Inflation is the rate at which purchasing power declines due to the rise in the general price level of goods and services. In other words, inflation means that a currency causes less goods or services to be obtained and it should be distinguished from an increase in the cost of living.
Central banks try to keep inflation at a limited level and avoid deflation in order to keep the economy running smoothly. The depreciation of the currency is a phenomenon that affects the whole economy of the country.
As an example of inflation, if the inflation rate is 2 percent, then a pack of chewing gum that costs $1 in one year will cost $1.02 in the next year.
There is no single theory for the factors of inflation by economists and academicians which is universally accepted, nevertheless, there are several hypotheses that widely used.
- ‘‘The inflation of demand’’
The inflation of demand occurs due to the increase in demand for goods and services. This theory can be summarized as, ‘‘a blind bit of goods and great deal of money.’’
- ‘‘The inflation of cost’’
This type of inflation occurs when companies' production costs rise. Therefore, to maintain profit margins, the prices must be increased.
Increased costs may include wages, taxes, or increased natural resource or import costs.
- ‘‘The inflation of money’’
While inflation is caused by over excess supply in the economy, the supply and demand of prices are determined. If there is too much supply, the price of that thing goes down. To many sources of money devalue money, as a result, the increase of costs observed in everything.
‘How to measure inflation?’’
In spite of the fact that it is very arduous to calculate inflation in terms of official statistical institutions, the calculation is carried out by creating a catchall of some representative goods. Afterwards, the changes in this catchall over time are observed. There are generally two calculation methods for this index;
- Consumer Price Index (CPI): It is used to calculate consumption goods or services (such as gasoline, food, clothing, automobiles). It depends on the consumer's perspective.
- Producer Price Index (PPI): It shows the changes in the index created from domestically produced goods and services. This is interpreted from the perspective of the manufacturer.
These indicators can be considered as large scale surveys. Each month, official statistics agencies examine diversed locations, such as retailers, service providers, gas stations, and clinics to detect price changes.
‘‘Inflation and interest rates’’
While the inflation rates are being announced, it is essential that the impressions of the central banks about the current figures are also closely followed. In many economies, central banks determine the interest rates, the CPI and PPI are among the indicators that these banks pay attention to most.
Because of high interest rates increase the cost of borrowing, interest rates directly affect the credit market. By changing interest rates, central banks try to stabilize the money market, also at the same time they supports employment and growth. The fall in the interest rate may increase consumer spending and create a growth-supportive outlook.
‘‘What are the consequences of high inflation and solutions?’’
In order to solve the inflation predicament, it is required to first look at where the inflation originates from.
First of all, high inflation creates an uncertainty. An uncertain environment makes it difficult for manufacturers to set prices.
In this sort of atmosphere, consumers cannot adapt to changes in prices. Banks give their loans with high interest rates, in addition, while investment decisions and consumption preferences cannot be taken in a healthy way, the expiries of investments are shortened.
High inflation leads to an increase in poverty and the income gap between classes. Also, those who can save and increase their earnings by taking advantage of high interest rates, there may be situations where the low-income group has to borrow at high interest rates.
High inflation, which reduces the purchasing power of money, causes difficulty to pay for a meal today with an amount that could be bought a house 50 years ago. As the value of the currency decreases therewithal, the confidence to national currency may decrease.
If an economy gives these kind of signals about inflation, there is two ways to go. The first way is the intervention of Central Bank to inflation with arrangement of interest rates, cooling the economy, and as a result to reduce inflation by resetting the output gap.
Another way is, to take inflation on its course. When this way is preferred, hence the economy is not cooled by the arrangement of interest rates, it is forced to cool itself through inflation. Rising inflation deteriorate purchasing power of households. In this way, the output gap is reset once again, with demand withdrawing out of control.
However, this time, because of the slowdown in the economy is not the interest but the increase in inflation, inflation has increased permanently at the final point.
Lastly, it is doubtless that the domestic effects of the second way will be much more devastating and in an ideal economy, inflation should be low and in a trend that meets expectations.
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