Explain the consequences of inflation.?

Answer 1

In mainstream economics, the word “inflation” refers to a general rise in prices measured against a standard level of purchasing power. Previously the term was used to refer to an increase in the money supply, which is now referred to as expansionary monetary policy or monetary inflation. Inflation is measured by comparing two sets of goods at two points in time, and computing the increase in cost not reflected by an increase in quality. There are, therefore, many measures of inflation depending on the specific circumstances. The most well known are the CPI which measures consumer prices, and the GDP deflator, which measures inflation in the whole of the domestic economy.

The prevailing view in mainstream economics is that inflation is caused by the interaction of the supply of money with output and interest rates. Mainstream economist views can be broadly divided into two camps: the "monetarists" who believe that monetary effects dominate all others in setting the rate of inflation, and the "Keynesians" who believe that the interaction of money, interest and output dominate over other effects. Other theories, such as those of the Austrian school of economics, believe that an inflation of overall prices is a result from an increase in the supply of money by central banking authorities.

Related terms include: deflation, a general falling level of prices; disinflation, the reduction of the rate of inflation; hyper-inflation, an out-of-control inflationary spiral; stagflation, a combination of inflation and poor economic growth; and reflation, which is an attempt to raise prices to counteract deflationary pressures.

A problem of econometrics
of maggets that is, finding objective ways of comparing nominal prices to real activity. In many places in economics, "real" variables need to be compared, in order to calculate GDP, effective interest rate and improvements in productivity. Each inflationary measure takes a "basket" of goods and services, then the prices of the items in the basket are compared to a previous time, then adjustments are made for the changes in the goods in the basket itself. For example if a month ago canned corn was sold in 10 oz. jars, and this month it is sold in 9.5 oz jars, then the prices of the two cans have to be adjusted for the contents. The result is the amount of increase in price which is attributed to "inflation" and not to improvements in productivity.

This means that there are many measures of inflation, depending on which basket of goods and services are used as the basis for comparison. Different kinds of inflation measure are used to determine the real change in prices, depending on what the context is.

Commonly used measures of inflation
Examples of common measures of inflation include:

consumer price indices (CPIs) which measure the price of a selection of goods purchased by a "typical consumer".
Cost-of-living indices (COLI) which often adjust fixed incomes and contractual incomes based on measures of goods and services price changes
producer price indices (PPIs) which measure the price received by a producer. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. Producer price inflation measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" as consumer inflation, or it could be absorbed by profits, or offset by increasing productivity.
wholesale price indices, which measure the change in price of a selection of goods at wholesale, prior to retail mark ups and sales taxes. These are very similar to the Producer Price Indexes.
commodity price indices, which measure the change in price of a selection of commodities. In the present commodity price indexes are weighted by the relative importance of the components to the "all in" cost of an employee.
GDP Deflators measures price increases in all assets rather than some particular subset. The term "deflator" in this case means the percentage to reduce current prices to get the equivalent price in a previous period. The US Commerce Department publishes a deflator series for the US economy.
au of Labor Statistics breaks down CPI-U calculations down to different regions of the US.

Historical Inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology. This is equivalent to not adjusting the composition of baskets over time.

Hedonic adjustments to measuring inflation
Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods from the present are compared with goods from the past. This includes hedonic adjustments and “reweighing” as well as using chained measures of inflation. As with many economic numbers, inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost increases, versus changes in the economy. Inflation numbers are averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices. Finally, when looking at inflation, economic institutions sometimes only look at subsets or special indices. One common set is inflation ex-food and energy, which is often called “core inflation”.

In classical political economy, “inflation” referred to government policy itself: inflation meant increasing the money supply over and above that necessary to accommodate any increase in real GDP, while “deflation” meant decreasing it. Some economists in a few schools of economic thought, generally described as libertarian, classical liberal, or ultra-conservative, still retain this usage. In mainstream economic terms these would be referred to as expansionary and contractionary monetary policies.

The role of inflation in the economy
In the long run, inflation is generally believed to be a monetary phenomenon, while in the short and medium term, it is influenced by the relative elasticity of wages, prices and interest rates. [1] The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian schools. In monetarism, prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trendline. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.

A great deal of economic literature concerns the question of what causes inflation and what effect it has. A small amount of inflation is often viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are "sticky downward" and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Efforts to attain complete price stability can also lead to deflation, which is generally viewed as a negative outcome because of the significant downward adjustments in wages and output that are associated with it.

Inflation is also viewed as a hidden risk pressure that provides an incentive for those with savings to invest them, rather than have the purchasing power of those savings erode through inflation. In investing inflation risks often cause investors to take on more systematic risk, in order to gain returns that will stay ahead of expected inflation. Inflation is also used as an index for cost of living adjustments and as a peg for some bonds. In effect, inflation is the rate at which previous economic transactions are discounted economically.

Inflation also gives central banks room to maneuver, since their primary tool for controlling the money supply and velocity of money is by setting the lowest interest rate in an economy - the discount rate at which banks can borrow from the central bank. Since borrowing at negative interest is generally ineffective, a positive inflation rate gives central bankers "ammunition", as it is sometimes called, to stimulate the economy.

