FREE ESSAY ON INFLATION

INFLATION

"INFLATION"
Inflation, in economics, is used to describe an increase in the value of money; in
relation to the goods and services it will buy. Inflation is the sustained rise in the
aggregate level of prices measured by an index of the cost of various goods and services.
Repetitive price increase cause the purchasing power of money and other financial assets
with fixed values, creating serious economic uncertainty. Inflation results when actual
economic pressures anticipation of future developments cause the demand for goods and
services to exceed the supply available at existing prices or when available output is
restricted by undecided productivity and marketplace constraints. Constant price
increases were historically linked to wars, poor harvests, political upheavals, or other
unique events.
Examples of inflation have occurred throughout history, but detailed records are not
available to measure trends before the Middle Ages. Economics historians have identified
the 16th to early 17th centuries in Europe as a period of long-term inflation. Major
changes occurred during the American Revolution, when prices in the U.S. rose an average
of 8.5 percent per month, and during the French Revolution, when prices in France rose at
a rate of 10 percent per month. Theses relatively brief events were followed by long
periods of alternating international inflations and deflations linked to specific
political and economic actions. The U.S. reported average annual price changes as
follows: 
1790 to 1815- up 3.3 %
1815 to 1850- down 2.3 %
1850 to 1873- up 5.3 %
1873 to 1896- down 1.8 %
1896 to 1920- up 4.2 %
1920 to 1934- down 3.9 %
Consumer prices accelerated during the World War 11 era, rising at an average rate of
7.0% from 1940 to 1948, and then stabilizing from 1948 to 1965, when annual increases
averaged only 1.6 percent. 
There is various kind of inflation. When upward trend of prices is gradual and irregular,
averaging only a few percentage points each year, inflation is not considered a serious
threat to economic and social progress. It may even stimulate economic activity: The
illusion of personal income growth beyond actual productivity may encourage consumption;
housing investment may increase in anticipation of future price appreciation; business
investment in plants and equipment may accelerate as prices rise more rapidly than cost;
and personal, business, and government borrowers realize that loans will be repaid with
money that has potentially less purchasing power. A greater concern growing is chronic
inflation. Chronic inflation tends to become permanent moving upward to even higher
levels as economic distortions and negative expectations are brought on. To accommodate
chronic inflation, normal economic activities are disrupted: Consumers buy goods and
services to avoid even higher prices, real estate speculation increases; businesses
concentrate on short-term investments; governments rapidly expand spending in
anticipation of inflated revenues; and exporting nations suffer competitive trade
disadvantages forcing them to turn to protectionism currency controls. In the extreme
form, chronic price increases become hyperinflation, causing the entire system to break
down. During a hyperinflation the growth of money and credit becomes explosive,
destroying any links to real assets and forcing a trust on complex barter arrangements.
As the governments try to pay for increased spending programs by rapidly expanding the
money supply, the inflationary financing of budget deficits disrupts economic, social,
and political stability.
There are many causes of inflation. The demand -pull inflation occurs when aggregate
demand exceeds existing supplies, forcing price increases and pulling up wages,
materials, and operating and financing costs. Cost-push inflation occurs when prices rise
to cover total expenses and preserve profit margins. A persistent cost-price spiral
eventually develops as groups and institutions respond to each new round of increases.
Deflation occurs when the spiral effects are reversed. To explain why the basic supply
and demand elements change, economists have suggested three substantive theories: the
available quantity of money; the aggregate level of incomes; and supply-side productivity
and cost variables. Monetarists believe that changes in price levels reflect fluctuating
volumes of money available, usually defined as currency and demand deposits. They argue
that, to create stable prices, the money supply should increase at a stable rate matching
with the economy's real output capacity. Critics of this theory claim that changes in the
money supply are a response to, rather than the cause of, price-level adjustments. The
aggregate level of income theory is based on the work of the British economist John
Keynes published during the 1930s. According to this approach, changes in the national
income determine consumption and investment rates; thus, government fiscal spending and
tax policies should be used to maintain full output and employment levels. The money
supply, then, should be adjusted to finance the desired level of economic growth while
avoiding financial crises and high interest rates that discourage consumption and
investment. Government spending and tax policies can be used to offset inflation and
deflation by adjusting supply and demand according to this theory. In the U.S., however,
the growth of government spending plus "off-budget" outlays (expenditures for a variety
of programs not included in the federal budget) and government credit programs has been
more rapid than the potential real growth rate since the mid-1960s. The third theory
concentrates on supply-side elements that are related to the significant erosion of
productivity. These elements include the long-term pace of capital investment and
technological development; changes in the composition and age of the labor force; the
shift away from manufacturing activities; the rapid increase of government regulations;
the diversion of capital investment into nonproductive uses; the growing scarcity of
certain raw materials; social and political developments that have reduced work
incentives; and various economic shocks such as international monetary and trade
problems, large oil price increases, and sporadic worldwide crop disasters. These
supply-side issues may be important in developing monetary and fiscal policies.
The specific effects of inflation and deflation are mixed and fluctuate over time.
Deflation is typically caused by depressed economic output and unemployment. Lower prices
may eventually encourage improvements in consumption, investment, and foreign trade, but
only if the essential causes of the original decline are corrected. Inflation primarily
increases business profits, as wages and other costs lag behind price increases, leading
to more capital investment and payments of dividends and interest. Personal spending may
increase because of buy now, it will cost more later attitudes; potential real estate
price appreciation may attract buyers. Domestic inflation may temporarily improve the
balance of trade if the same volume of exports can be sold at higher prices. Government
spending rises because many programs are explicitly, or informally, indexed to inflation
rates to preserve the real value of government services and transfers of income.
Officials may also anticipate paying larger budgets with tax revenues from inflated
incomes. The impact of inflation on individuals depends on many variables. People with
relatively fixed incomes, particularly those in low-income groups, suffer during
accelerating inflation, while those with flexible bargaining power may keep pace with or
even benefit from inflation. Those dependent on assets with fixed nominal values, such as
savings accounts, pensions, insurance policies, and long-term debt instruments, suffer
erosion of real wealth; other assets with flexible values, such as real estate, art, raw
materials, and durable goods, may keep pace with or exceed the average inflation rate.
Workers in the private sector strive for cost-of-living adjustments in wage contracts.
Borrowers usually benefit while lenders suffer, because mortgage, personal, business, and
government loans are paid with money that loses purchasing power over time and interest
rates tend to lag behind the average rate of price increases.