Title of Project: Causes and effects of inflation in the economy

Name of Student: Sabareesh B. Nair

Name of Professor: Thomas Schoenfeldt

Name of Subject: Addressing Business Problems with Research BR 6450

Name of University: Madonna University

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Table of Contents

1) Introduction

2) Theoretical Explanation

3) Case study

4) Conclusion

5) Bibliography

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1) Introduction

A  simple commonly used definition of the word inflation is simply "an increase in

the price you pay for goods."  In other words, a decline in the purchasing power of

your money". Technically, Price Inflation is when prices get higher or it takes

more money to buy the same item. Inflation is when prices continue to creep

upward, usually as a result of overheated economic growth or too much capital in

the market chasing too few opportunities. Usually wages creep upwards, also, so

that companies can retain good workers. Unfortunately, the wages creep upwards

more slowly than do the prices, so that your standard of living can actually

decrease

A persistent increase in the level of consumer prices or a persistent decline in the

purchasing power of money, caused by an increase in available currency and credit

beyond the proportion of available goods and services is also called as inflation.

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2) Theoretical explanation

Causes of inflation

There are many causes for inflation, depending on a number of factors. For

example, inflation can happen when governments print an excess of money to deal

with a crisis. As a result, prices end up rising at an extremely high speed to keep up

with the currency surplus. This is called the demand-pull, in which prices are

forced upwards because of a high demand.

Another common cause of inflation is a rise in production costs, which leads to an

increase in the price of the final product. For example, if raw materials increase in

price, this leads to the cost of production increasing, which in turn leads to the

company increasing prices to maintain steady profits. Rising labor costs can also

lead to inflation. As workers demand wage increases, companies usually chose to

pass on those costs to their customers.

Inflation can also be caused by international lending and national debts. As nations

borrow money, they have to deal with interests, which in the end cause prices to

rise as a way of keeping up with their debts. A deep drop of the exchange rate can

also result in inflation, as governments will have to deal with differences in the

import/export level.

Finally, 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. Wars are often cause for inflation, as

governments must both recoup the money spent and repay the funds borrowed

from the central bank. War often affects everything from international trading to

labor costs to product demand, so in the end it always produces a rise in prices.

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There are a few different reasons that can account for the inflation in our goods and

services; let's review a few of them.

Demand-pull inflation refers to the idea that the economy actual demands more

goods and services than available. This shortage of supply enables sellers to raise

prices until equilibrium is put in place between supply and demand.

The cost-push theory , also known as "supply shock inflation", suggests that

shortages or shocks to the available supply of a certain good or product will cause

a ripple effect through the economy by raising prices through the supply chain

from the producer to the consumer. You can readily see this in oil markets. When

OPEC reduces oil supply, prices are artificially driven up and result in higher

prices at the pump.

Money supply plays a large role in inflationary pressure as well. Monetarist

economists believe that if the Federal Reserve does not control the money supply

adequately, it may actually grow at a rate faster than that of the potential output in

the economy, or real GDP. The belief is that this will drive up prices and hence,

inflation. Low interest rates correspond with a high level of money supply and

allow for more investment in big business and new ideas which eventually leads to

unsustainable levels of inflation as cheap money is available. The credit crisis of

2007 is a very good example of this at work.

Inflation can artificially be created through a circular increase in wage earners

demands and then the subsequent increase in producer costs which will drive up

the prices of their goods and services. This will then translate back into higher

prices for the wage earners or consumers. As demands go higher from each side,

inflation will continue to rise.

* Profiteering: With increase in domestic and international demand for goods and

services, demand outstrips supply in short and medium term which leads to

charging excess and above the normal profit causing spiral inflation.

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* Black Economy: Due to people’s unwillingness to pay taxes, government

systems are not very efficient for revenue collection due to ambiguity of laws and

system. This leads to people accumulating unaccounted money supply in Gold ,

land and incurring high expenses on luxury goods, leading to high demand and

profiteering. Some countries have 30 to 40% of unaccounted money supply in

circulation.

* Information systems: System like credit rating for every citizen, common

Social Security number and all required economic management systems are absent,

due to high corruption at Autocratic level and unwillingness of autocrats to

implement the required system.

* Population Growth in weaker sections of society is also a main factor for

pushing inflation up, as demand keeps increasing and supply in medium term is

restricted leading to spiral inflation on all necessary commodities and services.

