Question

What are the causes of inflation? Why are some types of inflation more damaging to the economy than others. Be specific.

Answer 1

Inflation is defined as a rise in the general price level. In other words, prices of many goods and services such as housing, apparel, food, transportation, and fuel must be increasing in order for inflation to occur in the overall economy. If prices of just a few types of goods or services are rising, there isn't necessarily inflation.

Inflation means there is a sustained increase in the price level. The main causes of inflation are either excess aggregate demand (economic growth too fast) or cost push factors (supply-side factors).

Main causes of inflation

1. Demand-pull inflation – aggregate demand growing faster than aggregate supply (growth too rapid)
2. Cost-push inflation – higher oil prices feeding through into higher costs
3. Devaluation – increasing cost of imported goods, also boost to domestic demand
4. Rising wages – higher wages increase firms costs and increase consumers’ disposable income to spend more.
5. Expectations of inflation – causes workers to demand wage increases and firms to push up prices.

There are two main types of inflation: demand pull and cost push. Fueled by income and strong consumer demand, demand-pull inflation occurs when the economy demands more goods and services than are available. Cost-push inflation happens when the demand for goods increases because production costs rise to the point where fewer goods can be produced. Both drive prices upward.

Other types of inflation include hyperinflation, a rapid and out-of-control form of inflation; pricing power inflation, which occurs when businesses raise prices to increase profits; sectoral inflation, which is when the rising prices are confined to just one industry; and stagflation, which occurs when inflation is rising despite slow economic growth.

While many people may think that all inflation is bad, economists argue that some controlled inflation is good for an economy. Inflation encourages spending, because when dollars are losing value, it provides a disincentive to save those dollars. Inflation also provides companies with confidence to hire new employees. Inflation only becomes dangerous when it is uncontrolled and unexpected, increasing prices quickly to the point it grinds all spending (and, therefore, economic activity) to a halt.

The economy doesn't necessarily experience inflation every year. The opposite of inflation, deflation, is when prices go down, and the inflation rate falls below 0 percent. While you might think, "Oh boy, lower prices," deflation is not usually a welcome thing. An indicator that economic conditions are deteriorating, deflation often results in lower levels of production and ultimately high rates of unemployment.

Essentially, the wrong kind of inflation is cost-push inflation. This inflation is due to rising costs of production, such as rising energy prices, rising transport costs, imported inflation and rising food prices. This inflation causes a shift to the left of short run aggregate supply. This wrong kind of inflation leads to a fall in living standards. Since 2008, the UK has seen a fall in real wages.

Usually inflation is caused by rising aggregate demand (demand-pull inflation). Inflation is a sign the economy is approaching full employment. Growth is strong, unemployment low, and the government are receiving strong tax revenues helping to reduce the budget deficit. Inflation may have some costs, but at least we get lower unemployment as a result.