Inflation

Question 6. Inflation

(i) With reference to research that you have completed, discuss in detail each of the THREE main causes of inflation

This research must be cited in the body of your slides and should include two examples from economic history of times that Demand Pull, Cost Push and Increases in Money Supply caused inflation.

(ii) Outline three problems caused by high inflation.

Overview1. Inflation

2. Causes of inflation

(Demand Pull, Cost Push, Increase in Money Supply)

3. Problems caused by inflation

4. Conclusion

InflationInflation is defined as a steady and persistent increase in the general level of

prices.

Its the rate at which your money loses its value to buy goods and services.

In Europe, the ECB aims to try to maintain inflation rate below, but close to, 2% over the medium term. The Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep excessive growth of prices to a minimum.

Inflation is measured by CPI or by PPI. CPI (consumer price index) is a measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles (basket of goods). PPI (producer price indexes) is a family of indexes that measure the average change over time in selling prices by domestic producers of goods and services.

Current rates of inflationCentral Statistics Office (CSO) & Consumer Price Index (CPI)

Average rate of inflation 2013: 0.56%

Causes of inflation

Demand Pull InflationOccurs when aggregate demand is greater than aggregate supply, therefore increasing prices.

Causes of demand pull inflation?

• Growing economy• Continued rise in aggregated demand• Easy access to bank credit (celtic tiger)• Increase in government expenditure• Consumer purchasing power

Property Bubble in IrelandFrom 1991 to 2001, Ireland’s real GDP growth averaged above 7% and Ireland was reaching full employment. Per capita income reached above average in the EU. This meant that the population had more income to spend. Lending to households from 2003-2007 was one of the highest in the euro area.

House prices increase by 17% between May 2000 and May 2001 alone. Since the population had more to spend, people invested into housing. The amount of people wanting to buy a house exceeded the amount of houses available for sale.

GOLDThe direct aftermath of the 2008 global financial crisis caused an inflation for one particular asset, gold.

Investors worries grew over over the economic fallout from both the eurozone and U.S debit crisis. This led to an increase in demand pull inflation for gold.

The price of gold reached a record of $1,895 per ounce in 2011.

Cost Push InflationCost Push inflation occurs when there is a shortage of supply of labor, raw materials and capital. Demand for products and services remains constant but the prices of commodities increase causing a rise in the overall price level.

Cost push inflation occurs when firms increase prices to maintain or protect margins after experiencing a rise in their costs of production, wages, electricity bills. Firms will cover these costs by partly passing it on the customer (increase price) and by cutting back production.

Crude OilOil is an example of a cost push inflation. If oil prices increase, then they may lead to sustained increase in the overall inflation rate. If rising oil prices lead to higher inflation over the longer term, rising energy and wage costs are more likely to be passed through in terms of rising consumer prices. However if oil prices stabilise, the corresponding inflationary pressure will disappear.

1970s Oil crisisSeries of energy caused by problems in the Middle East. Price of crude oil rose from 3 to 12 dollars by 1974. The price of petrol rocketed,making transport more expensive. Inflation rate hit more than 24%.

Natural disastersNatural disaster or the environment can be catalysts for cost push inflation.

In 2011, a 9 magnitude earthquake and tsunami destroyed towns and cities in Japan. This greatly affected Japan’s economy as well due the massive damages to factories and production plants. Japan manufacturers 20% of the world’s semiconductor products. Since production were halted, there was less products manufactured and available which resulted in increase of prices.

In 2013, olive oil production was affected by series of natural disasters. Olive trees in Italy are affected by a plant germ. This plant germ is killing centuries old trees which are a great part of olive oil production. In Greece, bad weather affected the olive trees which led to a shortage of crops. In Spain, shortage of olive oil was due to the lack of water during the long hot summer weather. The price of Spanish olive oil has risen by roughly 30 % while the olive oil from Greece has risen in price by nearly 50%.

Increase in Money SupplyInflation can occur due to the increase in money supply in the economy. As more and more money is released into circulation, the more likely it can increase inflation.