* Non Convertible Currency: This means their currency has not allowed to

trading and the rate is regulated by government and not the free market. This leads

to artificial increase or decrease in the value of currency against the USD. As

normally, most of the developing countries’ currency is pegged with the USD.

* Ineffective monetary and fiscal policy: The indices on which central bank

depends on to implement these policies are highly inaccurate and do not project

realistic picture.

Economists and monetarists views on causes of inflation

Keynesian view

Keynesian economic theory proposes that money is transparent to real forces in the

economy, and that visible inflation is the result of pressures in the economy

expressing themselves in prices.

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

"triangle model"

Demand-pull inflation: 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 favourable market

conditions will stimulate investment and expansion.

Cost-push inflation: also called "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.

Built-in inflation: induced by adaptive expectations, often linked to the

"price/wage spiral" because it involves workers trying to keep their wages up

(gross wages have to increase above the CPI rate to net to CPI after-tax) with

prices and then employers passing higher costs on to consumers as higher prices as

part of a "vicious circle." Built-in inflation reflects events in the past, and so might

be seen as hangover inflation.

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 Death.

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

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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 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. 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, central banks

influence the money supply by making money cheaper or more expensive, and thus

increasing or decreasing its production.

A fundamental concept in inflation 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 (sometimes

referred to as stagflation) 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 workings 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.

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Another concept of note 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 (and 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 , 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.

Monetarist view

Monetarists believe the most significant factor influencing inflation or deflation is

the management of money supply through the easing or tightening of credit. They

consider fiscal policy, or government spending and taxation, as ineffective in

controlling inflation.

Monetarists assert that the empirical study of monetary history shows that inflation

has always been a monetary phenomenon. The quantity theory of money, simply

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stated, says that the total amount of spending in an economy is primarily

determined by the total amount of money in existence. This theory begins with the

identity:

where

P is the general price level;

V is the velocity of money in final expenditures;

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

M is the quantity of money.

In this formula, the general price level is affected by the level of 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

expenditure () to the quantity of money (M).

Velocity of money is often assumed to be constant, 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 constant velocity, the money supply determines the

value of nominal output (which equals final expenditure) in the short run. In

practice, velocity is not constant, and can only be measured indirectly and so the

formula does not necessarily imply a stable relationship between money supply

and nominal output. However, in the long run, changes in money supply and level

of economic activity usually dwarf changes in velocity. If velocity is relatively

constant, the long run rate of increase in prices (inflation) is equal to the difference

between the long run growth rate of money supply and the long run growth rate of

real output.

Rational expectations theory

Rational expectations theory holds that economic actors look rationally into the

future when trying to maximize their well-being, and do not respond solely to

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immediate opportunity costs and pressures. In this view, while generally grounded

in monetarism, future expectations and strategies are important for inflation as

well.

A core assertion of rational expectations theory is that actors will seek to "head

off" central-bank decisions by acting in ways that fulfill predictions of higher

inflation. This means that central banks must establish their credibility in fighting

inflation, or have economic actors make bets that the economy will expand,

believing that the central bank will expand the money supply rather than allow a

recession.

Austrian theory

The Austrian School asserts that inflation is an increase in the money supply, rising

prices are merely consequences and this semantic difference is important in

defining inflation. Austrian economists measure the inflation by calculating the

growth of new units of money that are available for immediate use in exchange,

that have been created over time. This interpretation of inflation implies that

inflation is always a distinct action taken by the central government or its central

bank, which permits or allows an increase in the money supply. In addition to

state-induced monetary expansion, the Austrian School also maintains that the

effects of increasing the money supply are magnified by credit expansion, as a

result of the fractional-reserve banking system employed in most economic and

financial systems in the world.

Austrians argue that the state uses inflation as one of the three means by which it

can fund its activities (inflation tax), the other two being taxation and borrowing.

Various forms of military spending is often cited as a reason for resorting to

inflation and borrowing, as this can be a short term way of acquiring marketable

resources and is often favored by desperate, indebted governments.

