Inflation means there is a sustained increase in the general levels of prices and services across the economy. Countries have individual methods of measuring inflation but the consumer price index (CPI), compiled using consumer-spending patterns is generally used. The goods and services selected in the basket are also individually weighted depending on the frequency of their consumption. Some theories put forward to explain the causes of inflation include the following:
Cost-push inflation Increases in prices of factors of production like wages, rent, raw materials and interest rates translate into rising costs for business owners. These are passed on to consumers through increased product prices in order to maintain profit levels.
Demand-pull inflation Increased demand in the economy for goods and services which is not satisfied by an adequate supply can also bring about inflation. This is a common scenario in many developing countries.
Money supply inflation Monetarists believe that the increased supply of money in the economy is the cause of inflationary tendencies. Others believe that external factors like increasing oil prices bring about inflation.
Problems caused by Inflation
High prices of goods and services in the economy mean that domestic products are more expensive and people look at imports for cheaper options. The balance of payments suffers as imports exceed exports leading to deficit problems. Unemployment occurs in related industries and investment and economic growth is affected. Companies find their real profits do not improve even if they seem to show an increase.
People with fixed incomes or who work in jobs that pay cash suffer because inflation affects their purchasing power as high prices mean they can get fewer goods with the same amount of money.
How inflation is controlled
Fiscal policy: Taxes are raised to control public spending, but choosing the right taxes is a difficult decision for governments as the outcome can affect vital industries in the economy. Moreover, any governmental policy implemented takes time before the outcome can be properly assessed.
Wages policy: While some economists see wage controls as tools to counter inflationary trends, others see wage rises as one of the causes of inflation. The fact is that wage control does play a role in reducing unemployment as employees can hold on to their jobs without wage increases even if prices are rising elsewhere in the economy.
Money supply: Monetarists believe that there should be a gradual reduction in the supply of money so that it is in line with output in the economy. This is done by increasing interest rates so that availability and demand for credit is curbed and investment reduced. Another way is by reducing the printing of money by the government to control public spending. http://www.bized.co.uk/virtual/economy/library/theory/monetarist.htm
Exchange rates: To control inflation, some countries resort to devaluation of their currency. Exports become cheaper and imports are more expensive, thus improving the balance of trade. The success of this policy depends on the country’s reliance on imported goods.
In an economy where inflation is controlled, there is economic growth, asset values increase, wages rise and the real value of debts decreases which is beneficial for borrowers.