Increase of money supply in circulation can occur due to1. Monetization (more money being printed)2. Banks lending loans3. Banks giving out credit cards4. Quantitative easing ( A monetary policy in which a central bank purchases government securities from the market in order to lower interest rate and increase the money supply)

Inflation caused by the increasing money supply circulation happened in Zimbabwe, Hungary, Germany, Yugoslavia and Argentina (these countries experienced hyperinflation due to the monetization).

ZimbabweZimbabwe was the first in 21st century to experience hyperinflation due to the large monetization by the government. Before becoming independent in 1980, the country was involved with guerrilla wars.Inflation occurred due to the preceded economic decline over several years and the mounting public debt.

Economy of Zimbabwe started to decline in 1999, when external debt increased and commercial output worsened. There was uncontrolled government spending which greatly affected the economy as well. Tax collection did not help to cover the large government expenditure thus the government decided to begin monetization. The government printed even more money when they were unable to cover expenditures thus increasing money supply in the economy.

The high inflation rates throughout the years eroded currency’s purchasing power. Usually when the currency is almost worthless, the use of foreign exchange or barter frequently occurs-People traded gold for products and services, Zimbabwean dollar became irrelevant.

By the end of 2009, the population started to use US dollars which helped in stabilising the economy of Zimbabwe.

In summer 2008, inflation reached 231,000,000%.

In 2009, the Zimbabwean Government issued the highest denomination which was one hundred trillion dollar (100,000,000,000,000). Compared to this, in 1980, when Zimbabwe gained independence, existed only Z$2, Z$5, Z$10 and Z$20 denominations.

Yugoslavia Under Tito (Dictator), Yugoslavia (now Serbia and Montenegro) ran a budget deficit that was financed by printing money. This led to a rate of inflation of 15 to 25 percent per year. New policies led to heavier reliance upon printing, creating money to finance the operation of the government and the socialist economy. This created hyperinflation.

The government tried to counter the inflation by imposing price controls. But when inflation continued, the government price controls made the price producers were getting so ridiculous low that they simply stopped producing. Later the government tried to curb inflation by requiring stores to file paperwork every time they raised a price. This meant that many store employees had to devote their time to fill out these official forms. Instead of curbing inflation, this new policy actually increased inflation because store owners tended to increase prices by a large increments so they would not have to fill forms each time price changed.

In october of 1993, the Yugoslavian government created a new currency. One that was worth one million of the ‘old’ dinars. The government simply removed six zeros from the paper money. This did not stop the inflation. Between October 1993 to January 1995, prices increased by 5 quadrillion percent. Many Yugoslavian businesses refused to take the Yugoslavian currency and instead used the German Deutsche Mark. The average daily rate of inflation was 100%.

In January 1994, the government introduced the ‘super’ dinar equal to 10 million of the ‘new’ dinars.

Problems caused by high inflation

Balance of paymentsBalance of payments record the flow of money between residents of the country and the rest of the world. Inflation is likely to worsen the balance of payments.

If a country suffers from relatively high inflation, its exports will become less competitive in world markets (prices increasing). Imports will become relatively cheaper than home produced goods. Thus exports will fall and imports will rise. As a result, the balance of payments will deteriorate and/or the exchange rate will fall.

Shoe leather and Menu costShoe leather refers to the costs (in time and energy) of efforts intended to counteract the effect of inflation. The term comes from the belief that people will cope with inflation by keeping less cash on hand and making more trips to the bank. When inflation is high, interest rates go up as well, which means that keeping money in interest bearing accounts can be a good strategy.

Menu cost occurs during high inflation. Minor costs of changing catalogues, price labels or adjust slot machines due the changing prices in the economy.

Income Re-DistributionInflation redistributes income away from those on fixed incomes and those in a weak bargaining position, to those who can use their economic power to gain large pay, rent or profit increases. Those people on fixed incomes (social welfare) suffer when inflation is high as their incomes remain at the fixed rate while prices continue to rise thus reducing their standard of living.

High inflation redistributes wealth to those with assets that rise in value particularly rapidly during periods of inflation, and away from those with types of savings that pay rates of interest below the rate of inflation and hence whose value is eroded by inflation. Unexpected inflation can lead to borrowers paying a smaller real interest rate, transferring wealth from creditors to borrowers.

Conclusion

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