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In other cases, Austrians argue that the government actually creates economic

recessions and depressions, by creating artificial booms that distort the structure of

production. The central bank may try to avoid or defer the widespread bankruptcies

and insolvencies which cause economic recessions or depressions by artificially

trying to "stimulate" the economy through "encouraging" money supply growth

and further borrowing via artificially low interest rates. Accordingly, many

Austrian economists support the abolition of the central banks and the fractional-

reserve banking system, and advocate returning to a 100 percent gold standard, or

less frequently, free banking. They argue this would constrain unsustainable and

volatile fractional-reserve banking practices, ensuring that money supply growth

(and inflation) would never spiral out of control.

Real bills doctrine

Within the context of a fixed specie basis for money, one important controversy

was between the quantity theory of money and the real bills doctrine (RBD).

Within this context, quantity theory applies to the level of fractional reserve

accounting allowed against specie, generally gold, held by a bank. Currency and

banking schools of economics argue the RBD, that banks should also be able to

issue currency against bills of trading, which is "real bills" that they buy from

merchants. This theory was important in the 19th century in debates between

"Banking" and "Currency" schools of monetary soundness, and in the formation of

the Federal Reserve. In the wake of the collapse of the international gold standard

post 1913, and the move towards deficit financing of government, RBD has

remained a minor topic, primarily of interest in limited contexts, such as currency

boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of

the Federal Reserve going so far as to say it had been "completely discredited."

Even so, it has theoretical support from a few economists, particularly those that

see restrictions on a particular class of credit as incompatible with libertarian

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principles of laissez-faire, even though almost all libertarian economists are

opposed to the RBD.

The debate between currency, or quantity theory, and banking schools in Britain

during the 19th century prefigures current questions about the credibility of money

in the present. In the 19th century the banking school had greater influence in

policy in the United States and Great Britain, while the currency school had more

influence "on the continent", that is in non-British countries, particularly in the

Latin Monetary Union and the earlier Scandinavia monetary union.

Anti-classical or backing theory

Another issue associated with classical political economy is the anti-classical

hypothesis of money, or "backing theory". The backing theory argues that the

value of money is determined by the assets and liabilities of the issuing

agency.Unlike the Quantity Theory of classical political economy, the backing

theory argues that issuing authorities can issue money without causing inflation so

long as the money issuer has sufficient assets to cover redemptions.

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Effects of inflation

The most immediate effects of inflation are the decreased purchasing power of the

dollar and its depreciation. Depreciation is especially hard on retired people with

fixed incomes because their money buys a little less each month. Those not on

fixed incomes are more able to cope because they can simply increase their fees. A

second destablizling effect is that inflation can cause consumers and investors to

changer their speeding habits. When inflation occurs, people tend to spend less

meaning that factories have to lay off workers because of a decline in orders. A

third destabilizing effect of inflation is that some people choose to speculate

heavily in an attempt to take advantage of the higher price level. Because some of

the purchases are high-risk investments, spending is diverted from the normal

channels and some structural unemployment may take place. Finally, inflation

alters the distribution of income. Lenders are generally hurt more than borrowers

during long inflationary periods which means that loans made earlier are repaid

later in inflated dollars.

Social and Economic Effects of Inflation

Inflation is detrimental to all creditors. The higher prices rise, the lower will fall

the purchasing power of the principal and interest payments due. The dollar which

was loaned out had a higher purchasing ability, could provide more goods, than the

dollar which is paid back.

And who is a creditor? Does inflation touch only businessmen and financiers?

Nothing of the sort. You who read these lines are certainly a creditor. Every person

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who has a legal claim to deferred payments of any kind is a creditor. If you have a

savings account with a bank, if you own bonds, if you are entitled to a pension, if

you have paid for an insurance policy, you are a creditor, and are, hence, directly

hit by inflation.

Professional men, civil servants, commissioned officers of the armed forces,

teachers, most white-collar workers, salaried employees, skilled specialists,

mechanics, and engineers normally provide for their own old age and for their

dependents in ways that make them creditors, that is through savings, insurance,

pensions, and annuities. Moreover, Social Security has brought the great masses of

ordinary workers into the ranks of creditors. For all these millions of people, every

further step towards inflation means a further decline in the real value of the claims

or credits they have saved up by years of toil and sacrifice. They will collect the

number of dollars to which they are entitled? but each of those dollars will be

thinner than it used to be, capable of providing less food, clothing, and shelter.

