Inflation's Grip: Uncovering the Causes, Consequences, and Cures
Often, you hear the word ‘inflation’ being thrown around on the news, in speeches, and even in daily conversations, yet most are not aware of the extent of its influence on our society. Inflation is the increase in prices or cost of living over time. A perfect example to illustrate this phenomenon would be the change in the price of a Big Mac from McDonald's - two decades ago, a single Big Mac only cost $3.49. Yet, the price has spiked to $5.99 now. This happens when the aggregate quantity demanded of goods at any particular price level rises more quickly than the aggregate quantity supplied of goods at that price level (Abel).
Inflation is caused by two main things: demand-pull inflation and cost-push inflation. Demand-pull inflation happens when demand for goods and services outweighs supply, which remains stable or drops, resulting in higher prices. In a growing economy, more labour is employed to increase the output of production units. Assume the economy is initially at full employment equilibrium, producing potential GDP, shown as Yp in Figure 1. The economy experiences an increase in aggregate demand appearing as a rightward shift of the AD curve from AD1 to AD2 in both diagrams. The impact on the economy is to increase the price level from Pl1 to Pl2 and to increase the equilibrium level of real GDP from Yp to Yinfl. The increase in the price level from Pl1 to Pl2 due to the increase in aggregate demand is known as demand-pull inflation. A prominent macroeconomic model closely related to demand-pull inflation is the Phillips Curve, discovered by economist Alban William Housego Phillips, which states that unemployment and inflation have an inverse relationship. Governments widely used the Philips Curve to manage the economy by adjusting fiscal and monetary policies to target a particular combination of unemployment and inflation in the 1960s and 1970s. Despite its prominence, a phenomenon known as stagflation occurred in the late 1970s. Stagflation is where inflation and unemployment are at high rates simultaneously, along with stagnant economic growth. Cost-push inflation happens when production falls while demand for goods remains changed, price increases from production are passed onto consumers, creating cost-push inflation. Assume the economy is initially at the full employment level of output, Yp in Figure 2, and suppose there is an increase in costs of production. The SRAS curve shifts from SRAS1 to SRAS2, leading to an increase in the price level from Pl1 to Pl2, and a fall in the equilibrium level of real GDP from Yp to Yrec.
When it comes to the effects of inflation, there are two sides of the same coin. On the “bad” side, the purchasing power of consumers is lowered by the increase in price levels. Low-wealth households tend to hold a larger share of their assets in the form of nominal claims, such as cash, deposits, and fixed-income securities. These assets have a fixed monetary value, regardless of changes in general price or inflation. On the contrary, high-wealth households have a larger share of their wealth in real assets that can maintain their value even during periods of high-level inflation, such as real estate, equity, and durable goods. Due to their high proportion of nominal wealth, low-wealth households' savings and other nominal assets depreciate, rapidly eroding their purchasing power and lowering their living standards. Additionally, low to middle-class elderlies are also one of the affected groups. The elderly often rely on fixed income or other nominal assets accumulated over their lifetime, which are vulnerable to the negative impacts of high inflation levels. Inflation causes a redistribution of wealth that benefits high-income households with more real assets, which widens the wealth gap between different social classes. This may lead to social tensions, as the wealth redistribution disproportionately fails lower-income and elderly households (Doepke). Furthermore, periods of high inflation often coincide with financial crises, such as banking and currency crises. Economists argued that erosion of the real value of assets and liabilities, increased uncertainty in markets, and reduced effectiveness of monetary policies in maintaining financial stability all contribute to financial uncertainty in sectors (Reinhart). However, on the flip side, inflation can benefit financial institutions. When price levels are raised, consumers and other firms need more money to carry out purchases, leading to an increased demand for money, subsequently increasing the interest rates on mortgages, loans, and other financial services offered by such institutions. As a result of the increase in interest rates, lenders can receive more compensation in terms of nominal value for the deferred consumption of money. Additionally, financial institutions often hold a large portfolio of bonds or other fixed-income securities. Although the value of the existing bonds decreases as interest rates increase, firms can reinvest the proceeds from maturing bonds at higher prevailing interest rates to earn higher returns over time.
With the negative impacts of inflation outweighing the positive ones, governments and central banks have come up with a variety of policy tools to combat high and persistent inflation in the economy. Central banks often try to anchor inflation expectations and achieve their inflation objectives by adjusting the nominal interest rate. Higher nominal interest rates increase the cost of borrowing, reducing the consumption of households and firms, hence decreasing the aggregate demand which puts downward pressure on output and employment in the short run. On top of the reduced aggregate demand, a tightening of monetary policy and an increase in nominal interest rates also raises the real interest rate, which affects current and future expected outputs, and therefore affects current and future inflation. When central banks adopt policies that target a steady, controlled, and low rate of growth in the money supply, the rate of inflation in an economy can be regulated properly. Moreover, fiscal policies also play a significant role in managing inflation. Higher taxes on goods and services decrease disposable household income, leading to lower consumer spending and investment spending ie. aggregate demand for such purchases. Policies on government spending can also help reduce the aggregate demand. When government spending on public consumption and investments, such as infrastructure or transportation networks, the overall spending of the economy is lowered, which can alleviate inflationary pressures. Last but not least, wage and price controls can also be used to lower the rate of inflation. Businesses often pass on the increased cost of production to consumers by raising the selling prices of their goods or services, but with the help of price controls, the government can limit the maximum prices that can be charged for certain products or services, preventing certain businesses from contributing further to high inflation. One of the largest contributing factors to inflation is the increase in aggregate demand due to a rise in consumer income from economic growth. By implementing a maximum increase in income to prevent wages from rising too quickly, inflation can be slowed down. Despite all these available policies that can be used to combat inflation, this phenomenon is still inevitable and can only be slowed down, rather than eradicated.
In summary, inflation impacts both individuals and the broader economy. While it can provide some benefits to financial institutions, the negative effects of inflation, such as the erosion of purchasing power for low-income households, the widening of wealth gaps, and the potential for financial instability, generally outweigh the positives. Governments and central banks have developed a range of monetary and fiscal policy tools to combat high and persistent inflation, including adjusting interest rates, controlling the money supply, raising taxes, and implementing wage and price controls. However, ultimately, there is no real ‘cure’ to inflation. It can only be managed, not fully eliminated. Understanding the causes and effects of inflation, as well as the policies available, is crucial for individuals, businesses, and policymakers who strive to build a thriving economy.
Sources:
Abel, A. B., Bernanke, B. S., & Croushore, D. (2006). Macroeconomics Plus MyEconLab Plus EBook 1-semester Student Access Kit. Addison-Wesley Longman.
Ellie Tragakes - Economics for the IB Diploma (Second Edition) - Cambridge 2012
Doepke, M., & Schneider, M. (2006). Inflation and the redistribution of nominal wealth. Journal of Political Economy, 114(6), 1069-1097.
Reinhart and Rogoff (2009) - "This Time is Different: Eight Centuries of Financial Folly"
Mamaysky, H. (2018). The time scaling of asset returns: The case of interest rates and implications for portfolio choice. The Review of Asset Pricing Studies, 8(2), 207-247.
Friedman, M. (1968). The Role of Monetary Policy. The American Economic Review, 58(1), 1-17
Alesina, A., & Ardagna, S. (2010). Large Changes in Fiscal Policy: Taxes Versus Spending. Tax Policy and the Economy, 24, 35-68.
