Example Of Essay On The Effect Of Inflation And Deflation

Introduction

Inflation is the persistent increase in general price level of goods and services over a period of time in a given economy/country (Lindauer, 92). Types of inflation include open inflation, suppressed inflation, galloping inflation, creeping inflation and hyperinflation. Open inflation arise due to rising costs of goods and services. Depressed inflation arises due to price restrictions by the government. Galloping inflation is inflation that rises very fast at a persistent rate. Creeping inflation is inflation that rise slowly but at a steady rate over time. Hyperinflation is caused by increased debt by the government. Inflation is measured using Consumer Price Index (CPI) and Purchasing Power Parity (PPP). Inflation is a bad phenomenon because of the following reasons: It erodes the purchasing power of money, it affects fixed income earners especially pension, it leads to macroeconomic distortions, it slows down economic growth, it makes prices for domestic exports high, and it leads to political upheavals. There are two causes of inflation namely demand side factors and supply side factors (Taylor, 111).

Demand side factors

These are factors which lead to excess demand of goods and services. The factors which relate to demand side inflation include: Monetarist explanation - This factor was supported by Milton Friedman who said that “inflation is always and everywhere a monetary phenomenon”. This type of inflation is brought about by increase in money supply.
Quantity theory of money – This theory states that money velocity is equal to price multiply by output. It assumes that velocity is constant and price is fixed in the short run. As a result, money supply and inflation have a direct relationship.
Expansionary fiscal policy – This means increase in government expenditure or tax cut which lead to increase in output. This expansionary policy can lead to increase in demand for goods and services which can lead to inflation.

Supply side factors

These are factors which lead to shortage of supply relative to demand. These factors include: Shortage of goods and services - This can lead to inflation because the available supply cannot meet the demand requirements. This shortage can lead to slowed economic growth. Bottlenecks in supply side – This relate to shortage in supply due to bad weather which leads to less production, shortage of factor inputs such as fertilizer, labor and capital, structural rigidities such as infrastructure and the presence of taxes and/or subsidies by the government. Inflation and unemployment – it is described by Philips curve which states that increase in inflation leads to unemployment. There is an inverse relationship between inflation and unemployment.
Inflation affects foreign exchange. High inflation rates lead to depreciation of domestic currency relative to currencies of other countries. Nominal exchange rate is adjusted for inflation to get real exchange rate. Inflation causes interest rate to rise which further affects the ability to get credit from financial institutions. Other investments such as stocks and bonds fetch low returns because of high interest rates. Inflation has a bad effect on production. It leads to high production cost which reduces the amount of goods and services produced at any point leading to decreased supply (Mankiw & Mark, 99).
Inflation also leads to unequal distribution of income. This arises because inflation affects both the poor and the rich. Because of high costs, the poor become even poorer because they bear the heaviest burden as they struggle to meet their basic needs. Inflation leads to slow economic growth. This is because high costs affect saving. An economy grows through investment and investments grow through savings. Inflation affects balance of payment. High cost through interest rate makes debts expensive. The effect is higher when a country has huge debts.

Deflation

Deflation is the persistent decrease in general price level of goods and services over time (Mankiw & Mark, 236). Deflation slows down economic growth. It leads to increased real value of money. Deflation arises when inflation rate falls to zero. It is caused by decrease in aggregate demand. There are two types of deflation namely benign and malevolent deflation. Benign deflation is caused by improved technology and change in demographic characteristics which lead to shrinking of population hence lower demand. Malevolent deflation is caused by a decreasing aggregate demand leading to an output gap which is negative. A worrying phenomenon of deflation is that it has a deflationary effect. Deflationary effect is caused by reduced aggregate demand which lead to low production and reduced investment. This results into unemployment and low disposal income which leads to a further reduction in demand leading to default of loans (Lindauer, 158). During inflation, interest rate can rise to any level but in deflation there is a level that interest rate cannot fall. Prices of goods and services drop and this could lead to recession. Deflation is not easy to manage, therefore its long-term effects are low consumption of goods and services and unemployment. People fall in a situation called debt trap because though prices are falling, the income is also falling and it becomes difficult to service loans. This spiral effect of deflation can be solved by reducing the long term interest rate to discourage investment in government debts. This will help investors invest in production of goods and services. The federal government can also inject more money in the economy and sustainable monetary policies can be made in the economy by cutting taxes, borrowing and spending.
In conclusion, both inflation and deflation are undesirable conditions in an economy. The federal and State governments through the central bank should implement policies like expansionary fiscal policy and monetarist policy that ensure relatively stable inflation rate (Taylor, 52). It should also reduce the long term interest rate by reducing government debt which might lead to deflationary spiral. Measures such as cost of reducing inflation can be applied. Cost of reducing inflation, also referred to sacrifice ratio is the percentage fall in output due to one percent reduction in unemployment. This can be done by incorporating all available information when making future decisions. This can be aided by the central bank through credible policy pronouncements. If credibility is high, sacrifice ration will be low. Inflation can be reduced by involving the federal government in demand management policies such as monetary and fiscal policies. These measures can help stimulate economic growth through increased consumption and tax cuts. This is achieved by using demand management policies such as monetary and fiscal policies.

Works cited

Lindauer, John. The General Theories of Inflation, Unemployment, and Government Deficits. Bloomigton: iUniverse, 2013. Print.
Mankiw, N G, and Mark P. Taylor. Economics. London: Thomson, 2006. Print.
Taylor, John B. Low Inflation, Deflation, and Policies for Future Price Stability. Tokyo: IMES, 2000. Print