Combating Inflation
We all have heard of inflation several times in the news, however, most of us do not understand what this term means. Simply put, inflation is the rise of the prices of goods and services in an economy. Some causes of inflation are an increase in the costs of raw materials and wages or a sudden increase in the demand for a given good or service, causing its price to increase.
This reduction in value has disadvantages such as reducing the purchasing power of money. This is why governments create policies to tackle inflation. However, inflation can also be beneficial in some aspects. Read more to find out!
Inflation Explained - The Business Cycle
The Business Cycle consists of short-term fluctuations in the growth of real output, which are alternating periods of expansion (increasing real output/ GDP) and contraction (decreasing real output/ GDP). These expansions experience inflation. The periods in the Business Cycle have no given timelines. They can last for a few months or years.
The Costs of Inflation
Menu Costs - In economic terms, a menu cost is a cost to a firm that results from changing its prices. It is called “menu costs” because of the restaurant’s costs to print a new menu with the new prices. With inflation, the prices of goods and services increase but to evaluate by what amount these costs must increase takes time and effort and can be quite a costly activity.
Shoeleather Costs - These costs refer to the cost of time and effort that people spend trying to counteract the effects of inflation. Some examples include investing in different currencies, keeping less cash at hand, and making several trips to the bank. The name
“Shoeleather costs” come from the fact that walking to the bank wears out your shoes and causes you to buy new shoes - creating a new cost.Causes more inflation - With inflation rising more and more every day, consumers look to spend their money quickly while it still has some value, and the same applies to firms with their investments. However, this creates an unfortunate loop of more inflation. Because of higher spending and investing, prices continue to rise and so does inflation. Purchasing power continues to decrease and the supply of money outstrips the demand.
Income redistribution - Inflation has major effects on borrowers and lenders as well. It makes borrowers better off and lenders worse off. This is because borrowers must have borrowed money of X amount before the inflation and would have to pay back X+Y (added interest) to the lender. However, because the purchasing power of that X+Y amount has decreased they can pay their debts more easily. Inflation reduces the values of savings if they are in the form of cash or a bank with a low-interest rate.
Fiscal Drag - Because of inflation, workers will receive higher wages which means they will have to pay higher taxes because of their salary coming into the top income tax brackets.
Do We Need Inflation?
Although inflation is traditionally known as a bad impact on the economy it has some positive outcomes as well. Inflation is beneficial to the economy when it is running with unused labour resources or with a rate of unemployment greater than the natural rate. Inflation then helps increase production and more money printed results in more spending which equates to aggregate demand.
Inflation helps prevent the Paradox of Thrift. The paradox states that if the economy is becoming too productive with prices falling tremendously, consumers will wait to make their purchases, with a desire to catch the best deal. This causes a decrease in spending and in turn a decrease in production and more layoffs leading to greater unemployment of resources.
As discussed in the costs of inflation, inflation makes the lenders worse off but the borrowers better off. This is because they repay their loans with less valuable money. This encourages lending and borrowing, which increases spending and economic growth.
All in all, inflation is needed in small and steady amounts for economic growth and to reduce the unemployment of resources including labour.
Traditional Methods Of Reducing Inflation
According to classical economics, the money supply in an economy has a direct relationship with the changes in the prices of an economy. Therefore, by controlling money supply countries may control inflation. If the money supply is increased, prices will soar. If decreased, prices will fall. These changes to the money supply can be made by the country’s central bank - by open market operations, changing the reserve ratio, etc. Essentially, according to this theory, monetary policy becomes inflationary policy as well. This school of thought came to be known as monetarism.
However, the problem with monetarism is that it is not effective in the short run. Monetarism was seen to be effective in explaining the changes in the economy in the long run, only. Therefore, this school of thought was obsolete for understanding short-run inflation, and the policy implications were that the money supply was ultimately used as a long-run instrument.
Another traditional method to control inflation is making alterations to fiscal policy. By increasing or reducing taxes on consumers the government can control how much each consumer spends in the market, thus controlling demand. By increasing taxes, expenditure is reduced and vice-versa. This will lead to a fall in demand or a rise in demand, leading to lower and higher prices respectively.
The next aspect of fiscal policy would be wage control. By changing the minimum wages, the government influences firms to change their wages. With an increase in wages, workers will spend more, leading to higher inflation. Lower wages will incentivize them to spend less, which will lower inflation.
These methods aren’t perfect, though. Fiscal policy doesn’t always have the expected effect on the economy, sometimes increasing unemployment or market imperfections. Secondly, wages are sticky in an economy. Simply by changing the minimum wage laws, wages themselves take a lot of time to adjust. Expenditure is also a sticky phenomenon, where taxes have a very diminished effect. Therefore, new methods of dealing with inflation need to be looked at.
Contemporary Methods
Seeing the difficulties of traditional methods, newer techniques have been devised to predict and control inflation. In a recent experiment by researchers at Stanford, a machine learning algorithm was successfully used to predict national inflation. This was replicated in Costa Rica, India, and the United Kingdom.
Other research suggests that by controlling the market’s natural interest rate, inflation can be completely stabilized, without needing to change demand or wages. Further, by controlling the exchange rate of an economy, governments can control how much foreign assets their central banks hold. Thus by “exchange rate pegging” governments can control the net foreign assets of a central bank. These assets play a very important role in determining the money supply and the rate of inflation.
Therefore, by using technological developments such as AI and newer macroeconomic practices, inflation may be controlled.
Written by Rayandev Sen, Aryan Jain; edited by Alidar Kuatbekov
