Inflation can be defined as a persistent increase in the general level of prices. 'Persistent' alerts us to one important feature of inflation: it occurs over several periods. 'General' alerts us to another: inflation occurs throughout the economy, with the prices of many items rising in the same period. Inflation reduces the value of money because each dollar buys less.
High rates of inflation can have serious social, economic and political consequences. Some of the effects of rapid inflation are:
(i) It can penalize people on fixed incomes, like pensioners and self funded retirees, because their income does not rise as rapidly as prices, so they are able to buy fewer goods and services.
(ii) Inflations tend to redistribute income from low income groups to higher-income groups because low income groups have few real assets like property, which may rise in price, and are in jobs where it is difficult to get a pay rise to help offset the effects of inflation.
(iii) People lose faith in currency as a store of value and often borrow as much as possible to invest in 'real' assets like gold, houses and antiques, the price of which tend to rise faster than the general inflation rate.
(iv) Forecasts of the rate of return on capital investments become unreliable, and this makes businesses unwilling to undertake long-term projects. Because of this, future living standards may not be as high as they would have been.
(v) If the rate of inflation in a country is higher than those of its major trading partners, the ability of that country to compete on world markets is damaged.
(vi) High inflation rates lead to higher interest rates.
Different groups in society have different abilities to protect themselves from the effects of inflation. Powerful entities - trade unions, large companies, wealthy individuals - may be able to increase their share of national income at the expense of weaker groups - pensioners, the unemployed, and other groups that depend on social welfare. Thus, consistently high inflation can threaten social and political stability.
There is no single cause of inflation. Rather, at any given time, a number of factors interact to cause inflation. For example, a fall in the exchange rate may lead to an increase in the price of imports, which causes a genera! rise in the rate of inflation. Trade unions may react to this by seeking higher wages, which leads to an increase in the costs of businesses, which causes them to raise the prices of their goods and services. This scenario has happened in many countries of the world.
The main causes of inflation are:
(i) External factors, such as changes in exchange rates or changes in the price of goods. An example is oil prices during periods of war in the Middle East in the 1990s.
(ii) Excessive demand in the domestic economy. Suppliers of labor and goods and services seek to take advantage of the situation by raising their prices. This is usually described as demand-pull Inflation. It is sometimes associated with excessive rates of growth in the money supply.
(iii) If wages increase faster than the rate of increase in productivity, companies may find it necessary to raise prices to maintain profitability. This is known as cost-push inflation.
(iv) Government-induced price increases can cause the general rate of inflation to increase, for example, increases in indirect taxes raise the retail price of goods and services.
(v) As we have seen, what people think about prices can actually affect the level of inflation, creating a self-fulfilling prophecy; when people expect inflation to rise, they increase their prices, thus ensuring that inflation increases.