What are the causes and effects of inflation

1 Introduction

Inflation is the term used to describe a continuous increase in the general level of prices throughour the economy. Rising prices is a source of concern as it can have a serious impact on many aspects of the economy. The causes and effects of inflation need to be examined in order to have a better understanding of the problem.

2. Causes of Inflation
Below are a number of elements

    Demand Pull Inflation
    This is inflation caused by persistent rises om aggregate demand. It is a dddituation where the demand for goods and services is greater than their supply.

    Cost Push Inflation
    Persistent increases in costs of production, independent of demand, is known as cost push inflation. Examples would be wages, taxation and fuel costs.

    Imported Inflation
    If Irish inflation is lower than its international competitors then because of competitive advantage there will be an increased infflow of funds . Thjis will stimulate demand until prices increase here to the same level as in that of its trading partners.  When raw materials are imported from a country with a higher inflation rate there will be an increase in the price of those products using those items.

    Devaluation
    This can be seen as an aspect of imported inflation, where devaluation of the currency means a decision is taken to reduce the value of the currency such as 1 Euro is reduced from $1.10 to $1.04. This has the effect of increasing the price of all imported goods. Since much of our imports are raw materials and capital goods there will be a consequent increase in the prices of finished goods.

    Expectations
    When people expect prices to continue to increase they build these expectations into future dealings. This has a particular impact where workers are concerned. If they believe prices are going to rise next year they negotiate on that basis. This has the effect of setting the wage-price spiral in motion where producers will increase increase prices in order to cover the wage increases, which is followed by increasing wage demands to cover the rise in prices and so on.

    Taxation
    An increase in indirect taxation such as VAT can have an immediate and obvious effect on price levels across a wide range of products.

3. Effects of Inflation
The effects of inflation can be represented by the headings below.

Competitiveness
Where international trade is concerned, if our inflation is greater than that of those countries we trade with it can erode any competitive advantage we may have Should this situation continue it can have very serious effects such as loss of markets and likely consequences such as increased unemployment.

Fixed Income Recipients
Those people on fixed incomes (social welfare), such as old age pensioners, suffer when inflation is high as their incomes remain at the fixed rate while prices continue to rise thus reducing their standard of living.

Borrowing
Very high rates of iinflation can encourage borrowing where the inflation rate is greater than the rate of interest. Consumers will consider it more appropriate to borrow money for that suite of furniture they were planning to buy. If they were planning to save for the suite there is the prospect of the price rising faster than they could save.
So thrift declines while borrowing increases.

Wage-Price Spiral
Workers may try to maintain their real income by seeking higher wages in inflationary times to maintain their real incomes and protect their standard of living. If they are granted the increase this can set the sequence of wage increase - price increase wage increase price increase in motion known as the Wage Price Spiral.

Taxpayers
Wage increases can lead to taxpayers moving from a lower tax band to a higher one.
There is however, one positive feature of inflation

Stimulant
Slowly rising prices are preferable to falling prices (deflation), and can act as a stimulant to the economy. If deflation were present it would indicate a sslackness in the economy, while moderately rising aprices point to an economy which has vitality.