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1、 TABLE OF CONTENTSINTRODUCTION91.DEFINITION OF INFLATION102.HISTORY OF INFLATION103.MODERN DAY MEANING OF INFLATION104.CONSUMER PRICE INDEX115.INFLATION RATE126.CAUSES OF INFLATION147.EFFECTS OF INFLATION158.CONTROLLING INFLATION15CONCLUSION16REFERENCES20INTRODUCTIONThe purpose of this project is to
2、 clearly define INFLATION, identify its causes and effects and the ways of effectively controlling it. This assignment is designed to provide clear understanding of what inflation is. Further the essay will outline the causes and effects of inflation in the economy as a whole and will identify measu
3、res on how the government can influence and effective control inflation to the advantage of the state economy.1.DEFINITION OF INFLATIONIn Economics, Inflation is a rise in the general level of prices of goods and services in economy over a period of time. (Michael Burda and Charles Wyplosz(1997), Ma
4、croeconomics: A European text, 2nd ed., p. 579 (Glossary)2.HISTORY OF INFLATIONThe origin of Inflation dates back to the time when gold was used as the purchasing medium in trading goods. It is a term which was referred to a condition of currency. It was originally referred to as the devaluation of
5、the currency. The best example to show this devaluation is when a ruler or a king collects gold from his people and subsequently melt these down then mix it with other semi-precious metals such as silver, copper or lead to increase the coins in circulation without the need to increase the amount of
6、gold to produce them. And when the ruler or king adopts this practice, the supply of coins in circulation would increase but will ultimately decrease the value of the coin. Once the value of the coin declines, it would increase the number of coins required to exchange for goods or services. Applying
7、 the basic concept of the Law of Supply and Demand in Economics, this would mean that as the value of a coin decreases due to a generous supply in circulation, there is a proportionate increase in the number of coins required in exchange of goods or services And although this will increase the money
8、 supply, the value of the coin is decreased. When the relative value of the coin decrease, the consumers would require more coins to purchase and would experience a price increase with the decline of the coins value.3.MODERN DAY MEANING OF INFLATIONFor many years inflation was not related to price b
9、ut rather a condition of currency as described above. Over the years and with many arguments amongst economists, what was once described as a monetary cause now is being described as a price outcome. (Michael F. Bryan, 1997, On the Origin and Evolution)In the modern day, we hear different types of i
10、nflation. It is a word often used synonymously with price increase. In todays economy, Inflation is defined as the sustained rise of the average price level of a country over a period of time. (http:/en.wikibooks.org/wiki/IB_Economics/Macroeconomics)4.CONSUMER PRICE INDEXThe rate of inflation is mea
11、sured by the annual percentage in the level of prices as measured by the Consumer Price Index (CPI). (Robert Hall and John Taylor (1986), Macroeconomics: Theory, Performance, and Policy, page 5. The Consumer Price Index measures prices of a selection of goods or services purchased by a typical custo
12、mer. The Consumer Price Index aims to measure how consumers purchasing power is affected by rising prices. (Blanchard et al, 1993, 2000, 2002) It measures the process of a selection of goods and services purchased by a typical consumer. (Mankiw 2002, p.22-32) Household expenditure surveys are perfor
13、med which seeks to measure what people spend their money on to get a typical basket of goods. This basket of goods is updated each year to take into consideration changes in expenditure. The basket of goods gives relative importance to each different item and changes in the prices of goods or servic
14、es monthly are monitored and combined into a single figure with using weights in the basket.The below is the typical basket of goods and services for UK consumers:(Consumer Prices Index and Retail Price Index: the 2008 Basket of Goods and Services, National Statistics Office, 2008)5.INFLATION RATETh
15、e Inflation rate is the percentage rate of change of a price index over time. (http:/en.wikipedia.org/wiki/Inflation_rate) It is calculated using the Inflation rate formula:CPI Current - CPI Previous=Current Inflation Rate CPI PreviousCPI April September 2008(First Release: Consumer Prices Indices,
16、September 2008 p.1, National Statistics Office)Applying the formula of calculating the Inflation rate using actual data from the National Statistics Office, the resulting inflation rate over the 3 month period from April to June 2008 is 1% which means that the general level of prices for typical UK
17、consumers rose approximately by 1% over a three-month period. And over a six-month period, April to September 2008, Inflation rate was at 2.51% which is 151% increase from the Inflation rate calculated in June 2008.April to June 2008 109.00 - 107.60 =1.00% 107.60 April to September 2008 110.30 - 107
18、.60 =2.51% 107.60 In general, high or unpredictable inflation rates are harmful to the economy as a whole. They make it difficult for companies to develop budgets and long-term plans and this contribute inefficiencies in the market. After several and serious debates that economists had over the peri
19、od of years, there is an underlying agreement that in the long run Inflation is essentially a monetary phenomenon. In contrast, in the short term and medium, it will be affected by the supply and demand in the economy, taking into consideration the elasticity of wages, prices and interest rates. (Fe
20、deral Reserve Boards semiannual Monetary Policy Report to the Congress Roundtable Introductory statement by Jean-Claude Trichet on July 1, 2004)The measured inflation rate at any point in time will be made up of an array of individual price changes. But the amount of inflation in the economy is abou
21、t more than just the sum of all individual price changes. Something more fundamental determines the amount of inflation in the economy - whether it is 1%, 10 or 100%. (http:/www.bankofengland.co.uk/education/targettwopointzero/inflation/whatCausesInflation.html)6.CAUSES OF INFLATIONOne of the most e
