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A preview of policy discussions of inflation

This chapter has focused on how inflation is measured, historical experience with inflation, how to adjust nominal variables into real ones, how inflation affects the economy, and how indexing works. The causes of inflation have barely been hinted at, and government policies to deal with inflation have not been addressed at all. These issues will be taken up in depth in other chapters. However, it is useful to offer a preview here.

The cause of inflation can be summed up in one sentence: Too many dollars chasing too few goods. The great surges of inflation early in the twentieth century came after wars, which are a time when government spending is very high, but consumers have little to buy, because production is going to the war effort. Governments also commonly impose price controls during wartime. After the war, the price controls end and pent-up buying power surges forth, driving up inflation. On the other hand, if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation. Therefore, slowdowns in economic activity, as in major recessions and the Great Depression, are typically associated with a reduction in inflation or even outright deflation.

The policy implications are clear. If inflation is to be avoided, the amount of purchasing power in the economy must grow at roughly the same rate as the production of goods. Macroeconomic policies that the government can use to affect the amount of purchasing power—through taxes, spending, and regulation of interest rates and credit—can thus cause inflation to rise or reduce inflation to lower levels.

A $550 million loaf of bread?

As we will learn in Money and Banking , the existence of money provides enormous benefits to an economy. In a real sense, money is the lubrication that enhances the workings of markets. Money makes transactions easier. It allows people to find employment producing one product, then use the money earned to purchase the other products they need to live on. However, too much money in circulation can lead to inflation. Extreme cases of governments recklessly printing money lead to hyperinflation. Inflation reduces the value of money. Hyperinflation, because money loses value so quickly, ultimately results in people no longer using money. The economy reverts to barter, or it adopts another country’s more stable currency, like U.S. dollars. In the meantime, the economy literally falls apart as people leave jobs and fend for themselves because it is not worth the time to work for money that will be worthless in a few days.

Only national governments have the power to cause hyperinflation. Hyperinflation typically happens when government faces extraordinary demands for spending, which it cannot finance by taxes or borrowing. The only option is to print money—more and more of it. With more money in circulation chasing the same amount (or even less) goods and services, the only result is higher and higher prices until the economy and/or the government collapses. This is why economists are generally wary of letting inflation get out of control.

Key concepts and summary

A payment is said to be indexed if it is automatically adjusted for inflation. Examples of indexing in the private sector include wage contracts with cost-of-living adjustments (COLAs) and loan agreements like adjustable-rate mortgages (ARMs). Examples of indexing in the public sector include tax brackets and Social Security payments.

Problems

If inflation rises unexpectedly by 5%, indicate for each of the following whether the economic actor is helped, hurt, or unaffected:

  1. A union member with a COLA wage contract
  2. Someone with a large stash of cash in a safe deposit box
  3. A bank lending money at a fixed rate of interest
  4. A person who is not due to receive a pay raise for another 11 months

Got questions? Get instant answers now!

Rosalie the Retiree knows that when she retires in 16 years, her company will give her a one-time payment of $20,000. However, if the inflation rate is 6% per year, how much buying power will that $20,000 have when measured in today’s dollars? Hint : Start by calculating the rise in the price level over the 16 years.

Got questions? Get instant answers now!

References

Wines, Michael. “How Bad is Inflation in Zimbabwe?” The New York Times , May 2, 2006. http://www.nytimes.com/2006/05/02/world/africa/02zimbabwe.html?pagewanted=all&_r=0.

Hanke, Steve H. “R.I.P. Zimbabwe Dollar.” CATO Institute . Accessed December 31, 2013. http://www.cato.org/zimbabwe.

Massachusetts Institute of Technology. 2015. "Billion Prices Project." Accessed March 4, 2015. http://bpp.mit.edu/usa/.