The loss of the creditor, of course, is the profit of the debtor. The man who

borrowed a thousand or a million full-sized dollars repays his lender with a

thousand or a million depreciated dollars. The mortgages on farms and on real

estate, the debts owed by industrial enterprises, all shrink as inflation proceeds.

Thus, a comparatively small group of debtors is favored at the expense of the

teeming groups of creditors.

The most fateful results of inflation derive from the fact that the rise of prices and

wages which it causes occurs at different times and in a different measure for

various kinds of commodities and labor. Some classes of prices and wages rise

more quickly and rise higher than others. Not merely inflation itself, but its

unevenness, works havoc.

While inflation is under way, some people enjoy the benefit of higher prices for the

goods or services they sell, while the prices for goods and services they buy have

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not yet risen or have not risen to the same extent. These people profit from their

fortunate position. Inflation seems to them "good business," a "boom." But their

gains are always derived from the losses of other sections of the population. The

losers are those in the unhappy situation of selling services or commodities whose

prices have not yet risen to the same degree as have prices of the things they buy

for daily consumption.

These victims, by and large, are the same kind of people? roughly, the middle

classes? who are injured as creditors through the depreciation of their bank

savings, insurance policies, pensions, etc. The salaries of teachers and ministers,

the fees of doctors, go up only slowly as compared to the tempo with which prices

of food, rent, clothing, and so on, go up. There is always a considerable time lag

between the increase in the money income of the white-collar workers and

professional people and the increase in costs of food, clothing, and other

necessities.

Price inflation has immense effect on the Time Value of Money (TVM) as well.

This acts as a principal component of the rates of interest, which forms the basis of

all TVM calculations. The real or estimated changes occurring in the rates of

inflation lead to changes in the rates of interest as well.

Inflation exerts impact on the treasury of a nation as well. In United States of

America, Treasury Inflation-protected Securities (TIPS) ensures safety to the

American government, assuring the public that they will get back their money.

However, the rates of interest charged by TIPS are less compared to the standard

Treasury notes.

The most immediate effect of inflation is the decrease in the purchasing power of

dollar and its depreciation. Inflation influences the investments of a country. The

Inflation-protected Securities (IPSs) may act as a guard against the loss in the

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purchasing power of the fixed-income investments (like fixed allowances and

bonds), which may occur during inflation.

Inflation changes the allocation of income. This exerts maximum effect on the

lenders than the borrowers at the time of persisting inflation, because the loans

sanctioned previously are paid back later in the form of inflated dollars.

Inflation leads to a handful of the consumers in making extensive speculation, to

derive advantage of the high price levels. Since some of the purchases are high-risk

investments, they result in diversion of the expenditures from regular channels,

giving birth to a few structural unemployments.

Hedging Against Inflation

Has the average man any means of evading the detrimental effects of inflation?

Those insured, or entitled to pensions or social security benefits, cannot avoid

being victimized. And the picture is not much brighter for other groups of

creditors. Of course, the bondholder may sell his bonds and the bank depositor may

withdraw his balance. But if they keep the money, they are no less subject to the

harmful effects of the fall in the money's purchasing power. In other words, the

dollar continues to evaporate whether it is resting in a bank, a bond, or a strongbox

at home.

For the Europeans, struck by the great inflations of World War I and its aftermath,

there was a simple means of escape. They needed only to change their local

currencies for the money of a country with a sound currency. They bought dollars

or they bought gold. It might have been illegal, but it worked. For Americans, no

such remedy is available. If the dollar goes bad, no foreign currency can

conceivably prove better. At the same time, the U.S. government has closed the

avenue of escape by forbidding its citizens to own gold coins or ingots.

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You may buy a farm. But that is a remedy only if you become a farmer and till the

soil with your own hands. Otherwise, it is a remedy not for yourself but for the

tenant who works the farm. It may reasonably be expected that, in the course of

inflation, new laws will safeguard tenants? whether on farms or in residences?

against rises in rent. In European inflations, rents were always restricted by

legislation.

You may buy a home for yourself and your family. But in a period of inflation,

economic conditions change swiftly and in unexpected ways. You cannot foresee

whether it will be necessary suddenly to change your place of residence and

employment. Then you will have to sell the house? renting it is almost useless?and

experience proves that such forced sales rarely bring the amounts laid out for

acquiring the property.

