Inflation: Definition, Types, Causes, Effects & Control of Inflation

What is Inflation?

Inflation refers to a persistent and sustained rise in the general price level. A general phenomenon during a period of inflation is a continuous fall of the value of money in the economy.

Price Index

Changes in the value of money are usually measured through the use of the Index of Retail Prices.

This measures the change from month to month in the average level of prices of the commodities and services purchased by the great majority of households in the given countty, including practically all wage~earners and most small and medium salary earners.

This measurement is sometimes referred to as cost of living index which indicates what it costs the average family in the country to obtain the basic necessities of life. A rise in the cost of living index implies a fall in the standard of living of the people in the country and vice-versa.

Types of Inflation

1. Demand Pull Inflation

This is the type of inflation that is induced by a sustained rise in the general price level as a result of a persistent rise in aggregate demand in the economy.

Control of Demand Pull Inflation

• Through reduced government expenditure.
• Through increased taxes on income.
• Through increased output.
• Through price control mechanism.
• Through the use bf monetary policy instruments such as the Open Market Operation, Bank Rate, Cash Ratio, etc.

2. Cost-push Inflation

If the general increase in activity means an increase in the demand for a limited supply of the factors, e.g. raw materials, then shortages develop, labour difficulties tend to rise, a cost-push inflation develops and prices ofproducts rise.

In short, cost-push inflation occurs when an increase in the cost of production is passed on to consumers in the form of high prices.

Causes of Inflation

General causes of inflation include the following:

• Deficiencies in domestic supply of goods and services: Low domestic output of goods and services is brought about by certain constraints in the economy such as inadequate capital, poor infrastructural facilities, etc.
• Increased incidence of government budget deficit financing, consequently affecting the magnitude of money supply in the system.
• Low productivity in almost all the sectors of the economy resulting mostly from very low capacity utilization especially in the industrial sector.
• Fiscal and monetary policies which tend to hinder rather than encourage domestic production of goods and services.
• Price and income policies which drastically reduce the purchasing power of the majority of consumers in the country.
• Poor distribution system which confers undue advantage on a few who exploit the generality of consumers in the country.
• Imported inflation arising from indefensible undervaluation of the national currency.

Effects of Inflation

These include the following:

• Increased earnings by businessmen and a higher level of investment: Businessmen earn higher profits because of the rising prices of their products, thereby encouraging further investments. Businessmen and investors thus gain in a period of inflation in a country.
• Re-distribution of income: People on fixed incomes such as wage and salary earners suffer during an inflationary period in an economy. This is because the value of their real income falls. There is therefore a re-distribution of income in favour of investors;
• Creditors lose while debtors gain: Since the value of money falls during inflation, creditors receive less in real terms than what they lent out, while debtors repay less in real terms.
• Low level of savings and capital formation: During a period of inflation, people are generally not encouraged to save. This is because they spend more money on goods and services and are afraid that the value of their savings will fall. Capital formation, which depends on savings, is therefore low.
• Increased balance of payments difficulties: Inflation increases the prices of exports relative to the prices of imports. This would lead to increased imports and decreased exports with a consequent worsening effect on the nation’s balance of payments.
• Reduced burden of the national debts: The value of loans taken by government falls in real terms in an inflationary period in a country.
• Loss of confidence in the monetary system: A prolonged hyper-inflation may lead to loss of confidence in a nation’s monetary unit of account.

Positive Effects of Inflation

• Reduction in the burden of debts as debtors gain during inflation.
• Higher prices of commodities encourage higher output and possibly result in higher profits.
• Higher tax yield of taxes are ad valorem taxes.
• Higher prospects of profit lead to increased employment of resources and factors

Negative Effects of Inflation

• lt redistributes income haphazardly. There is a fall in income especially of those on fixed incomes e.g. pensioners, poor people, rural dwellers, etc.
• Creditors obviously lose during inflation.
• Higher prices discourage exports since such countries will be high-cost producers.
• Balance of payments problem arises since foreigners will want to sell to such countries and do minimal buying from such high-cost producers
• Inflation discourages savings in the economy.
• It encourages increase in interest rates.

Control of Inflation | How to Control Inflation

A number of measures could be taken to curb inflation. They are:

• Price control: This involves fixing maximum prices on celtain essential commodities.
• Wage control: Frequent wage increases should be prevented. Wage control involves the use of an appropriate income policy in which wages are only increased as the level of productivity increases and vice-versa.
• Control of bank lending: Commercial and merchant banks should be discouraged from granting too many loans (through the use of restrictive monetary policy).
• Sectoral allocation of credit to the more productive sectors of the economy: More loans should be directed to the productive sectors of the economy. This would help to increase the output of domestic goods and services and thus reduce their prices.
• Use of the budget surplus or reduction in government expenditure: Government expenditure should be reduced relative to its earned income. This would lead to a reduction in aggregate demand in the economy and thus lead to lower prices.
• Fiscal Policy: By increasing taxes especially on income and profits. This would reduce disposable income and effective demand in the system. Lower aggregate demand would lead to a fall in the prices of commodities.
• Importation of essential commodities: Scarce but essential commodities could be imported to supplement domestic production and reduce their prices.
• Improving the distributive system: The nation’s distribution network should be drastically improved by ensuring efficiency in the transportation system to prevent unnecessary scarcity of commodities.
• Government must as a matter of deliberate policy, adopt measures which aim at increasing the suppply of factors in the system for increased production of commodities. These measures, if religiously implemented, will bring about a reduction in prices.
• Export drive: Government must with the full cooperation ofthe organized private sector of the economy, engage in a forthright export drive. This would ensure increased foreign exchange earnings for enhanced domestic production and exportation.

Possible Solutions to the Problems of Inflation

• Monetary policy related actions which include mopping up of excess liquidity through open market operations, buying and selling of securities, use of bank rate, issuing of directives by the Central Bank, etc.
• Fiscal policy: general increase in tax and reduction in government expenditure.
• By increasing production in the economy.
• By reducing bottlenecks in distribution.
• By preventing hoarding.
• Through price control and other relevant legislations.
• Through improved infrastructures such as electricity, water, telecommunications, etc.
• Restraint from granting increases in factor incomes that are not accompanied by increases in output.