Friday, October 10, 2008

Types and Causes of Inflation

Types and Causes of Inflation

Cost-push inflation is an increase in the price level caused by higher costs of production. The world experienced a dramatic increase in inflation in the 1970s when the Organization of Petroleum Exporting Countries (OPEC) caused the price of oil to quadruple, practically overnight. Cost-push inflation also can be caused when the unemployment rate becomes too low. This is frequently referred to as a tight labor market. For example, when unemployment is low, businesses may need to pay higher wages to attract new workers. Higher labor costs can lead to higher prices. This is one of the chief concerns of Alan Greenspan, the chairman of the Board of Governors of the Federal Reserve System.

A factor that contributes to cost-push inflation is the expectation of further inflation. For example, if the prices of most consumer products (e.g., groceries, clothing, rent) are increasing and people expect the inflation to continue, there is a natural tendency for people to ask for wage and salary raises to cover their increased living costs. Wage and salary increases, however, are increased labor costs for businesses. Higher costs of production lead to even higher prices for the consumer products and the expectation that the inflation will continue. Once inflation becomes entrenched in an economy, it tends to be self-perpetuating. Businesses seek higher prices for their products to cover increasing costs. In turn, workers seek higher wages & salaries to cover their increased cost of living. A key to reducing cost-push inflation is to break the cycle of expectations that the price level will continue to rise.

Demand-pull inflation is an increase in the price level caused by excess demand. It is often referred to as "too much money chasing too few goods." The link between the supply of money and the inflation rate is often made using the quantity theory of money. The quantity theory of money is based on the following axiom:

M = the supply of money (influenced by the Fed)
V = the velocity of money (the number of times a unit of money is typically spent)
P = the price level
Q = the quantity of output produced and sold

The left side of this equation measures the value of the products purchased in the economy. The right side of this equation measures the value of the goods and services produced and sold in the economy. The above equation is a truism because it states that the value of the goods and services purchased in an economy is equal to the value of the goods and services produced and sold in the economy. The quantity theory of money adds two assumptions to this equation. The first assumption is that the velocity of money is relatively constant. Measurements of the velocity of money indicate this is a fair assumption. The second assumption is that is that the quantity of output is relatively constant over time. This assumption is less realistic. If it were true, however, then the quantity theory of money predicts that any changes the price level (P) are caused by changes in the money supply (M). According to the quantity theory of money, the way to prevent demand-pull inflation is to keep the money supply (M) from increasing. This theory suggests a different conclusion if the assumption about the quantity of output (Q) remaining constant is relaxed. In order to keep inflation low, the price level (P) needs to remain fairly constant. If the economy’s quantity of output (Q) changes [and if the velocity of money (V) is relatively constant], then the way to keep the price level (P) constant is to change the money supply (M) in proportion to changes in output (Q). If real GDP increases by 3%, for example, then the money supply should also grow by 3%. Thus, if monetary policy is used to keep inflation low, it should try to increase the supply the money at the same rate as the growth of the economy’s real GDP.

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