You may buy common stock. But the experts are convinced that taxation will

confiscate not only the profits but a good deal of the capital invested, too. While

the prices of all commodities are rising, stock market quotations may still cling

more or less to pre-inflation levels. This means that in owning common stock you

are not much better protected than in owning bonds.

You may buy jewelry and other valuables. But you cannot always expect to sell

these at a later date for what you paid for them. Nobody knows in advance how the

market conditions for any given valuable will develop. Diamonds and rubies, for

instance, may hold much of their value. But what if the owners of the largest

hoards of precious stones should unload them because of changing political or

social conditions?

Neither is it possible to escape the detrimental effects of the time lag between the

rise of different prices and wages. Trade union policies are futile in this

connection. As long as the war (World War II) is going on, labor may succeed in

obtaining, at least for some groups, wages which correspond to the rise of

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commodity prices. But sooner or later if industry does not keep pace, they will face

the choice between a sharp decline in wages and the maintenance of high wage

levels with long-lasting unemployment for millions. In the long run, inflation hurts

the interests of all groups of labor, as well as those of the middle classes.

There is only one class which, as a whole, derives profit from inflation: the

indebted farmers. Their mortgages are wiped out and the products of their own toil

bring higher returns corresponding to the higher prices they must pay for things

they purchase.

The owners of really large fortunes, too, may succeed in preserving a greater or

smaller portion of their wealth, but inflation results in the consumption of a good

deal of a nation's capital stock.

Even if some special groups profit, the whole country is poorer.

Moral and Political Effects of Inflation

Worse than the immediate economic consequences of inflation are its attendant

moral and political dangers.

It has been asserted that Nazism is the fruit of the vast German inflation of 1923.

That is not quite correct. It would be more correct to say that the great inflation and

the Nazi scourge both derived from the mentalities and the doctrines that long

dominated German public opinion. The State, which the German socialist

Ferdinand Lassalle had already proclaimed as god, was supposed to be able to

achieve anything. The omnipotent State was credited with the magic power of

unlimited spending without any burden on the citizenry. Money, said the German

"monetary cranks," is a creature of the State; there is no harm in issuing infinite

quantities of paper currency.

Fortunately, such superstitions are strange to the healthy common sense of

America. Inflation, therefore, will never go as far in this country as it did in

Germany. Even a much more moderate inflation, however, shakes the foundations

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of a country's social structure. The millions who see themselves deprived of

security and well-being become desperate. The realization that they have lost all or

most all of what they had set aside for a rainy day radicalizes their entire outlook.

They tend to fall easy prey to adventurers aiming at dictatorship, and to charlatans

offering patent-medicine solutions. The sight of some people profiteering while the

rest suffer infuriates them. The effect of such an experience is especially strong

among the youth. They learn to live in the present and scorn those who try to teach

them "old-fashioned" morality and thrift.

Inflation and Government Borrowing

Inflation is not an act of God. It is a result of the methods used to provide a part of

the means for the conduct of the war. One set of methods can still be replaced by

another, less harmful set. It is still possible to keep down the amount of money and

money substitutes by financing the total amount necessary through taxation and

loans.

People sometimes call inflation a special way of "taxing" a country's citizens. This

is a dangerous opinion. And it is wholly untrue. Inflation is not a method of

taxation, but an alternative for taxation. When a government imposes taxes, it has

full control. It can tax and distribute the burden any way it considers fair and

desirable, allotting a larger share of the tax burden to those who are better able to

carry it, reducing the burden on the less fortunate. But in the case of inflation, it

sets in motion a mechanism that is beyond its control. It is not the government, but

the operation of the price system, that decides how much this or that group will

suffer.

And there is another important difference. All taxes collected flow into the vaults

of the public treasury. But with inflation, the public treasury's gain is less than

what it costs the individual citizen, since a considerable part of that cost is drained

off by the profiteers, the minority that benefits from the inflation.

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It is no less fallacious to consider inflation as a method of raising loans for public

use. Technically, inflation does increase the total of the government's indebtedness

to the banks. But the banks' intervention is only instrumental. If the government

borrows from the banks, the banks do not grant loans out of their own funds, or out

of money deposited with them by the public; the banks are not real lenders; they

grant the loans out of their "excess reserves." They merely expand credit for the

benefit of the government. In other words, they increase the quantity of money

substitutes.