However, in general, inflation rates above the nominal amounts required to give monetary freedom, and investing incentive, are regarded as negative, particularly because in current economic theory, inflation begets further inflationary expectations.

Increasing uncertainty may discourage investment and saving.
Redistribution
It will redistribute income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and profits which may keep pace with inflation.
Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow. For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax.
International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade.
Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.)
Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.
Relative Price Distortions: Firms do not generally synchronize adjustment in prices. If there is higher inflation, firms that do not adjust their prices will have much lower prices relative to firms that do adjust them. This will distort economic decisions, since relative prices will not be reflecting relative scarcity of different goods.
Hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.
Inflation tax when a government can improve its net financial position by allowing inflation, then this represents a tax on certain holders of currency. Governments may decide to use this "stealth tax" in order to avoid hard fiscal decisions to cut expenditures, raise taxes, or confront government unions with greater efficiency.
Bracket Creep is related to the inflation tax. By allowing inflation to move upwards, certain sticky aspects of the tax code are met by more and more people. Commonly income tax brackets, where the next dollar of income is taxed at a higher rate than previous dollars. Governments that allow inflation to "bump" people over these thresholds are, in effect, allowing a tax increase because the same real purchasing power is being taxed at a higher rate.
As noted, some economists see moderate inflation as a benefit; some business executives see mild inflation as "greasing the wheels of commerce." A very few economists have advocated reducing inflation to zero as a monetary policy goal - particularly in the late 1990s at the end of a long disinflationary period, when the policy seemed within reach.

Causes of inflation
There are different schools of thought as to what causes inflation. Most can be divided into two broad areas: quality theories of inflation, and quantity theories of inflation. Many theories of inflation combine the two. The quality theory of inflation rests on the expectation of a buyer accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the equation of the money supply, its velocity, and exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.

Keynesian economic theory proposes that money is transparent to real forces in the economy, and that visible inflation is the result of pressures in the economy expressing themselves in prices.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":

Demand pull inflation: inflation from high demand for goods and low unemployment.
Cost push inflation: presently termed "supply shock inflation," from an event such as a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.
A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This has been seen most graphically when governments have financed spending in a crisis by printing money excessively (from war or civil war conditions), often leading to hyperinflation where prices rise at extremely high rates (such as, doubling every month). Another cause can be a rapid decline in the demand for money as happened in Europe during the black plague.

The money supply is also thought to play a major role in determining levels of more moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics by contrast typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians, the money supply is only one determinant of aggregate demand.

A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggested that price stability was a trade off against employment. Therefore some level of inflation could be considered desirable in order to minimize unemployment. The Philips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s.

Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.

Another Keynesian concept is the potential output (sometimes called the "natural gross domestic product"), a level of GDP where the economy is at its optimal level of production, given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.

However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under Prime Minister Margaret Thatcher in the UK may have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed (also see unemployment), unable to find jobs that fit their skills in the British economy. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.

Problems of inflation
If inflation is high in an economy there are three main problems it can cause:

People on a fixed income (e.g. pensioners, students) will be worse off in real terms due to higher prices and equal income as before; this will lead to a reduction in the purchasing power of their income.
Rising inflation can encourage trade unions to demand higher wages. This can cause a wage spiral. Also if strikes occur in an important industry which has a comparative advantage the nation may see a decrease in productivity and suffer.
If inflation is relatively higher in one country, exports will become more expensive for other countries to purchase, this will create a deficit on the current account.

Monetarism
One of the most influential schools of economic thinking rests on a quantity theory of money, namely monetarism. Monetarists assert that empirical study of monetary history shows that "inflation is always and everywhere a monetary phenomenon." Modern mainstream central bank practice until recently adhered closely to this concept.

These economists derive this belief from what is known as the Quantity Theory of Money. The Quantity Theory of Money, simply stated, is that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:



where P is the general price level of consumers' goods, DC is the aggregate demand for consumers' goods and SC is the aggregate supply of consumers' goods. The idea behind this formula is that the general price level of consumers' goods will rise only if the aggregate supply of consumers' goods goes down relative to the aggregate demand for consumers' goods, or if the aggregate demand increases relative to the aggregate supply of consumers' goods. Based on the idea that total spending is based primarily on the total amount of money in existence, the economists calculate aggregate demand for consumers' goods based on the total quantity of money. Therefore, they posit that as the quantity of money increases, total spending increases and the aggregate demand for consumers' goods increases as well. For this reason the economists who believe in the Quantity Theory of Money also believe that the only cause for rising prices in a growing economy (this means aggregate supply of consumers' goods is increasing), is an increase of the total quantity of money in existence, which is caused by monetary policies, generally of central banks where there is a monopoly on currency issue and the lack of a commodity peg to currency. The central bank of the United States is the Federal Reserve; the central bank backing the euro is the European Central Bank.

Answer 2

From a layman's perspective, inflation makes it so it costs more to buy the same product. Or, in other words, your money is "worth less" because you can't buy as much for the same amount of money. During the Great Depression, there was so much inflation that it cost more to buy firewood than it did to burn that cash in the fireplace instead. So basically, inflation is normal, but high inflation is bad.