Questions & Answers

an increase in demand (while supply remains constant) what will happen to deh graph?
Thabiso Reply
what is going to happen to the graph if there is an increase in demand, While supply remains constant .
Thabiso
What will happen to the graph if there is an increase in demand While supply remains constant?
Thabiso
price will increase high than automatically demand will decrease
takshaveer
equilibrium ?
Issum
is when the supply and demand are balanced
ISAH
what is demand
Sarkwah Reply
demand is the willingness to buy a commodity backed by the ability to pay.
Runwell
demand is mere desire on commodity with ability to back up with purchasing power
Terkimbi
Equilibrium is when there's an equality between quantity demanded and quantity supplied
Victory Reply
Again the consumer will be in equilibrium if the price of the commodity is equal to Marginal utility of that product
daniel
wat is the law of supply
Agnes Reply
It's what* -The law of supply states that price and supply is relative. As all factors are equal, if price increases then quantity of supply there for increases.
Nathaniel
the law of suppy state that when prise is high, more commodity with be supply and when p is low less of the same commodity will be supply.
BEGE
It states that, "other things being equal, move supplied at a higher price than at a lower price ".
Murewah
okay
Agnes
it's state that the increased in prices will lead to decreased in supply
Asuquo
what is the theory of supply and the determinants of demand
Murewah
And please what is change in quantity supplied?
Agnes
guys why are you so quiet
Murewah
A woman has a television set which cost her $800 two years ago. A new set would cost her $1000 and she could sell her television set for $450. What is the opportunity Cost of keeping the old TV?
Murewah Reply
principle of effective demand?
Abubakar Reply
the is the situation in which the need of individuals exceed the available resource. increase in population rate and wrong decision making
esther Reply
what is the different between wants and demand?
Terkimbi
wants are what people desire to have but they can live without them and demand is a thing that is most wanted
Murewah
what are the demand pull inflation
Hijja
the higher the aggregate level of activity, the larger the proportion of areas and industries which experience excess demand for goods and labour of various sorts , and the more powerful is demand-inflationary pressure . Demand inflation is contrasted with cost inflation , in which price and wage
Murewah
increases are transmitted from one sector to another. These should be regarded as different aspects of an overal inflation starts , cost inflation explains why inflation once begun is so difficult to stop.
Murewah
what is the important difference between positive and normative economics
Umar
positive economics is the study of how an economy works in practice, as opposed to the theoretical study of how it should run in theory and normative economics is the party of economics that is concerned with how the economy ought to be run.
Murewah
positive economic deal with fact and also talks about how the economy actually is like while normative economic deal with value judgement and talks about how the economy ought to be like
esther
What is the difference between opportunity cost and choice
Murewah
opportunity cost are also known as forgun alternative why choice is to select one among alternative
Terkimbi
importance of economic
Zakaria Reply
satisfaction of human wants
Festo
economics is about to economise . discuss
Angel Reply
Underlines the efficiency aspect. Economise towards what: Economise factors to reach equal distribution of Material wealth or Just to operate optimally to Service demand, i. e. Run markets efficiently?
Homo
join the conversation
abba Reply
Hi I'm Ashnly Parker.
Murewah
what is terms of trade
Ibrahim Reply
different btn import and export
Angel
No question... This is nice
Gbenga Reply
hw can we solve problem of scarcity
Oigebe
scarcity is not necessarily a problem but a constant condition of the world. there are not enough resources to satisfy the unlimited wants.
Matthew
wee need to be cooperative
Zakaria
by unlimited resourses and abundant want
Angel
What is the economic problem
Murewah
inflation
Lazizjon
And what is demand pull inflation
Murewah
why do compute GDP?
steven Reply
can anyone shortly determine the word inflation.
Ibrahim Reply
Continous increase in the general level of prices or in the cost of living.
arshad
persistent increased in general price level
Machall
all correct...
paa
inflaction
Angel
rise in price.
Abubakar
deserving of money
Lazizjon
A persistent tendency for nominal prices to increase
Murewah
What is the problem of economic problem
Murewah
the father of economics
Reuben Reply
Adem smith
sj
Adem smith
Ajit
Adem smith sure
Adigwe
the father of economic regarding to adam Smith
Ibrahim
the father of political of economic and capitalism in his book and inquary in to the wealth of the nation.
Umar
Adam Smith his the father of economic
Mamudu
difference between injection and leakage
Asif
what is monopoly
Razak
Monopoly is a market structure where there is one firm who dominate the industry
wisdom
hi,, I am new here. please welcome me.
Mohammad
you are welcome
Adigwe
monopoly is the one characterized by a mkt power in which a firm is a price maker
Festo
Some member just ask questions but not answering so y this happen
Festo
Monopoly is a market where only one seller exists. No competition
Fred
how long does the patent right prevail the monopoly
Festo
no attempt
Zakaria
what is state farming
Sadiq
anybody to attempt
Festo
Hi, I'm a new member please will you welcome me
Murewah

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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