When you as an individual buy a government bond, you make a loan to the

government; you put part of your cash holdings into the hands of the treasury.

There is then no increase in the total quantity of currency or credits available and

hence no inflation.

However, it is different when government borrows from the banks' "excess

reserves." Their so-called "excess reserves" are not a tangible thing. The term is

merely a phrase indicating the limits within which the law is prepared to tolerate

credit expansion, that is to say further inflation. The effects of loans from available

"excess reserves" are just as inflationary as the effects of issuing more paper

money. It is a mistake, therefore, to confuse this government "borrowing" from the

"excess reserves" of the banks with genuine loans.

Popular education is absolutely essential. It is clear that the efforts of the U.S.

government to collect the means necessary for the conduct of the war by taxation

and by sale of government bonds represent sound measures for heading off

inflation. Everybody should be made to understand that the burden of high taxes

and of making personal loans to the government are minor evils compared to the

disastrous and inexorable consequences of inflation. Not only for the sake of the

national welfare, but for the sake of your own interests? Whether you are rich or

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poor, employer or wage earner? You should do your best to arrest the further

progress of inflation.

Inflation is viewed as being undesirable because of some serious economic and

social effects. Inflation impacts on income distribution making an random

redistribution of real income. Those receiving fixed money incomes (e.g.,

pensioners, beneficiaries etc.) are usually disadvantaged because often their

incomes are not adjusted upwards fast enough to compensate for the effects of

continually rising prices. Their real incomes (i.e., the goods and services their

incomes will buy) will fall. Individuals whose incomes rise more rapidly than the

inflation rate will experience increasing real incomes. Generally, the pattern of

income distribution tends to become more unequal than it was before inflation. If

the rate of inflation is high, individuals with money tend to buy real assets such as

property, gold and antiques, which often increase in value faster than the rate of

inflation. This group will gain by increasing the size of their share of the nation's

wealth.

Inflation tends to increase spending and encourage borrowing at the expense of

savings. If prices are rising quicker than incomes, individuals will tend to buy at

current prices before goods and services become more expensive and less

affordable. Some consumers may buy using higher levels of debt (i.e., borrowing)

than otherwise might the case. Savings may be discouraged because with high

inflation when the money saved is repaid, it can be worth much less than when it

was lent and the real rate of interest may be low. The real rate of interest rates fail

to keep pace with inflation the saver loses purchasing power, i.e., their ability to

buy things falls. Rising prices are a boon to borrowers because the repayment of

interest and the sum borrowed (i.e., the principal) is with lower valued money.

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Inflation reduces the real value of the amount they owe, as the sum repaid has less

purchasing power. Of course, any gain by borrowers must be weighed against the

interest they must pay.

Investment, in economics, means the creation of new capital goods. Investment can

only take place if there is saving. Inflation encourages spending and discourages

saving, so funds that might otherwise have been available for investment tend to

dry up. With lower levels of investment there is likely to be a slowing of the rate of

growth of national output (GDP). This in turn leads to a reduction in new jobs and

so can increase the level of unemployment. Inflation can distort market price

signals and the market may fail to allocate resources efficiently. Planning and

investment decisions become more difficult to predict as firms are unsure what will

happen to prices and costs during times of inflation. If firms are unable to pass on

the increase in costs to consumers this will impact on profits possibly causing some

firms to close or cut back production and subsequent employment.

Effects of inflation on investments

Inflation causes many distortions in the economy. It hurts people who are retired

and living on a fixed income. When prices rise these consumers cannot buy as

much as they could previously. This discourages savings due to the fact that the

money is worth more presently than in the future. This expectation reduces

economic growth because the economy needs a certain level of savings to finance

investments which boosts economic growth. Also, inflation makes it harder for

businesses to plan for the future. It is very difficult to decide how much to

produce, because businesses cannot predict the demand for their product at the

higher prices they will have to charge in order to cover their costs. High inflation

not only disrupts the operation of a nation's financial institutions and markets, it

also discourages their integration with the rest of the worlds markets. Inflation

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causes uncertainty about future prices, interest rates, and exchange rates, and this

in turn increases the risks among potential trade partners, discouraging trade. As

far as commercial banking is concerned, it erodes the value of the depositor's

savings as well as that of the bank's loans. The uncertainty associated with

inflation increases the risk associated with the investment and production activity

of firms and markets.

