What is inflation? What are the causes of inflation?

BlogNovember 30, 2021

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Inflation is understood as an increase in prices in the economy. However, economists prefer to measure with more specific indicators, namely the consumer price index (CPI) and adjusted national income index.

What is inflation?

Inflation is the continued increase in the general price level of goods and services over time and the loss of the value of money. When the general price level rises, a unit of currency buys fewer goods and services than it used to, so inflation reflects a decrease in purchasing power per unit of currency.

Inflation has 3 levels:

Natural inflation: 0 – less than 10% 

Hyperinflation: 10% to less than 1000% 

Super Hyperinflation: above 1000%.

In practice, countries expect inflation to occur only around 5% or less. Think about it, in a year when the economy is expected to grow about 10%, money depreciating by about 5% is good enough. That country has a real growth rate of 5%.

A classic example of hyperinflation: In 1913, before the world war broke out, 1 USD = 4 German Marks. However, just 10 years later, 1 USD was exchanged for 4 billion German Marks. At the time, newspapers published caricatures of the issue: People were drawn to people pushing a money trolley to the market just to buy a bottle of milk, or a picture showing the value of money. German Marks at that time were used only as wallpaper or as fuel.

Some other related concepts

Deflation: is a decrease in the general price level of the economy

Hyperinflation (over 1000%): is the highest type of inflation, has a destructive effect on the economy, following a spiral out of control. 

Reinflation: Efforts to raise the general price level to combat deflationary pressure

Causes of inflation?

You should temporarily consider money as an object of exchange in the time of barter. If an item has a price, that item will be exchanged for more than the other item. US Dollar (USD) is a currency of value, you can use it to buy goods anywhere as it is a universally supported and valuable currency.

As for a country with weak production, scarce goods, the price of goods increases. If the price increases, you have to spend more money to buy. But when money is too much inconvenience, the state will print large denomination bills to facilitate the circulation of goods more neatly. Then inflation started happening. There are many reasons but “demand-pull” and “cost-push” are considered as the two main causes.

Demand Inflation When the market demand for a certain commodity increase, the price of that commodity will also increase. Prices of other commodities also escalated accordingly, leading to an increase in the prices of most items on the market. Inflation caused by increased demand (increased consumer demand in the market) is called “demand-pull inflation”.

Cost-push inflation Cost-push costs of businesses include wages, input material prices, machinery, taxes, etc. When the price of one or more of these factors increases, the total costs of The production of enterprises also increased accordingly. Therefore, product costs will also increase to preserve profits. An increase in the general price level of the economy as a whole is called “cost-push inflation”.

Example: Wages make up an important part of production and service costs. Where wages increase faster than labor productivity, the total cost of production will increase. If producers can pass this cost increase on to consumers, then of course the price of the product will increase, workers and unions will demand higher wages to match the increased cost of living, which creates a valuation spiral. Another cost factor is the price of the raw material, in this case crude oil. Between 1972 and 1974, the international price of oil increased nearly fivefold, leading to an increase in worldwide inflation from 4.6% to 13.5%. However, the drop in oil prices in 1980 also brought inflation to an all-time low.

Structural inflation With an efficient business operation, enterprises gradually increase the “nominal” wages for employees. But there are also groups of businesses that do not work effectively, businesses that follow that trend are forced to increase wages for employees.

But because these businesses are inefficient, when they have to increase wages for workers, they are forced to increase the selling price of their products to ensure profits and generate inflation.

Inflation due to changes in demand When the market decreases the quantity demanded a certain product, while the quantity demanded another product increases. If the market has a monopolistic supplier and a firm price is below it, the good for which the quantity demanded is reduced will not decrease in price. On the other hand, when the quantity demanded increases, so does the price. As a result, the general price level increases, leading to inflation.

Inflation due to exports When exports increase, the aggregate demand increases higher than the total supply (the market consumes more goods than the supply), then products are collected for export, making the supply for the domestic market decrease (to attract row ). domestic supply) makes total domestic supply lower than aggregate demand. When aggregate supply and aggregate demand are out of balance, inflation will arise.

Import Inflation When the price of imported goods increases (due to an increase in import taxes or due to an increase in world prices), the domestic selling price of that product will have to increase. When the general price level is inflated by import prices, it will lead to inflation.

Currency inflation When the money supply in circulation in the country increases, for example, because the central bank buys foreign currency to keep the domestic currency from depreciating against foreign currencies; or because the central bank buys bonds at the request of the state, causing the amount of money in circulation to increase, which is also the cause of inflation.

Example: In 1966-1967, the US government used the extra money to pay for the escalating costs of the war in Vietnam. Inflation increased from 3% (1967) to 6% (1970). In the long run, the real interest rate (i) and real output (y) reach equilibrium, that is, (i) and (y) stabilize. The real money demand doesn’t change, so the M/P doesn’t change either. Accordingly, when the nominal quantity of money (M) increases, the price will increase by a corresponding proportion. So inflation is a monetary phenomenon. This is why the central bank pays so much attention to this cause.

