Price Stability
Inflation
The rise in the general levels of prices for both goods and services and a consequent fall in an economies money power indicate inflation. Inflation also affects the saving rate negatively hence diminishing the purchasing power of savings. Inflation Occurs when there is too much money in circulation in an economy. Demand-pull inflation is the first type of inflation followed by Cost-push inflation. In demand pull inflation an increase in aggregate demand causes the general price level to rise, the quantity theory of money is included and too much money in the economies circulation creates more demand for the same number of goods and services. While in the Cost-push inflation the production costs of goods rises causing aggregate supply to decrease.
Evaluation of Inflation
Inflation is evaluated by adjustments in Price Indices like Consumer and Producer indices where the Consumer Price Index measures price changes of approximately 364 frequently used consumer goods and the Producer Price Index measures price changes in approximately 3,000 consumer goods before they arrive at the retail level, The Gross National Product needs to be considered when evaluating a countries inflation.
A simple example to measure inflation suppose that a representative market basket of the yearly expenditure of students is 1000 for commodity A, 1000 for commodity B, 500 for commodity C and 10 for commodity D.
COMMODITYMARKET
BASKETPRICE 1
YEAR 1PRICE 2
YEAR 2PRICE 3
YEAR 3A100020.0021.0019.00B100013.0015.0018.00C50015.5014.0020.00D10120.00135.00165.00MARKET BASKET (B) B141950B244350B348650PRICE INDEX (P)P1100P2105.7P3116
The total cost of a basket is calculated by multiplying the quantities by their respective prices and getting the sum of everything. It can be seen that between the first and second year, the cost of this basket of goods has risen from 41,950 to 44,350 or by 5.7. From the first to the third year, the cost has risen from 41,950 to 48,650, or by the equivalent of 16. The price index could also be used to express the same information. In order to calculate the price index, the cost of the market basket in any period is divided by the cost of the market basket in the base period, and the result is multiplied by 100. In the table above, year 1 is the base period. Therefore, the price index of year two and three is calculated by the formulae
Price Index (year 2) P2 (B2B1)100 (4435041950)100 105.7 and
Price Index (Year 3) P3 (B3 B1)100 (4865041950)100 116 respectively.
As shown by the example, the price index may increase despite some prices actually declining. From the first to the third year the price index has risen by 16, this clearly depicts inflation.
Controlling Inflation
For many years controlling inflation has been prioritized by the UK government. The UK government through the Bank of England (MPC) is trying to control inflation by stabilising prices. Price Stability is one of the best ways of controlling inflation. Price stability is a situation in which prices in any given economy do not change much over time, in other words an economy with stable prices would not experience an increase in the general levels of prices for both goods and services. The following arguments supported by economic evidence will explain in great detail how the central bank that maintains stable prices in an economy contributes significantly to the accomplishment of broader economic goals. In many countries, methodologies and periods, display that in the long-run, economies with decreased inflation on average grow more swiftly in real terms.
Price stability decreases inflation uncertainty hence preventing resource misallocation by assisting the market to guide resources to productive use. Lasting stable prices increases the competence of the economy and households. Secondly, creditors will never demand an extra return (called inflation risk premium) if they can be guaranteed that the prices will remain stable. By decreasing such risk premium, lower nominal interest rates will be brought about. Stable prices contribute to the effectiveness with which the capital markets distribute resources hence increasing investment incentives hence fostering job creation and economic well being.
Thirdly, tax and welfare systems can build incentives which alter economic behaviour. In many cases, these alterations are worsened by inflation, as fiscal systems do not normally allow for the indexation of tax rates and social security contributions to the inflation rates. For instance, the salary increases meant to compensate employees for inflationary developments could result in workers being subject to a much higher tax rate. Price stability decreases these misrepresented effects associated with the impact of inflationary development on taxation and social systems. Fourth, preserving stable prices avoids considerable economic, social and political problems associated with the arbitrary redistribution of income and wealth experienced during most inflation times. This is evident in particular if changes in the levels of prices are complex to anticipate, and for the cluster in society who have a difficulty protecting their supposed claims against inflation. For instance, with the existence of an unexpected rise in inflation, everybody with supposed claims in the form of longer term wage contracts, bank deposits or government bonds, incur losses in the real value of their claims. Riches are then shifted in an arbitrary way from lenderssavers to the borrowers because the value of the money in which a loan will have ultimately been repaid will have decreased, hence buying fewer items than was expected when the loan was given.
Effects of Inflation
As the prices for food, commodities and services increase and the currency weakens we notice some of the following effects increased costs where the customers have to pay more for energy commodities, food, transport and even services, this price rise effect will be significant for imported goods like oil. Inflation can also cause loans to become costlier since most loan rates will increase, so individuals are forced to pay more for the commodities acquired through loans like vehicles and homes. To guarantee continued existence or growth of on going projects, companies may cut down on their expenditure by reducing their working cost, these may cause a decrease in allowances and annuities and a drop in parties and travels. Inflation, by all means, may also cause a reduction in the returns from investments this mainly have an effect on persons who seek monthly returns for their investments since fixed bank deposits and mutual fund returns yield low or negative returns when adjusted for inflation.
Who Gains, Who Loses
A large number of people have vested interests in terms of the price rise that it causes. For instance, economists, politicians and others with interests in the persistence of the policies causing inflation in some cases choose to pretend that there is no inflation or they can minimise its extend for the prolonged period when inflationary forces manifest themselves in ways other than in pushing prices higher. In other cases, econometric technicians ignore the current levels of inflationary forces until those forces cause prices to rise to a measurable level. Highrising inflation causes unemployment of labour and capital assets. It becomes very difficult for firms to employ more labourers when the prices of the resources required by the firm increase concurrently with the decrease in the value of the money the employees receive for their labour. In other cases the employees are retrenched because the firm may fail to afford their salaries since some labour unions may begin to ask for pay rises for the sake of their union members.
According to Blatt 2004, classically, the poorest cluster of society habitually suffers the most from inflation, due to their limited possibilities to hedge against inflation. Price stability thus helps uphold social unity and stability. Throughout the 20th century , high rates of inflation has often created social and political instability as those clusters who incur losses due to inflation feel cheated if inflation acts like a tax and eventually taxes away quite a good portion of their savings.