The impact inflation has on a portfolio depends on the type of securities held there.

Investing only in stocks one may not have to worry about inflation. In the long

run, a company’s revenue and earnings should increase at the same pace as

inflation. But inflation can discourage investors by reducing their confidence in

investments that take a long time to mature. The main problem with stocks and

inflation is that a company's returns can be overstated. When there is high

inflation, a company may look like it's doing a great job, when really inflation is

the reason behind the growth. In addition to this, when analyzing the earnings of a

firm, inflation can be problematic depending on what technique the company uses

to value its inventory.

The effect of inflation on investment occurs directly and indirectly. Inflation

increases transactions and information costs, which directly inhibits economic

development. For example, when inflation makes nominal values uncertain,

investment planning becomes difficult. Individuals may be reluctant to enter into

contracts when inflation cannot be predicted making relative prices uncertain. This

reluctance to enter into contracts over time will inhibit investment which will

affect economic growth. In this case inflation will inhibit investment and could

result in financial recession. In an inflationary environment intermediaries will be

less eager to provide long-term financing for capital formation and growth. Both

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lenders and borrowers will also be less willing to enter long-term contracts. High

inflation is often associated with financial repression as governments take actions

to protect certain sectors of the economy. For example, interest rate ceilings are

common in high inflation environments. Such controls lead to inefficient

allocations of capital that inhibit economic growth. The hardest hit from inflation

falls on the fixed-income investors. For example, suppose one year ago an investor

buys a $1,000 T-bill that yields 10%. When they collect the $1,100 owed to them,

is their $100 (10%) return real? No, assuming inflation was positive for the year;

the purchasing power of the investor has fallen and thus so has the real return. The

amount inflation has taken out of the return has to be taken into account. If

inflation was 4%, then the return is really 6%. By the Fisher equation (nominal

interest rate – inflation rate = real interest rate) we see the difference between the

nominal interest rate and the real interest rate. The nominal interest rate is the

growth rate of the investors’ money, while the real interest rate is the growth of

their purchasing power. In other words, the real rate of interest is the nominal rate

reduced by the rate of inflation. Here the nominal rate is 10% and the real rate is

6% (10% - 4% = 6%).

Inflation causes anxiety particularly for retirees who are uneasy about inflation

adjustments to their pensions and financial investments. Planning for retirement

requires expectations of future prices. Inflation makes this more difficult because

even a series of small, unanticipated increases in the general price level can

significantly erode the real value of savings over time. Social Security payments

are now indexed to inflation, a policy change that has reduced the effects of

inflation uncertainty on retirement.

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There are securities that offer investors the guarantee that returns are not eaten up

by inflation. Treasury Inflation-Protected Securities are a special type of Treasury

note or bond that offers protection from inflation.

With a regular Treasury bond, interest payments are fixed, and only the principal

fluctuates with the movement of interest rates. The yield on a regular bond

incorporates investors' expectations for inflation. So at times of low inflation,

yields are generally low, and they generally rise when inflation does. Treasury

Inflation-Protected Securities are like any other Treasury bills, except that the

principal and coupon payments are tied to the consumer price index (CPI) and

increased to compensate for any inflation. As with other Treasury notes, when you

buy an inflation-protected or inflation-indexed security, you receive interest

payments every six months and a principal payment when the security matures.

The difference is that the coupon payments and underlying principal are

automatically increased to compensate for inflation by tracking the consumer price

index (CPI). Treasury Inflation-Protected Securities are the safest bonds in which

to invest. This is because the real rate of return, which represents the growth of

purchasing power, is guaranteed. The downside is that because of this safety and

the lower risk, inflation-protected bonds offer a lower return.

Sustained inflation is damaging to long-run growth and the financial system in

general. Increases in inflation lead to lower real returns not just on money, but on

all other assets too. These low returns interfere with the functioning of financial

markets and the allocation of investment. Lower real returns have the effect of

severely damaging the credit market. As a result, higher inflation contracts the

supply of credit available to fund capital investment damaging the economy.

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It has been shown that inflation affects investment in several ways, mostly

inhibiting economic growth. The source of inflation is money and the supply of it.

