarily imply a stable short-run relationship between the money supply and nominal output. However, in the long run, changes in velocity are assumed to be determined by the evolution of the payments mechanism. If velocity is relatively unaffected by monetary policy, the long-run rate of increase in prices (the inflation rate) is equal to the long run growth rate of the money supply plus the exogenous long-run rate of velocity growth minus the long run growth rate of real output.

 

 

3. Types of Inflation

 
There are four main types of inflation and the all various possible types of Inflation:

Wage Inflation:

Wage inflation is also called as demand-pull or excess demand inflation. This type of inflation occurs when total demand for goods and services in an economy exceeds the supply of the same. When the supply is less, the prices of these goods and services would rise, leading to a situation called as demand-pull inflation. This type of inflation affects the market economy adversely during the wartime.

When demand of product and services exceeds the supply of the product in the economy it is known as wage or demand-pull inflation. This scarcity of good and services pushes the general price level upward. This trend follow the common law of demand as demand increases so the prices level and situation prevail until supply adjust accordingly. In the time of emergencies like during or after wartime the affect is more Sevier.

Inflation caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favorable market conditions will stimulate investment and expansion. The failing value of money, however, may encourage spending rather than saving and so reduce the funds available for investment.

According to the demand-pull theory, prices rise in response to an excess of aggregate demand over existing supply of goods and services. It is also called excess-demand inflation. In the excess-demand theories of inflation, excess demand means aggregate real demand for output in excess of maximum feasible, or potential, or full employment, output (at the going price level). The demand-pull theorists point out that inflation (demand-pull) might be caused, in the first place, by an increase in the quantity of money. Demand-pull or just demand inflation may be defined as a situation where the total monetary demand persistently exceeds total supply of real goods and services at current prices, so that prices are pulled upwards by the continuous upward shift of the aggregate demand function. Causes of Demand-pull inflation are: Increase in Public; Expenditure Increase in Investment; Increase in money supply.

 
Cost-push Inflation:

As the name suggests, if there is increase in the cost of production of goods and services, there is likely to be a forceful increase in the prices of finished goods and services. For instance, a rise in the wages of laborers would raise the unit costs of production and this would lead to rise in prices for the related end product. This type of inflation may or may not occur in conjunction with demand-pull inflation.

Cost push inflation or cost inflation is induced by the wage-inflation process. This is especially true for a Country like India, where labour intensive techniques are commonly used. Theories of cost-push inflation (also called sellers’ or mark-up inflation) came to be put forward after the mid-1950s. They appeared largely in refutation of the demand-pull theories of inflation and three important common ingredients of such theories are 1) that the upward push in costs is autonomous of the demand conditions in the concerned market 2) that the push forces operate through some important cost component such as wages, profits (mark up), or materials cost. Accordingly, cost-push inflation can have  the forms of  wage-push inflation, profit-push inflation, material-cost push inflation, or inflation of a mixed variety in which several push factors reinforce each other and that  the increase in costs is passed on to buyers of  goods in the form of higher prices, and not absorbed  by producers. Thus, a rise in wages leads to a rise in the total cost of production and a consequent rise in the price level, because fundamentally, prices are based on costs. It has been said that a rise in wages causing arise in prices may, in turn, generate an inflationary spiral because an increase would motivate the workers to demand more wages.

When the cost of production increase it has a direct affect of price incremental shift to end user, this increase in price level is called cost-push inflation. For example if the there is a rise in labor wages it will increase the unit cost and price of that product will increase. Once this price upward movement trend set forth it affects whole economy and inflation level rise.  Cost-push inflation may or may not be occur with Wage inflation.

Presently termed "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.

 

Cost-push inflation:

High inflation can prompt employees to demand rapid wage increases, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wage growth will be set as a function of inflationary expectations, which will be higher when inflation is high. This can cause a wage spiral. In a sense, inflation begets further inflationary expectations, which beget further inflation.

 
Pricing Power Inflation:

Pricing power inflation is more often called as administered price inflation. This type of inflation occurs when the business houses and industries decide to increase the price of their respective goods and services to increase their profit margins. A point noteworthy is pricing power inflation does not occur at the time of financial crises and economic depression, or when there is a downturn in the economy. This type of inflation is also called as oligopolistic inflation because oligopolies have the power of pricing their goods and services.

 
Sectoral Inflation:

This is the fourth major type of inflation. The sectoral inflation takes place when there is an increase in the price of the goods and services produced by a certain sector of industries. For instance, an increase in the cost of crude oil would directly affect all the other sectors, which are directly related to the oil industry. Thus, the ever-increasing price of fuel has become an important issue related to the economy all over the world. Take the example of aviation industry. When the price of oil increases, the ticket fares would also go up. This would lead to a widespread inflation throughout the economy, even though it had originated in one basic sector. If this situation occurs when there is a recession in the economy, there would be layoffs and it would adversely affect the work force and the economy in turn.

Other Types of Inflation

 

Fiscal Inflation:

Fiscal Inflation occurs when there is excess government spending. This occurs when there is a deficit budget. For instance, Fiscal inflation originated in the US in 1960s at the time President Lydon Baines Johnson. America is also facing fiscal type of inflation under the presidentship of George W. Bush due to excess spending in the defense sector.

Hyperinflation:

Hyperinflation is also known as runaway inflation or galloping inflation. This type of inflation occurs during or soon after a war. This can usually lead to the complete breakdown of a country’s monetary system. However, this type of inflation is short-lived. In 1923, in Germany, inflation rate touched approximately 322 percent per month with October being the month of highest inflation.

 

Hyper inflation is the type of inflation in which inflation level wet abnormally high. The economies in disaster like war mostly face hyper inflation. This is the time when there is shortage of supplies of all necessities of life and prices go extraordinarily high. Hyper or runaway inflation doesn’t sustain for a long time. In recent years hyper inflation can be seen in Zimbabwe.

Hyperinflation takes place when prices of goods and services rise rapidly. This quick rise in prices can offset the balance of the economy, since wages usually don't raise enough to compensate for the increase in expenses.

 

Stagflation:

Stagflation is the dreaded combination of low wages and rapid inflation. Unemployment levels are high, prices keep going up and consumers stop consuming during a period of stagflation. Companies raise prices to try to stay afloat, but consumers can't buy because they either can't find work or aren't making enough, which results in economic challenges.

 

Moderate inflation:

Moderate inflation is a mild and tolerable form of inflation. It occurs when prices are rising slowly. When the rate of inflation is less than 10 percent annually, or it is a single digit annual inflation rate, it is considered to be moderate inflation in the present day economy. It does not disrupt the economic balance. It is regarded as stable inflation in which the relative prices do not get far out of line.