22、vident underlying causes of the rise of inflation is going back to the fundamental law of economics which is the Law of supply and demand. When demand increase above what companies can produce at a normal level there will be an upwards pull on costs and prices. So to produce more, the companies incr
23、ease their demand for resources which may result in the rise of production costs and prices.Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Robert Barro and Vittorio Grilli (1994), European Macroeconomics, Ch. 8, p. 13
24、9, Fig. 8.1) Views on which factors determine moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. The cons
25、ensus view is that a sustained period of inflation is caused when money supply increases faster than the growth in productivity in the economy. (Mankiw 2002, pp.81-107 Abel & Bernanke 2005, pp.266-269)However, the ultimate cause of inflation can be said to be the central banks which permits an incre
26、ase in the monetary supply. (Ludwig von Mises, The Theory of Money and Credit). The behavior and action of the central banks determine whether inflation is allowed to rise or to be kept low. In other words, whether they allow price to rise unchecked by monetary policy, or whether central banks seeks
27、 to influence the amount of money in the economy by changing the interest rates. (Bank of England, 2000-2009)7.EFFECTS OF INFLATIONAs Inflation is caused by several different factors, it also has it effects. Inflation contradicts the assumption that money has a fixed rate and that it is stable, this
28、 defeats the concept of historical value as basis of a traditional accounting. (Massone, 1981a. p.6) Rising inflation affects the salary demands of employee and prompts for higher salaries with the effect of fueling inflation. And with prices of commodities expected to rise as a result of inflation,
29、 people tend to hoard to get rid of excess monies before it gets devalued and can buy lesser goods. Hoarding creates shortage in supply which causes the increase in the prices of commodity as demand for them increase with their scarcity.The task of keeping the rate of inflation low is usually given
30、to monetary authorities who establish monetary policy. Generally today these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements. (Bank of E
31、ngland, Monetary Policy Framework, 2006)An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services.(Bulkley, George (3 1981), Personal Savings and Anticipated
32、 Inflation. The Economic Journal 91 (361): pp. 124-135, http:/www.jstor.org/pss/2231702. Retrieved on 18 November 2008) The effect of inflation is not distributed evenly, and as a consequence there are hidden costs to some and benefits to others from this decrease in purchasing power. For example, w
33、ith inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Inc
34、reases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments. (Taylor, Timothy, 2008, Principles of Economics)The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant.
35、 In many countries, employment contracts, pension benefits, and government entitlements (such as social security) are tied to a cost-of-living index, typically to the consumer price index. (Flanagan, Tammy, 2006). A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-livin
36、g index. Salaries are typically adjusted annually. (COLA Wars. Government Executive. National Journal Group)They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.Annual escalation clauses in employment contracts can specify retroactive or future per
37、centage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally-determined indexes. Most economists and compensation a
38、nalysts would consider the idea of predetermined future cost of living increases to be misleading for two reasons: (1) For most recent periods in the industrialized world, average wages have increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity
39、 and worker bargaining power rather than simply living costs, and (2) most cost-of-living indexes are not forward-looking, but instead compare current or historical data.In general wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies
40、designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourag
41、e future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is over consumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread mak
42、ing by the market to satisfy future needs, thereby exacerbating the problem in the long term.8.CONTROLLING INFLATIONAs Inflation affects the economy as a whole and that the ultimate cause of inflation are the central banks and the measures they apply, they are also the agency who can ultimately cont
43、rol inflation. The task of keeping the rate of inflation low is usually given to monetary authorities who establish monetary policy. Generally today these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market o
44、perations, and through the setting of banking reserve requirements.(Taylor, Timothy, Principles of Economics, 2008)Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of
45、money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy (Monetary Policy, Federal Reserve Board, January 3, 2006) Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either be
46、ing an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a concretionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest r
47、ates, while concretionary policy involves raising interest rates in order to combat inflation. Monetary policy should be contrasted with fiscal policy, which refers to government borrowing, spending and taxation.(B.M. Friedman Monetary Policy, International Encyclopedia of the Social & Behavioral Sc
48、iences, 2001, pp. 9976-9984 )The Bank of England, being the central bank of the United Kingdom must formulate and implement a monetary policy in the areas of money, banking and credit with the main aim of maintaining prices conducive to balanced and stable economic growth. In addition, it must promote and preserve monetary stability. The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks reserves on deposit at the central b