Investors need to be able to expect returns in order for them to make financial

decisions. If people cannot trust money then they are less likely to engage in

business relationships. This results in lower investment, production and less

socially positive interactions.

3) Case studies

In early 2007, in India, the inflation rate, as measured by the wholesale price index

(WPI)5, hovered around 6-6.8%, well above the level of 5-5.5% that would have

been acceptable to the Reserve Bank of India (RBI), the country's central bank.6

On February 15, 2007, the inflation rate reached a two-year high of 6.73%. In the

past7, the main cause of high inflation in India used to be rises in global oil prices.

However, in early 2007, the chief component of the inflation was the increase in

the prices of food articles - caused by increased demand as well as supply

constraints. According to analysts, the increased demand was due to high economic

growth and increased money supply, while stagnant agricultural productivity was

behind the supply constraints.

Apart from the rise in prices of food articles, fuel and cement prices too recorded

high increases. The Government of India (GoI), together with the RBI, took several

measures to contain inflation. For example, the RBI increased the Cash Reserve

Ratio (CRR)8 and report rates9 in an effort to check money supply; the GoI

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reduced import duties on several food products and cut the price of diesel and

petrol.

The RBI also chose not to intervene when the Indian Rupee rallied against the US

Dollar between March 2007 and May 2007. The decision not to intervene was

based on the idea that a stronger Rupee would bring down the cost of imports,

which, in turn, would help reduce domestic prices of goods. Though the measures

taken by the GoI were targeted at inflation, some analysts feared that some of these

measures, especially the ones leading to higher interest rates, might induce

recession in the Indian economy. There were others who felt that letting the Rupee

rise would not only have a negative effect on the bottom lines of companies that

earn a substantial percent of their profits from exports, but also impact the long-

term competitiveness of Indian exports.

India: Average inflation rates of manufactured products

YearAll commodities Manufactured products

Point-to-point Average Point-to-point Average

1990-91 12.1 10.3 8.9 8.4

1991-92 13.6 13.7 12.6 11.3

1992-93 7.0 10.0 7.9 10.9

1993-94 10.8 8.3 9.9 7.8

1994-95* 10.4 10.9 10.7 10.5

1995-96* 5.0 7.8 5.0 9.1

1996-97* 6.9 6.4 4.9 4.1

1997-98 5.3 4.8 4.0 4.1

1998-99* 4.8 6.9 3.7 4.5

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1999-2000 6.0 3.3 2.4 2.7

2000-01 4.9 7.2 3.8 3.3

#  Figures based on Wholesale Price Index calculated by RBI with base 1981-82

The above mentioned table depicts the extend of impact caused by inflation in

India on manufactured products. India should take significant measures to reduce

inflation in the economy.

4) Conclusion

The following measures can be used to curb inflation.

1 REDUCE DEMAND PRESSURES

If inflation is caused by high demand then

* Raise interest rates to reduce consumer’s disposable incomes

* Raise interest rates to discourage borrowing and demand

* Raise taxes to reduce disposable income and spending

* These policies should all reduce people’s ability to spend too much money

2 REDUCE COST PUSH PRESSURES

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If inflation is caused by high costs

• Limit wage increases if possible e.g. public sector workers

• Force electricity and gas companies to hold their prices

• Increase the value of £ in order to reduce the cost of importing

3. REDUCE MONEY SUPPLY PRESSURES

If inflation is caused by too much money in the economy

• Print less money and withdraw some money from circulation.

5) Bibliography

http://econc10.bu.edu/Ec341_money/Papers/Gerolamo_paper.htm

http://en.wikipedia.org/wiki/Inflation

http://www.economicshelp.org/macroeconomics/inflation/definition.html

http://www.thefreedictionary.com/inflation

http://useconomy.about.com/od/pricing/f/Inflation.htm

http://inflationdata.com/inflation/Inflation_Articles/Inflation.asp

http://www.wisegeek.com/what-causes-inflation.htm

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http://www.mysmp.com/bonds/inflation.html

http://en.wikipedia.org/wiki/Inflation

http://everything2.com/index.pl?node_id=1474863

http://www.economywatch.com/inflation/effects.html

http://wiki.answers.com/Q/What_are_the_effects_of_inflation

http://ideas.repec.org/p/wpa/wuwpma/0012017.html

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