How is inflation measured?

Inflation is measured by tracking the price changes of a large number of goods and services in an economy, often based on data collected by state organizations, labor unions, and government agencies. ten. motion and business magazine…

Consumer price index or CPI price index: calculated as a weighted average of a group of essential goods. The prices of goods and services are combined to create a price index that measures the average price, which is the average price of a set of products. The inflation rate is the percentage increase in the index.

In each period there may be an increase in the price of one good and a decrease in the price of another, but if the general price level rises then we have inflation. If the general price level falls, we have deflation. An increase in the price of some commodities such as sugar or rice does not mean inflation, but simply a temporary imbalance between supply and demand in the short term. When inflation occurs, the value of money decreases.

Example: In 2018, US CPI was $300,000. In 2019, the US CPI was 310,000 USD. So, the annual percentage inflation throughout 2018 is: ((310,000 – 300,000) / 300,000) x 100% = 3.33%

The Impact of Inflation on the Economy Inflation has an impact on a country’s economy in many ways, both positive and negative.

Positive Benefits Inflation does not always harm the economy. When the inflation rate is moderate, between 2-5% in developed countries and below 10% in developing countries will bring a number of benefits to the economy as follows:

Stimulate consumption, borrow, invest, reduce unemployment in the society. Allowing the government to more likely choose instruments to stimulate investment in less-priority sectors through credit expansion, helping to redistribute income and resources in a target-oriented society, and selectively over a certain period of time. However, this is a difficult and risky job, if not proactive, it will have bad consequences. In summary, inflation is a chronic disease of the market economy, it has both harmful and beneficial effects. When the economy maintains, controls, and regulates inflation at a moderate level, it will promote economic growth. Inflation of countries around the world, when occurring at high and prolonged levels, has adverse effects on all aspects of the economic, political, and social life of a country. In which, the first impact of inflation is the interest rate.

Real interest rate = Nominal interest rate – Inflation rate

Therefore, when the inflation rate is high, if the real interest rate is to be stable and positive, then the nominal interest rate must increase according to the inflation rate. An increase in nominal interest rates will lead to a recession and an increase in the unemployment rate.

*** Inflation and real income

There is a relationship between the real and nominal income of workers through the rate of inflation. When inflation increases but nominal income remain unchanged, the real income of workers decreases.

Inflation not only reduces the real value of non-yielding assets, but it also reduces the value of productive assets, i.e., reduces real income from interest and profits. That’s because the state’s tax policy is calculated on the basis of nominal income. When inflation is high, borrowers raise the nominal interest rate to compensate for the high rate of inflation even though the tax rate remains the same.

From there, the net (real) income of the lender equals the nominal income minus the inflation rate is reduced, which will greatly affect the socio-economic situation. When the economic recession, unemployment increases, workers’ lives are more difficult, it will reduce public confidence in the Government… When inflation increases, the value of money decreases, borrowers will benefit when installment loans for speculation and profit. Thus, increasing the demand for loans in the economy, pushing up interest rates.

High inflation also makes people who have excess money, rich, use their money to rob, plunder assets, speculate, to appear, this situation further seriously imbalance the supply-demand relationship. goods on the market, commodity prices also increased higher.

In the end, the people who are already poor are even more miserable. They could not even afford basic consumer goods, while speculators scoured the goods and became even richer. Such inflation will cause disturbances in the economy and create a large gap in income and living standards between the rich and the poor.

Inflation and national debt

High inflation makes the government benefit from income taxes levied on people, but foreign debts will be aggravated. The government benefits at home but will suffer from external debt. The reason is: Inflation causes the exchange rate to rise and the domestic currency to depreciate faster than the foreign currency in terms of debt.

Some options to control inflation

For each country, controlling inflation to protect the economy is always a top priority. There are many ways to curb inflation applied including:

  • Reduce the amount of money in circulation

Stop issuing money into circulation to reduce the amount of money put into circulation in society. Increase required reserve ratio: This is a measure to reduce the amount of money entering the market. This measure affects all banks and is equal among banks. Raising the rediscount rate and deposit interest rate: This measure will limit the fact that commercial banks bring valuable papers to the state bank for discounts. In addition, an increase in deposit interest rates will attract more depositors to banks. Central banks use open market operations to sell valuable documents to commercial banks. The central bank sells gold and foreign currency to commercial banks. Reducing budget expenditure: It is reducing recurrent expenditure and cutting public investment. Increase the consumption tax to reduce the spending needs of individuals in the society, increase the goods and services provided in the society.

  • Increase consumption fund to balance money in circulation

Promotion of free trade Measures to reduce taxes on imported goods

  • Borrowing foreign aid
  • Monetary reform

Above is the necessary information to help you understand what inflation is and the issues surrounding this concept. In summary, inflation occurs when there is a general increase in the prices of goods.

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