"Inflation is called a necessary evil- no one likes it but it is needed for economic growth."
― The Economic Times
One of the chief foundations of a functioning society is its economy. Without it, trade and business are almost impossible to manage. Lamentably, the economy is an extraordinarily complicated operation and is often especially difficult to keep in control. One aspect of an economy that makes it so impenetrable is inflation. Investopedia defines inflation as "the rate at which the value of a currency is falling and, consequently, the general level of prices for goods and services is rising." In other words, inflation refers to the instance when the value of money reduces due to various economic and social factors. For example, the value of 1 rupee in 1958 is equal to 84 rupees today, which means that 1 rupee today is 1/84th of 1 rupee from 1958. The aforesaid explains that the value of 1 rupee has reduced and that the economy has inflated by 8,332.84%.
Inflation has three primary factors. One is the 'Demand-Pull Effect'. When the interest rates fall, tax breaks are available, and there is an increase in the supply of money and credit; consequently, people gain disposable income and become more affluent. With this increase in wealth comes a rise in demand as the community can afford more products; this increase in demand, faster than the economy's production
capability, increases prices. For instance, if a car dealership offers ten cars, two of which are exceptionally expensive, most people will buy the remaining eight cars. However, when people have more disposable income, everyone can purchase the two expensive cars. Since the dealership cannot produce enough of those cars for everyone, they increase the cost of the two vehicles so only those with even more money can buy them.
Another cause is "Cost-Push". When renewable resources are scarce, or there are taxes imposed on those resources, the costs of those sources increase and hence the prices of the products made from those commodities also increase. For illustration, if oil levels happened to reduce, the value of oil would increase, and so would the price of plastic. Accordingly, all products made of plastic would become more costly as they would have to compensate for the increased production costs.
The third factor is "Built-in Inflation". As inflation occurs, workers demand a raise in salary to deal with the increased prices. When the employing organization agrees to provide higher wages, then they are forced to hike up the costs of their goods and services. Another form of this concept is when consumers base their consumption on expected inflations. To elaborate, when prices increase, people expect it to rise even higher; hence, they spend their money quickly before the prices rise again. Unfortunately, when everyone starts doing the same, money starts to circulate at an accelerating rate. Thus the velocity of money -the exchange rate of money- grows astronomically, which aggravates inflation. This vicious cycle keeps repeating almost automatically, hence the name.
Inflation has various effects on an economy, such as:
1. Inflation reduces purchasing power which means the value of the currency also reduces.
2. When most business people consider inflation, they realize that it is better to buy now than later. Subsequently, they buy more and more assets, causing a Demand-Pull effect resulting in more inflation.
3. Inflation increases interest rates. During low inflation, since prices reduce, the interest rates reduce; resultantly, more people can afford big loans and further spend them. Since so many people are purchasing, inflation heightens, and prices of goods increase along with the interest rates.
It is a common belief that inflation is always bad for the economy. That is incorrect as inflation has various positive effects too.
1. When the money supply reduces, buying reduces and hence the interest rate -more technically known as the 'cost of borrowing'- reduces.
2. Inflation reduces unemployment. When demand rises higher than production, businesses require more workers, and so the unemployment rate decreases. In other words, inflation is 'inversely related' to unemployment; this concept is called the "Phillips Curve".
3. Inflation discourages saving and encourages investing in property or commodities as the money keeps losing value. This boost to spending leads to economic growth.
Inflation can also occur as various extreme economic crises. One form is hyperinflation which refers to when inflation rates rise beyond 50%. Hyperinflation occurs when there is rapid growth in the paper money supply. While attempting to pay massive reparations to the Allies after World War I, Germany experienced hyperinflation in 1923. Since there were 1 trillion Marks in circulation, the value of their currency had reduced drastically, and citizens were either burning their money or using them as wallpaper. In 2007 Zimbabwe, inflation grew tremendously at a rate of 489 billion per cent, and businesses increased their costs multiple times in a day. The million-dollar bill, the billion-dollar bill and the infamous 100 trillion dollar bill
were issued to keep up with the rising prices. The situation was so dire that billionaires were starving as the billions were worthless. In Hungary, from 1945 to 1946, prices increased by a factor of 3 * 10^25. Another type is stagflation which is when economic growth slows down and the unemployment rate increases -essentially, the economy stagnates- while prices rise -inflation occurs. Stagflation is troubling as consumers cannot spend their money which prevents the economy from growing, and the money that consumers have keeps reducing in value as inflation continues. Too low inflation can cause recessions as low demand means less spending, which means slower economic growth. Such economic downturns can also cause liquidity traps which refers to everyone expecting reduced prices, thus reducing consumption, thus reducing income and employment. Recessions or extreme recessions -more appropriately named 'depressions'- can cause deflation which refers to a decline in asset prices and business income causing high unemployment rates.
The aforementioned proves that although inflation is an incredibly elaborate system that can be highly unpredictable and damaging, a constant level of inflation improves the economy. Furthermore, considering inflation is such a fundamental part of a working economy, it very much affects and depends on the people of the economy. Therefore, it is essential that we, as future members of our economic community, are aware of such intricate and intriguing systems.
Bibliography:
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4. Lioudis, Nick. "What Is the Relationship Between Oil Prices and Inflation?." Investopedia. 17 Nov. 2021. Web. 19 Nov. 2021.
5. David Floyd. "9 Common Effects of Inflation." Investopedia.
6. The Investopedia Team. "Stagflation Definition." Investopedia.
7. N.a. "Recession, Hyperinflation, and Stagflation: Crash Course Econ #13 - YouTube."
8. The Investopedia Team. "What Causes Negative Inflation (Deflation)?." Investopedia.
9. Become An Insider. "Depressions and recessions differ in their severity, duration, and overall impact. Here's what you need to know.." Business Insider.
10. Sean Ross. "When Is Inflation Good for the Economy?." Investopedia.
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